Retirement Spending Rules and Forced RRIF Withdrawals

Last week's post left unexplored retirement portfolio withdrawal strategies that could serve as alternatives to our base case of a constant inflation-adjusted dollar amount. This week, we'll look at several such optional strategies, plus we'll discuss what to do about forced minimum withdrawal rates for registered retirement income funds.

The portfolio assumptions we'll use for our comparisons:

• $100,000 in assets as of retirement date
• 30-year expected duration of retirement
• asset allocation 50% fixed income (Canadian government T-Bills/cash instead of the broad bonds in our previous so that we can use historical data going further back in the Stingy Investor Asset Mixer tool), plus 50% equity (in equal parts TSX Composite Canada, S&P 500 USA and MSCI EAFE Developed countries)

1) Base case: Constant Inflation-Adjusted Dollar Amount
Method: Calculate a dollar amount based on a sustainable withdrawal rate as a percentage of the portfolio at the start of retirement. Increase annually per the past year's inflation.

Example: using the 4.0% rate that worked in the past (though 3.5% is the going-forward sustainable withdrawal we estimated in our previous post to be reasonable nowadays), in Year 1, withdraw $4000, in Year 2, after a CPI rise of 2.0%, withdraw 4000 x 1.02 = $4080.

Key Characteristics:

• Designed to maintain a steady lifestyle - while early on retirement perhaps more is spent on travel and activities, even if life slows down later on spending may rise on health care or gifts.
• Usually ends up leaving a lot more legacy at death compared to the other alternatives due to conservative withdrawal rate based on worst case assumptions designed to avoid depletion of the portfolio.
• Withdrawal amounts may look very low after a multi-year stock market bull run, making it tempting to abandon the strategy and increase withdrawals

2) Constant Percentage of Portfolio Balance
Method: Every year withdraw the same percentage amount of the current portfolio remaining balance, which may be up or down according to market swings and the effect of withdrawals

Example: Stingy Investor's tool shows us that applying a 4% withdrawal rule to historical results for our sample portfolio from 1970 to 2013 produced the following table of real (inflation-adjusted) dollar withdrawals.

(click on image to enlarge)

Key Characteristics:

• Suited to luxury or discretionary spending - amounts from year to year are highly variable - see in the table above how the amount withdrawn fell about a third from 1972 to 1974 and took till 1986 to get back to near the initial $4000 mark.
• Allows slightly higher percentage withdrawal rate than the initial percent set in the constant dollar method, but despite never incurring the risk of totally depleting, higher withdrawal rates can eat into the portfolio enough to reduce the balance to very low levels and much diminished dollar withdrawal amounts. Using Stingy Investor again, we see that a 9% withdrawal rate would have started with $8878 withdrawn in 1970 but that would have dropped to less than half that by 1980 and to only about $3000 twenty years later in 2000. The portfolio had under $11,000 left after 30 years. That's only one scenario. In his classic book Conserving Client Portfolios During Retirement, William Bengen found that a constant percentage strategy for a US investor using data going back to 1926 would on average still have incurred a 15% drop from starting amounts, even using a 4.43% withdrawal rate.

3) Higher Withdrawals in Early Years
Method: Calculate a set dollar amount higher than the constant dollars of method 1 above, adjusting it annually for inflation as before too, for the first X years of retirement, then reduce the amount in later years, perhaps by cutting part or all of the inflation adjustment.

Example: There is no set way to decide on the parameters, many combinations are possible. Bengen gives an example of a 1955 retiree who takes a 4.78% withdrawal rate for the first ten years of retirement, i.e. a $4777 real annual withdrawal, then takes an adjustment of inflation less 3% for the next ten years and at inflation for the ten years following that. It's a combination that ensures the portfolio would not have run out after 30 years. He compares that to a fixed dollar withdrawal retiree who have been able to withdraw only $4433. In exchange for $343 more for ten years (7.8% more), the higher early withdrawal retiree would have suffered an income that eventually became 19% less.

Key Characteristics:

• Suited to those who don't mind a big drop in spending in later years - the income penalty of the later drop is much greater the reward of the early permissible boost, according to multiple scenarios Bengen constructed. More than half of the 30 years during retirement experienced lower spending than the constant dollar amount.
• Maximum workable non-depleting withdrawal rates are not much more than the maximum sustainable rate of the constant dollar approach. Eyeballing Bengen's results show the early boost possible in his formulations to be about 0.25-0.3% more.

4) Floor and Ceiling
Method: Calculate a first-year dollar amount then each year withdraw a percentage of the current portfolio value, within a lower "floor" limit and upper "ceiling" limit compared in real dollars to the initial amount (or in a variation proposed by Vanguard, in this review of the alternatives, compared to the previous year amount).

Example: A 5.0% initial withdrawal, or $5000 in our $100k portfolio is bounded to not fall less than 5%, i.e. below $4750 in real dollars, or go above 10% ($5500, which would mean the portfolio had risen to $110k - 5% of 110,000 is 5500 - or more).

Key Characteristics:

• Provides some flexibility in spending according to market performance, with reward in good times and restriction in bad times, yet quite a bit of stability in funds available for spending. It's a solution in between fixed dollar and percent of portfolio.
• Allows an appreciably higher initial spending rate. The downside restriction in particular is key in protecting the portfolio. The upside limits make no difference! Bengen's figures show that the larger the allowable downside reduction, the greater the safe initial withdrawal amount. a 5% reduction floor allows approximately a 0.8% higher initial percentage - instead of the 3.5% we calculated, that would allow 4.3%. A 10% floor gives a 1.2% initial boost and a 15% floor permits a 1.5% boost. The big question is whether the investor can and will carry out the actual spending reduction after markets have gone sour.

RRIF or LIF withdrawal rates complicate life - The requirement imposed by the federal government to withdraw a rising minimum percentage of money ( based on outdated longevity assumptions) from RRIFs and other registered retirement accounts is completely out of sync with any of the above strategies.  For the required withdrawals, see this table from TD Canada Trust. Being obliged at age 71, when all registered retirement accounts must begin withdrawing money, to take out 7.38% far exceeds the safe rates to avoid portfolio depletion. There have been complaints in the media, like this article in the Financial Post and this one in the Globe and Mail, about the unfairness and the danger to savings depletion.

What can an investor do: avoid spending the forced withdrawal amount in excess of the sustainable minimums we have discussed, and in particular,

• Delay conversion of RRSPs to RRIFs and forced withdrawals as long as possible (age 71), keeping in mind that partial conversion is worthwhile to take advantage of the pension income tax credit (consult this page at TaxTips.ca for details). This step, and the next, allow tax-free accumulation to continue as long as possible, which is a significant benefit.
• Contribute to a TFSA as much excess as possible. The yearly contribution limit is currently $5500 and there is no age restriction, nor any forced withdrawals. Like any registered account, all income and gains in a TFSA are tax-exempt.
• Re-invest the remaining excess amount in a taxable account. There is on-going tax paid on income in such an account but the judicious use of efficient investments can defer the payment of tax, which helps.

Bottom Line: The Floor and Ceiling method offers an appealing compromise between income stability and higher sustainable withdrawal rates for those who have the discipline to reduce withdrawals after market downturn years.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.