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In a recent article, I noted that the so-called 4% rule for retirement portfolio withdrawals is a reasonable starting point for calibrating an in-retirement spending rate. It's easy to understand and implement, and it allows for a fairly stable stream of income during retirement--a predictability that's desirable for most retirees.

For example, say a retiree with a $1.5 million portfolio has decided to use the 4% rule for her in-retirement withdrawals, combined with an annual adjustment to help her withdrawals keep up with inflation. That rule doesn't mean that she withdraws 4% of her portfolio in each year of retirement, which could result in wildly differing annual withdrawals, depending on her asset allocation and market performance. Rather, the 4% rule stipulates that she takes 4% of her portfolio in year one of her retirement, then inflation-adjusts that initial dollar amount each year thereafter. Assuming a 4% distribution rate and a $1.5 million portfolio, she would withdraw $60,000 in year one, and that amount would jump up to $61,800 in year two ($60,000, adjusted for a 3% inflation rate).

But sticking with a fixed withdrawal amount, as the 4% rule dictates, can also have some perverse effects in both very good and very bad market environments. The originator of the 4% rule, Bill Bengen, discussed the downside of underwithdrawing in buoyant market environments in this paper. Such a scenario is clearly better than running out of money during retirement. However, the net effect of ignoring the strong market performance and sticking with the original 4% withdrawal amount, adjusted for inflation, could be that the retiree lives more frugally than she actually needed to, passing money to heirs that she might've preferred to spend during her own lifetime.

On the flip side, employing the 4% rule during a very weak market environment can also lead to unintended consequences, particularly if the bear market hits early on in one's retirement years. To use a simplified example, say the aforementioned retiree encounters a bear market in year three of her retirement, nudging her original $1.5 million portfolio down to $1 million. Her withdrawal would be $63,654 in year three (arrived at by inflation-adjusting her year-two withdrawal amount of $61,800), pushing her total portfolio value down to $936,346 and below $900,000 in year four. What started as a 4% withdrawal rate in year one would grow to more than 7% by year four. Sticking with fixed dollar withdrawals during a sustained bear market also limits the pool of assets that can appreciate when the market improves.

Is there a better way to do it? That question has been the subject of much research during the past few decades, with many studies converging around the idea that withdrawal rates should fluctuate during a retiree's lifetime. Some of these studies, such as this one from financial planner Jonathan Guyton, are complicated and probably best employed by financial advisors. But there is a unifying message that retirees who are managing their own distribution streams should take to heart: As comforting as it might seem to rely on a straight inflation-adjusted withdrawal amount, for best results retirees should adjust withdrawals up or down as circumstances dictate. That means staying attuned to what's going on with the market and attempting to reduce withdrawals during periods of extreme market duress. It also means being realistic about the fact that your own income needs during retirement are apt to fluctuate, as I explored in this article.

Here's a roundup of some of the methods that lead to variable-dollar-amount withdrawals per year as well as some of their pros and cons.

Fixed-Percentage Withdrawals
At first blush, withdrawing a fixed percentage amount from a portfolio per year would seem to elegantly address some of the shortcomings of the 4% rule, which calls for withdrawing inflation-adjusted dollar amounts. Because the retiree's withdrawals are limited to a percentage of the portfolio, there's no risk of running out of money. Moreover, sticking with a fixed-percentage-withdrawal amount prompts the retiree to withdraw more in good markets and less in lean ones.

The big downside to taking a fixed percentage from a portfolio, however, is that volatile markets can mean big swings in the retiree's payout, which in turn can have a big impact on quality of life. A fixed percentage drawn on too small a portfolio might not result in a livable income stream.

The Income-Only Approach
Using this approach, retirees would simply live on whatever bond or dividend income their portfolios kick off. This is the most intuitively appealing strategy, in that a retiree wouldn't need to invade principal to fund living expenses, so there's no chance of outliving his or her portfolio.

Investors have experienced the downside of this strategy during the past several years, however, as bond yields have sunk ever lower and dividend payouts remain quite low by historical standards. For individuals without very large portfolios or income from other sources, such as pensions, this strategy doesn't deliver a livable income stream unless they heavily emphasize risky asset classes such as high-yield bonds or companies with very high dividend yields, which are often distressed. Moreover, income-focused portfolios can skew heavily to certain dividend-rich equity sectors such as financials, thereby jacking up their risk levels. 

via news.morningstar.com