Smart ways to withdraw money during your retirement

People who save for retirement typically spend decades carefully tending their portfolios like gardens, adding nutrients in the form of dollar contributions, tax savings and more. But these same individuals often spend much less timing pondering the best ways to harvest their savings.

Retirement-withdrawal strategies, long overlooked, are starting to garner more attention. The success of various approaches depends on three key factors: How long you live in retirement, how aggressively you spend down the money and how well your investments hold up, which is largely a function of how you allocate your stocks, bonds and other holdings.

When investing for retirement, the goal usually is to maximize your nest egg while avoiding too much volatility along the way. But when drawing down money, objectives vary. Do you want to spend everything eventually or would you prefer to leave a legacy to family members or charities? Do you want to spend more freely in the early years, when you are healthier and more active, or save a big cushion for later on?

Investment researcher Morningstar dug deeply into the topic with a new report that, among other conclusions, found that withdrawing 4% a year from an investment portfolio is about the highest rate you can safely take if you hope to have something left after a typical 30-year retirement.

The study largely ignored the impact of Social Security and other income sources, focusing on the investment component. It identified six key approaches that handle withdrawal rates, legacy concerns and other factors in different ways:

Strategy 1: Focus on fixed real results

With this approach, you begin by setting a yearly withdrawal rate then adjust that annually for inflation. Suppose you have a portfolio of $1 million, want to start taking out 4% annually and inflation runs 2.4%. You would withdraw $40,000 in year one, $40,960 in year two and so on.

This approach delivers paycheck-like cash flow with annual “real” or inflationadjusted increases yet still preserves a decent ending portfolio value, Morningstar said. It’s best for retirees who seek predictable income yet want to leave a healthy bequest.

Strategy 2: Use Treasury Inflation-Protected Securities

TIPS are bonds issued and backed by the federal government that pay yields pegged to inflation. If you bought one bond maturing in each 30 years of retirement, you would have a ladder of inflation-protected assets.

Morningstar found that this strategy provided the most predictable and highest cash flow, with the drawback that the portfolio eventually will liquidate. It’s best for those who want to spend more in retirement, don’t worry about running out of money and aren’t concerned about leaving behind a balance for heirs or charities.

Strategy 3: Skip inflation adjustments after down markets

Like the first strategy, this one starts with investors setting an initial withdrawal rate and keeping a close eye on inflation. However, following years when the stock or bond markets decline, you would skip or forego the inflation increase.

This would help to preserve your portfolio’s value but at the cost of less cash for you to spend. Retirees wind up spending less over the years (as each decreased withdrawal has a cumulative effect on future spending) but the ending portfolio balance is protected.

Strategy 4: Peg withdrawals to Required Minimum Distributions

Investors with Individual Retirement Accounts, 401(k) plans and similar vehicles typically must start pulling out money and paying taxes in retirement.

Each yearly RMD takes an increasingly large slice of a portfolio’s remaining balance, meaning the withdrawal percentage rises over time to ensure that investors draw down their balances and pay the taxes. This strategy relies on a similar, accelerated-liquidation approach. It supports high and rising cash flow but at the cost of a low ending balance. Morningstar calls it a good choice for people who don’t expect to live especially long. And because withdrawals can decrease following stock and bond slumps, it also can be suitable for those who can rely on Social Security and other outside income sources to cushion these market blows.

Strategy 5: Withdraw using investment ‘guardrails’

This approach sets an initial withdrawal percentage that adjusts in future years based on a portfolio’s investment results and inflation. “The guardrails attempt to deliver sufficient — but not overly high — raises in upward-trending markets while adjusting downward after market losses,” Morningstar said.

Investors can pursue various rules for adjusting, which can make this method complicated. Still, it tends to deliver high withdrawal rates, though with considerable cash flow volatility. It’s best for retirees who want to maximize spending and aren’t too concerned with their ending balance.

Strategy 6: Base withdrawals on actual spending

This approach acknowleges real-life studies that have found people often spend more in the early years of retirement then taper down over time.

For each of the six approaches, spending in retirement is highly dependent on individual situations and the extent to which retirees can draw on Social Security and other sources aside from their investment portfolios. This actual-spending method is good for those who want more money in the early years, along with cash-flow predictability and relatively high ending balances, Morningstar said.

Putting it all together

These descriptions touch only the surface of Morningstar’s analysis.

Among other key findings: The study affirmed 4% as the highest safe starting rate for those hoping to have some of their investments left after three decades. The company simulated 1,000 market conditions in reaching that and other conclusions. Appropriate investment portfolios for retirement generally hold 20% to 40% in stocks and stock funds, with the rest in bonds, bond funds and cash. Stocks still accomplish the lion’s share of work, even for many retirees. Morningstar estimates that equities over the next 30 years will generate average annual returns roughly double those of bonds. But the latter provides more of the stability and predictability that retirees typically favor.