RMDs a Viable Draw-Down Strategy

The Center for Retirement Research (CRR) at Boston College analyzed the traditional rules of thumb for withdrawal—including spending interest only, basing withdrawals on life expectancy or adopting the 4% rule—and compared them with the IRS’ RMD strategy (or a percent of assets that individuals are required to withdraw each year starting at age 70.5). In comparing the RMD with the 4% rule, the RMD strategy performed better. In dollar terms, a 65-year-old couple would need about $25,000 more (or 10%) of their $250,000 savings to be persuaded to use the 4% rule instead of the RMD strategy.

A spending interest only strategy can work for wealthy individuals, but has drawbacks for those who lack substantial retirement savings. One disadvantage is that when an individual dies, he will leave behind all of his initial wealth plus capital gains. In some cases, this unnecessarily restricts retirement consumption. Another drawback is that a retiree’s income and consumption are dictated by his asset allocation, running the risk of a portfolio allocation that does not minimize the risk for any given level of expected return on the portfolio. In other words, the retiree may overinvest in dividend-yielding stocks, losing the benefits of diversification.

A second strategy is to spend all financial assets over one’s life expectancy. The equation to calculate this is not simple for most people, and retirees face a high probability (a 50% chance) they will outlive their savings and be forced to rely solely on Social Security.

Spending a fixed percentage of one’s initial retirement savings is another popular strategy, commonly known as the 4% rule. The advantage is that the retiree has a low probability of running out of money; the drawback is that the rule does not permit retirees to periodically adjust consumption in response to investment returns. For instance, if returns are less than expected in a given year, the retiree should respond by reducing consumption to preserve the assets—a fixed 4% withdrawal does not allow this flexibility.

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The alternative strategy is to follow the IRS’s required minimum distributions, a strategy that is easy to follow, the brief said. The IRS stipulates withdrawal percentages based on life expectancy tables. Furthermore, it allows the percentage of remaining wealth consumed each year to increase with age, as the retiree’s remaining life expectancy decreases. Since the consumption is not restricted to income, the household is less likely to chase dividends and more likely to have a balanced portfolio. Additionally, consumption responds to fluctuations in the market value of the financial assets, because the dollar amount of the drawdown is based on the portfolio’s current market value.

A potential criticism of the RMD rule is that it results in relatively low consumption early in retirement. This outcome might be optimal for some households, particularly those fearful of rising health care costs, but others might prefer greater consumption at younger ages when they are better able to enjoy it. This can be achieved through a modification of the RMD rule, or to consume interest and dividends but not capital gains, plus the RMD percentage of financial assets. For example, a 65-year-old couple with financial assets of $102,000 who received $2,000 of interest and dividends in the last year would spend $5,130 (the $2,000 in interest and dividends plus the 3.13% annual RMD of $100,000). In contrast, a household following the unmodified RMD rule would spend just $3,130.

Rather than attempt the complicated calculations for drawing down and spending retirement savings, retirees rely on easy-to-follow rules of thumb such as the 4% rule, the brief said. The IRS’ RMD rule may be a viable alternative, the brief suggests, and a modified RMD strategy performs even better.

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