The Advantages of a Dynamic Retirement Income Strategy

January 13, 2015

by Joe Tomlinson

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Retirees will adjust their spending depending on investment experience. But most research uses withdrawal strategies that are fixed at inception, such as the 4% rule. I’ll show that when spending can adjust each year, retirement outcomes will improve. I’ll also show the gains that can be achieved by adding annuities.

Fixed strategies are straightforward to analyze. Consider the most prominent fixed strategy, the 4% rule.  Here, the first year retirement withdrawal is set at 4% of the initial portfolio, and withdrawals increase at the inflation rate each year thereafter.  The primary performance measure for this strategy is the failure rate – the percentage of Monte Carlo runs or historical simulations where the retiree depletes savings over a specified timeframe. Tests with different asset allocations determine the allocation that results in the lowest failure rate.

With dynamic strategies, where retirement withdrawals adjust based on realized investment performance, the asset allocation will affect the withdrawals and therefore levels of retirement consumption. Testing different asset allocations thus requires comparing not only failure rates but also levels of retirement consumption. A further complication is that more aggressive asset allocations will likely give rise to more variation in year-to-year consumption. Consumption paths that are high and variable will then need to be evaluated against others that are lower but steadier.

I’ll utilize an example and begin with withdrawals based on the 4% rule as a base case. I will then switch to a dynamic withdrawal strategy to show how retirement outcomes improve. I’ll expand the example by adding the option to purchase single-premium immediate annuities (SPIAs) and show how the outcomes can be further improved.

The example

This comparison of strategies will be based on a 65-year-old female with a 25-year life expectancy who has reached retirement with $1 million of savings that she will use to fund her retirement. She has chosen to defer Social Security to age 70 and set aside additional funds to generate income during the interim five years. She also has funds set aside for emergencies and has a plan for potential long-term-care needs that does not depend on the $I million. The $1 million can be dedicated solely to generating retirement income. Her objectives, loosely stated, are to generate a high level of retirement income with some variation from year-to-year but not too much. She doesn’t care about leaving a bequest.

Her basic living expenses are $50,000 increasing with inflation each year, and she will receive an inflation-adjusted $20,000 per year from the combination of Social Security starting at 70 and five years of withdrawals from the interim funds. She needs to fill a gap of $30,000 in real dollars to meet basic living expenses, and additional withdrawals can be used for discretionary spending. Her investment options include stocks with an arithmetic real return after inflation and expense charges of 5.35% and a standard deviation of 20%, and bonds with a 0.60% real return and 5.5% standard deviation. Later we will add the option of purchasing an inflation-adjusted SPIA with an initial annualized payout rate of 4.61%.

The assumed returns are significantly lower than historical averages, reflecting current interest rates and a lower-than-historical equity risk premium. The SPIA pricing is the current rate from a direct-purchase site. Monte Carlo simulations are used to generate yearly returns, and the year of death is also modeled stochastically. The analysis is pre-tax and future dollar figures are discounted for inflation and stated in real terms.

Fixed strategy

I’ll start with a 4% rule withdrawal strategy to establish a base case for comparison. Chart 1 shows outcomes based on different asset allocations.

Chart 1: Comparison based on fixed withdrawal strategy (4% rule)

Stock/Bond Mix Average Consumption Cert Equiv Consumption Failure Percentage Average Shortfall Median Bequest
0/100

$55,970

$46,551

44.8%

-$94,330

$57,433

25/75

$57,698

$51,751

24.8%

-$52,284

$291,975

50/50

$58,014

$53,704

21.0%

-$43,906

$515,542

75/25

$57,690

$53,631

20.1%

-$49,022

$724,131

100/0

$56,818

$52,156

23.7%

-$68,013

$768,259

Source: Author’s Calculations

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