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A retirement income strategy every advisor must know: Systematic withdrawals

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If there were such a thing as a “default” income planning strategy, systematic withdrawals might be it. While its popularity doesn’t limit its usefulness or effectiveness, this is the approach that is automatically used when no other approach has been chosen.

Therefore, it makes sense to spend some time better understanding the philosophy behind systematic withdrawals as well as the nuances that every advisor should consider when employing this method with retired clients. After all, having one’s life savings on the line should warrant more than a cursory understanding of the mechanics to ensure success.

Systematic withdrawals can be simply defined as drawing a predetermined rate or dollar amount from an investment portfolio each year to generate retirement income.

First, let’s define what “success” means to the client who is seeking lifetime income from their portfolio. Standard literature defines retirement income success as not running out of money before death, at a pre-determined withdrawal amount (not rate).

That means a 4 percent withdrawal rate was successful for the client when they pass away with money remaining, after having received the pre-determined amount of money each year from their portfolio. This is a very important distinction to make. I’ll say it another way: a 4 percent withdrawal rate is always possible because no matter how much the dollar amount of the withdrawals are, one can always take 4 percent per year out of the account (Remember studying the asymptote, the curve that never reaches the axis?).

However, this does not mean the client’s income plan was successful, because they may not have achieved the desired income level.

I labor this because a simple narrative understanding of the 4 percent withdrawal rate often leads to trouble. Given the client’s age and life expectancy, one can feasibly take a higher rate of withdrawals (greater than 4 percent) at later ages than someone at younger ages, with the same outcome. Because systematic withdrawals is a probability-based income strategy, you’d better know the probabilities of various withdrawal rates and clearly explain those to the client…and monitor the plan closely.

By monitoring the portfolio’s asset allocation and withdrawal rates, adjustments can and should be made to ensure success. Make sure this is well-understood by the client before the plan is implemented. (For a detailed look at various withdrawal rate probabilities, I highly recommend David Zolt’s work in targeting safe withdrawal rates.)

When drawing income from a portfolio using systematic withdrawals, proper asset selection is critical. Why? In times of historically low interest rates, the fixed income portion of the portfolio may provide low levels of income for the client, thus placing a heavier burden on the equities in the portfolio.

Naturally, this can result in less favorable outcomes during high market volatility. This challenge is well-documented in studies of “sequence-of-returns risk,” which translates roughly into: don’t allow the portfolio to perform poorly in the early years of one’s retirement, or chances of portfolio (income) failure increase dramatically.

With all of this in mind, for whom might a systematic withdrawals approach be suitable?

  • Retirees who are very comfortable with risks such as: market, interest rate, sequence of returns, frailty, and advisor risk
  • Those who wish to maximize possible estate size (as compared to safety-first approaches, which we’ll cover in the next installments)
  • Retirees who anticipate meaningful changes in their future income needs and desire maximum flexibility in their asset management
  • Those with a great concern of inflation and wish to maximize their inflation hedge
  • People who are vehemently opposed to using insurance-based products to generate income

While this discussion was never intended to be an exhaustive analysis of systematic withdrawals, it should serve as a catalyst to learn as much as possible before deciding on using the strategy as a default approach to income planning. As a true probability-based approach, systematic withdrawals offers a lot of possibility for those families and advisors who wish to understand its many nuances.

In the next installment, we’ll discuss Flooring, also known as Essential versus Discretionary. A safety-first approach to income planning, it seeks to plan away much of the risk present in systematic withdrawals, but as all things, offers its own list of drawbacks.