Much research has been done on the best way to generate retirement income. This is one of the most popular topics on HumbleDollar. I think this popularity is due to two things: its obvious importance and the fact that there is no single correct answer.
On the other hand, it's relatively easy to determine how much to save for retirement. It's not hard to pick a future retirement date, or at least a range of years in which you're likely to retire, and then figure out how much you should save.
But when it comes to generating retirement income, none of us knows how long we'll live, what the markets will do, or what our health needs will be. There are also subjective questions, like how much do we want to leave our heirs?
Last November, Morningstar published a report that looked at various methods for determining a retiree's safe wallet withdrawal rate. At 59 pages, it's quite long, but well worth the read.
It reviews various retirement strategies, discussing the pros and cons of each, and concludes with a process for developing an individual retirement income plan.
One of the options considered is the so-called RMD withdrawal strategy. Under this plan, annual withdrawals are based on the closing balance of the previous year's portfolio.
Withdraw a percentage of your portfolio that meets the required minimum distribution (RMD) guidelines provided by the IRS life expectancy tables. Under this plan, your income would rise or fall as the value of your portfolio changes.
Online financial planning magazine ThinkAdvisor recently asked three retirement planning experts for their thoughts on RMD's withdrawal strategy compared to the more well-known 4% rule.
By the 4% rule, you will withdraw 4% of your portfolio in the first year, and then increase this amount based on inflation in the second and subsequent years.
The 4% rule has been criticized on several grounds. Some say that 4% is too high due to low bond yields and high stock valuations. Others say the strategy is too robotic in the face of falling financial markets.
Michael Finke, a professor at the American College of Financial Services, doesn't like the potential income shock of the RMD approach. If a retiree invests heavily in stocks, one year of significant decline can reduce their income the following year.
"A better retirement plan assesses what part of the budget is flexible and what part is inflexible," Finke said. "Next, create an investment plan that doesn't expose inflexible spending to the market or longevity risk."
Finke said his experience shows that about two-thirds of retirees' expenses are fixed. The RMD strategy can only work for the subset of the portfolio dedicated to flexible spending, since the strategy tends to generate fluctuating income, Finke argued.
In contrast, David Blanchett, former head of retirement research at Morningstar, likes the RMD approach because it links withdrawals to retirement age. However, he recommends that retirees have a realistic estimate of their longevity, rather than relying solely on IRS tables.
Blanchett gave this example: If you love your life expectancy at 20 years, you can start with the 5% withdrawal rate. To borrow for the remaining 25 years, a 4% withdrawal fee is more appropriate. What if you had already withdrawn 8%? The RMD strategy gives you a red flag that you should reduce.
Christine Benz, director of personal finance at Morningstar, says that the RMD method is effective in "helping ensure a retiree spends the most of their money."
But he says the method is "not very viable" because it can be an extreme fluctuation of income to boost retirees with higher capital allowances.
Another concern raised by Benz: RMD life expectancy tables are average life expectancies. Retirees who live above the media risk running out of money.
Plus, your balance may decline as you age, just as you're faced with large medical or child care expenses.
In short, three of the leading voices in retirement planning are three different estimates of the RMD strategy. I even have that kind of disparity among my friends, family, and peers. We each look at the subject of retirement income with our own eyes.
For example, some withdrawals may be modest so they have enough money to pay for large medical bills later. Others may hope for the best and spend, but delivered. Still others choose to live frugally during pregnancy, hoping as long as possible for their children.
Each of us must answer questions like these for ourselves and plan accordingly.
It is essential to determine what is most important to you and to yourself. Many people's opinions are their experiences with their parents and relatives. This is useful and should be part of the analysis.
But we must also be open to new ideas. The planning complex of us is such an issue that we can all benefit from hearing what others think.