Here’s a news flash: the IRS offers a calculation that actually helps consumers. Who knew?
Little surprise, Alicia Munnell, director of the Center for Retirement Research at Boston College, took to the pages of SmartMoney Tuesday to decry the standard 4% withdrawal rate. What is surprising is the alternative she offered—the IRS’ required minimum distribution.
Mostly seen as a nuisance for those who don’t need it, the RMD forces investors to begin taking a minimum amount of money out of a tax-deferred savings vehicle at age 70 ½. The reasoning is twofold: the IRS wants their tax revenue, and the larger government wants the money in circulation. However, if investors base their non-RMD withdrawal rate on the RMD itself, it acts as a good alternative to the standard (and controversial) 4% rate.
A new paper from the organization Munnell leads shows that the RMD approach “stacks up pretty well against the traditional rules of thumb. Up until now, the three most common rules of thumb have been relying on the income produced by the assets, calculating withdrawals based on life expectancy and adopting the so-called 4% rule. Each has significant problems.”
With the first, she notes that using interest only can work for wealthy individuals, but has serious drawbacks for people who lack substantial retirement savings.
“One disadvantage is that people die with their initial assets intact, which may be fine for those who want to leave a bequest, but in other cases unnecessarily restricts retirement consumption,” she writes. “Another drawback is that the desire for income may lead retirees to over invest in high-dividend stocks, losing the benefits of portfolio diversification.”
Basing withdrawals on life expectancy has two significant drawbacks, she continues. First, the calculation involves applying a sophisticated equation, which may be beyond the capacity of many. Second, retirees face a high probability—a 50% chance—that they will outlive their savings.
Lastly, under the 4% rule, the retiree each year withdraws 4% of the initial balance. The advantage is that the retiree has a low probability of running out of money. The downside is that such a rule does not permit retirees to periodically adjust consumption in response to investment returns, she warns.
“An alternative strategy is to base withdrawals on the RMD rules,” Munnell explains. The IRS makes no claim that the RMD, which is designed to recoup deferred taxes, is the basis of an optimal draw-down strategy. Yet an RMD approach satisfies four important tests of a good strategy.”
First, like other rules of thumb, it is easy to follow. The IRS stipulates withdrawal percentages based on tables of life expectancies. Second, it allows the percentage of remaining wealth consumed each year to increase with age, as the retiree’s remaining life expectancy decreases. Third, as consumption is not restricted to income, the household is less likely to chase dividends and is more likely to have a balanced portfolio. Fourth, 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.
“To determine which real-world strategy would produce the best possible outcome, the paper compares the various rules of thumb, including the RMD approach, with an optimal wealth draw-down strategy,” she concludes. “The results show that the RMD approach does about as well as the other strategies and actually outperforms the 4% rule. Given that it also has the four desirable characteristics described above, the RMD approach should be viewed as an alternative viable strategy.”