Using Dynamic Distributions For Your Retirement Income
As we’ve been discussing in our series of retirement income, there are so many different ways that you can generate income in retirement. You have annuities, reverse mortgages, rental real estate and things like the 4% rule which govern how you can distribute money from your traditional stock/bond portfolio.
Today, I want to cover additional strategies that will give you guidance on how much money you can take from your investment portfolio.
Last week we talked about a popular strategy called the 4% rule, which is a form of a static distribution strategy.
This week we will cover three strategies that are grouped as Dynamic Distribution Strategies, and how you can use them to generate an income in retirement.
We are also going to discuss how it’s different compared to static distributions strategies like the 4% rule.
What are dynamic distributions?
Dynamic distributions are a retirement income strategy that will adjust how much money you spend depending on a number of factors. These factors depend on which strategy you choose, but they can include your current total investable portfolio, the recent returns on your portfolio, and the inflation rate.
Dynamic distributions are designed to make your retirement portfolio last while adjusting to those factors in your life that change on a regular basis.
Why it works compared to static distributions
Dynamic distributions are different from static distributions because a dynamic strategy allows you some flexibility when it comes to withdrawing money for your retirement.
Static distributions, like the 4% rule, assume you will be spending at the same level throughout your retirement, adjusted for inflation. As we’ve discussed previously on this podcast when we talked about the Retirement Smile, your expenses in retirement simply won’t work like that. It’s not reality for you to spend the same amount of money each and every year. Life doesn’t work that way.
In addition, static distributions don’t account for one-time withdraws from your retirement account, which you will also inevitably need at some point in your retirement.
So for these reasons, a dynamic distribution strategy in retirement changes as your life changes, which I think makes a lot more sense than assuming expenses will continually be the same over the entirety of your life.
Three types of popular dynamic distribution strategies
Now that you see what dynamic distribution can offer, let’s take a look at some of the top dynamic distribution strategies (and yes, there are more than this, but we will just be covering three of them today).
1. Withdraw a fixed percentage per year
This is one of the simplest ways to use dynamic distributions, simply withdraw a fixed percentage of your portfolio per year, every year.
Note: this is different from the 4% rule! The 4% rule assumes you take out 4% in your first year of retirement, and then adjust for inflation every year.
This strategy is different, in that you take out a fixed percentage of your account value every single year.
Now this strategy has some merit. First, You will never run out of money, because it’s simply not possible. You are only taking out 4% per year, so if you follow that, there’s no way you can run out of money.
In addition, if your portfolio increases from 1M to 1.5M, you will be able to increase your income. 4% of $1M is $40K. So if in a couple years your portfolio grows that much, to $1.5M, then your new distribution will be $60K. So that’s a significant increase in your income, and you were rewarded with that because your portfolio grew so much.
On the other hand, if your portfolio drops, then your income will drop as well. If your $1M account drops to $700K, which has happened before and will happen again, then your $40K distribution will drop to $28K per year.
So with a fixed percentage per year, you can withdraw more when the market is up and withdraw less when the market is down. This allows you some flexibility in terms of your income when your portfolio is doing well, while protecting your portfolio (and your retirement) from disaster when we have poor market performance. The reason it does that is because you intentionally lower your income when your portfolio is doing poorly, which is really important in ensuring the longevity of your portfolio and making sure your money lasts as long as you do.
2. The Vanguard Spending Rule
The Vanguard Spending Rule is another type of dynamic spending. Here’s how it works:
-You select an initial withdrawal rate, between 3.5% and 5.5%, depending on your portfolio allocation as well as your risk tolerance.
-You spend that money in your first year of retirement.
-At the end of the first year, you see how your portfolio has performed, and you set a floor as well as a ceiling, in terms of how much you will spend next year
-The floor (ie, the decrease) in spending is set at 1.5%. So the most you will spend less from year to year is 1.5%
-The ceiling (ie, the increase) in spending is set at 5%. So the most you will increase your income from year to year is 5%
-Your spending for the next year will be dependent on the rate of return, and if it falls within that floor and ceiling (-1.5% up to 5%), or if it falls outside of it.
-If it falls inside of that range, then set your new distributions at whatever initial withdraw rate you selected originally (let’s say 5%).
-If your rate of return was greater than your ceiling, increase your spending only by the amount of the ceiling (5%)
-If it was lower than your floor, reduce your spending only by the amount of the floor (1.5%)
Here’s an example of how the Vanguard Spending Rule with work with a $1 million dollar portfolio:
Let’s say you have a $1 million portfolio, and select a 5% distribution withdrawal rate. That works out to $50,000.
During the year, your portfolio returns 15%.
In this case, even though your portfolio was up by 15%, you can only increase your income by 5%, up to $52,500.
On the other hand, let’s say you started with $1M, but your portfolio has a negative 10% rate of return. You wouldn’t need to lower your income by 10%, you only lower it by 1.5%. So your $50K of income only drops to $49,250.
And you repeat this process every year. There is a lot to this strategy, it’s a little more difficult to maintain in my mind, but it accounts for changes in your portfolio every single year which is a really important component of retirement income.
According to Vanguard, by incorporating dynamic spending, with a 1.5% floor/5% ceiling, that retirees could withdraw 5% a year and have an 85% level of confidence that the portfolio would last through 35 years.
3. Guyton-Klinger Spending Decision Rules/ AKA Financial Guardrails
The Guyton-Klinger Spending Decision Rules was designed by Jonathan Guyton, certified financial planner (CFP) and William Klinger. The distribution is based on the following rules:
- Initial Withdrawal – The initial withdrawal is typically set between 4 and 6% of the account balance, depending on the risk tolerance of the investor and some other factors. I personally think 6% is a little high but I’m conservative when it comes to this stuff! The original withdrawal used in the study was 5.6%.
- Overall Strategy – You are trying to keep spending between two “financial guardrails”. You have your top guardrail and your lower guardrail. You want to make sure your spending falls somewhere in between those two.
- Capital Preservation Rule – Reduce annual spending by 10% if current withdrawal exceeds 20% of the initial withdrawal rate. So if your portfolio goes down by over 20%, then you will reduce your annual spending by 10% so that you are not distributing too much money while your portfolio is down significantly.
- Prosperity Rule – Increase annual spending by 10% if the current withdrawal rate falls 20% below the initial withdrawal rate. So if your portfolio goes up by over 20%, then you will increase your spending by 10% to reward yourself for good performance, and to ensure that you don’t leave too much money left behind.
- Example: You start with 5% withdrawal and we have our guardrails set up between 4 and 6% of the portfolio. And what we are trying to track here is that your withdrawals are between these percentages. So if your withdrawals start at 5%, but your portfolio falls to the point where your distributions exceed 6% of the portfolio, then we would cut your income by 10%, to get you back into the 4-6% range. And we would need to do that because your withdrawals are outpacing your investment growth.
- On the other hand, if your portfolio grows so much that your initial 5% withdrawal is now less than 4%, we would give you a 10% increase in income so that you are back into the 4-6% range, and enjoying the fruits of your labor and savings that you’ve accumulated.
- Withdrawal Rules – If your portfolio goes up over the course of the year, then you can get an increase for inflation. But if your portfolio goes down over the course of the year, you typically do not increase your income the next year, it stays the same (so long as it’s within the guardrails).
According to the study originally done by Guyton and Klinger, by following these sets of rules, you can have an annual withdrawal rate as high as 5.6% with a more than 99% chance of preserving your portfolio, depending on the portfolio allocation and your risk tolerance.
Why you will want to consider a dynamic distribution strategy for your retirement
Now that you have some understanding of dynamic distributions, let’s take a look at some reasons why you will want to consider this strategy for your retirement:
1. Allows you to raise your spending when your portfolio is doing well
During bull market times in the market, when things are going well, you will be able to comfortably raise your spending. This will allow you the opportunity to upgrade your lifestyle without worrying about overspending during your retirement.
2. Allows you to protect your portfolio when your portfolio is not doing well
During bad market times, in a dynamic distribution strategy, you will lower your spending without worrying about completely destroying your portfolio, because you will be selling less shares during a bad period in the market, which is really important. This can give you peace of mind during your retirement.
3. Allows you to better budget your retirement
When you have set rules in place when it comes to your retirement distributions, you will be better able to budget and plan. This takes the guesswork and uncertainty out of your retirement spending.
4. And most importantly, it protects the longevity of your retirement assets.
We’ve covered a lot, so I think the main points I want to make as we wrap up is that with dynamic distributions, you can have better control over your retirement portfolio as it will adjust to real-time factors in your life, as opposed to a simple, static distribution amount that is set for 30 plus years of your retirement.
Before you choose any of these strategies, I know I’m biased, but I think it’s so important to meet with a professional to discuss the pros and cons and decide which one is best for you. If you’d like to speak to me about your retirement income, I’d be happy to chat. You can schedule a time with me at StartMyRetirement.US