Do RMDs Work Better Than the 4% Rule?

Analysis February 09, 2022 at 05:36 PM Share & Print

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Using the 4% rule for retirement withdrawals has been a much studied approach and has produced some skeptics due to its lack of flexibility. There are several withdrawal strategies, which Morningstar compared in depth in a recent study.

But as ALM’s Tax Facts notes, “Some advisors find that the [required minimum distributions] method should be considered as a potential alternative to the 4% rule. … It may be, in many ways, more realistic than the 4% rule because it bases withdrawals on the current value of the taxpayer’s retirement assets.

“While this requires determining the account values each year, it also allows taxpayers to modify their consumption levels based on actual account performance. Because the percentages are based on life expectancy and vary with age, it is still unlikely that the taxpayer will outlive his assets.”

We asked three retirement specialists about this analysis, and here are their takes on using RMDs:

Michael Finke, professor and Frank M. Engle Chair of Economic Security at the American College of Financial Services

“The RMD approach is a variable spending plan. The 4% rule is a fixed spending plan. Any variable spending plan can allow a retiree’s savings to last indefinitely, but it means that they need to cut back if they don’t get favorable portfolio returns or if they live too long.

“It’s easy to gloss over this aspect of an RMD rule. Many retirees don’t have much flexibility in their budget — I’ve estimated that about 2/3 of expenses are inflexible.

"A better retirement plan evaluates how much of the budget is flexible and how much is inflexible, and then build an investment plan that doesn’t expose inflexible spending to either market or longevity risk. For the flexible part, by all means consider current portfolio balance and expected longevity to guide how much a retiree can spend.”

David Blanchett, managing director and head of retirement research, PGIM DC Solutions

“The RMD rule is definitely better than the 4% rule because it provides more context as someone ages through retirement. The 4% rule is effectively designed just for 65-year-olds and doesn’t really provide much guidance insight as people move 'through' retirement. For example, if you’re 75 years old, 4% would be a relatively conservative withdrawal.

“[However] I don’t think people should use the actual RMD factors when thinking more generally about the safe withdrawal rate. A much better approach is to get some type of individualized estimate of his/her/their life expectancy and use that in the equation. There’s lots of great free tools available online, but an easy one that I like is the Longevity Illustrator.

“So, using the ‘Modified RMD’ approach if you determine that you have a life expectancy of 20 years, a 5% withdrawal (1/20=5%) is a decent starting place. The key here to is that it is a quick way to determine the sustainability of a given withdrawal level. For example, if you have a life expectancy of 25 years and you’re only taking out 2% you can probably take out more (given a 1/25=4% target) and if you’re taking out something like 8% it would probably be good to cut back!”

Christine Benz, director of personal finance, Morningstar

“We did delve into the RMD method a bit in our paper — we tested it as one of several variable methods. Indeed it is ‘efficient,’ helping to ensure that a retiree spends most of his or her money, but we found it to be by far the most volatile of the methods we tested. In other words, the retiree's cash flows get buffeted around because so much of the payout depends on the portfolio's performance. It just might not be that livable.”

The paper reviews the RMD withdrawal in depth, and concluded: “The RMD method is simple and efficient but may not very livable, especially for retirees with balanced portfolios or even higher equity allocations. Not only do retirees using this method need to contend with extreme fluctuations in their spending, but balances also are ultra-low later in life, at a time when retiree expenses often increase because of high out-of-pocket healthcare costs.

"Importantly, using a single life expectancy RMD table to guide withdrawals, as we did in our test, could also lead some retirees to overwithdraw because it uses average life expectancies. Retirees who have much longer-than-average life expectancies and/or younger spouses will want to be more conservative.”