Here’s another data point in the debate about safe withdrawal rates, or how much money you can safely withdraw from an investment portfolio each year without running out of money. Merrill Lynch Private Banking recently released a whitepaper on “sustainable wealth” aimed at high net worth individuals. Supposedly, in more than 67% of rich families, their wealth fails to outlive the generation following the one that created it, and 90% of the time, assets are exhausted before the end of the third generation.

Rich people problems? Sure, but one of the reasons for this high failure rate is that many people don’t have a reasonable idea of what makes a sustainable spending strategy. This applies to anyone who will eventually draw income from a portfolio for an extended period of time. Making a portfolio last generations is very similar to planning for early retirement. As we are talking about percentages, the numbers apply just as well to smaller portfolios.

Here are the results from a survey of wealthy families ($5M+):

Here are the safe withdrawal rates they calculated for a 60% stocks, 35% bonds, 5% cash portfolio based on “Merrill Lynch capital market and fee assumptions”.

I couldn’t find where they state what their confidence level is or what their “fee assumptions” are but I would assume they would at least be in the neighborhood of 1% annually. If you invest in low-cost index funds, that would theoretically mean you could increase the provided withdrawal rates by another 0.8% to 1%.

It looks like 3% is a good number if you want to be safe for 50 years, which is close to my investment horizon. Unfortunately, it is just a matter of luck whether you really need to take things that safely. From this other Merrill Lynch paper, starting with the same portfolio balance you could have taken out 5% a year (67% more income) starting in 1974 and your portfolio would have lasted just as long as if you withdrew only 3% starting in 1972. That is the potential effect of retiring just two years apart.

If I do use the 3% sustainable withdrawal rate, that works out to putting aside 33 times my annual expenses. To increase flexibility, I also like the idea of making the withdrawal rate somewhat dynamic (adjusts with investment returns) similar to how Vanguard Managed Payout Funds are structured.

Merrill Lynch whitepaper (via BusinessInsider)

According to research from the Vanguard Group, another area where a skilled financial advisor is supposed to able to add value is helping retirees manage withdrawals from their portfolios in order to minimize taxes. According to their paper:

Advisors who implement informed withdrawal-order strategies can minimize the total taxes paid over the course of their clients’ retirement, thereby increasing their clients’ wealth and the longevity of their portfolios. This process alone could represent the entire value proposition for the fee-based advisor.

The paper goes on to show how correct ordering can improve returns by up to 0.70% annually versus people with multiple different account types withdrawing in the wrong order. The thing is, ordering your withdrawals properly isn’t all that complicated. Most of it is summarized in this flowchart:

• RMDs stand for required minimum distributions. In general, these are forced withdrawals from pre-tax “traditional” IRAs (including SEP and SIMPLE IRAs) and pre-tax workplace defined-contribution plans (including 401(k) and 403(b) plans) once you reach age 70.5. Since it is mandatory and taxed at ordinary income rates, you may as well spend them first.
• Next, taxable flows include things like interest, dividends, and capital gains distributions that are already being “spun off” from your taxable portfolio. These are also going to be taxed no matter what anyway.
• Next, spend your taxable portfolio itself by selling shares and paying any capital gains taxes that may be due. Sell investments with the lowest gains first to minimize taxes. Don’t sell if you don’t need the money.
• What you have left are tax-deferred or tax-free (Roth) accounts. Do you want to pay taxes now, or later? If you think your marginal tax bracket will be higher in the future, then you should pay taxes now (withdraw first from tax-deferred account). If you think your marginal tax bracket will be lower in the future, then you should pay taxes later (withdraw first from Roth accounts). You could make your decision differently each year depending on your current situation.

A key component of retirement planning is figuring out how to draw an income from all that money you’ve invested. “Create your own paycheck.” The trick is figuring out how to take a stable amount out every year without running out of money.

This has led to a debate about “safe withdrawal rates”. The 4% number has been thrown around a lot, where for example if you retired with $1,000,000 in a balanced portfolio of stocks and bonds you might take out $40,000 a year (increasing with inflation) for 30 years with confidence. The problem is that if you simply take out 4% of your starting balance and then keep taking that number out every year robotically then your outcome depends a lot on sequence of returns. If you hit a prolonged bear market just a couple years into retirement (i.e. value drops to $700,000), your nest egg is much less likely to survive. On the other hand, if you hit a bull market for the first 10-15 years and only experience the bear market afterward, then you may die with more money than you started with.

This is why many experts encourage a more flexible “dynamic” withdrawal strategy that adjusts withdrawals based on portfolio performance. There are an infinite number of ways to implement this, so I looked for an industry example and found it in the Vanguard Managed Payout Fund (VPGDX)*. This all-in-one fund uses a 4% target distribution rate and with regular, monthly distributions that you can indeed treat like a (somewhat variable) paycheck. The fund is actively managed for total return, although a majority of its components are passive index funds.

How does the Vanguard Managed Payout fund calculate how much you can spend each year? Reading through the prospectus, we find that the monthly payout is calculated on January 1st every year, then kept constant for the next 12 months, and then reset again the next January 1st. If you started January 1st, 2014 with a $1,000,000 in this fund you would get a payout every month of 2014 for $2,995 ($35,940 a year). Why isn’t it 4% or $40,000?

The fund’s dynamic spending approach uses a “smoothing” method that keeps the monthly payout from changing too dramatically from year to year. Specifically, the 4% withdrawal rate is based on a 3-year rolling average of hypothetical past account value (assumes you spend the monthly distributions, but reinvest any year-end capital gains and dividends). Screenshot from prospectus:

So since the average of the past 3 years is lower than the current value, you’re getting 4% of a smaller number. As you can see, with smoothing your annual income from this fund can vary significantly over time. A starting portfolio size of $1,000,000 might get you an annual distribution varying from less than $36,000 or more than $44,000. Other smoothing methods include setting a maximum ceiling or minimum floor value, but this fund does not do that. Ideally, you would use the income from this fund to supplement other income from more reliable sources like Social Security, pensions, or guaranteed income annuities. That way your overall income will vary even less, and you’ll only have to cut back a little during down years.

(* Previously, Vanguard had three different Managed Payout funds with three different target spending rates of 3%, 5%, and 7%. I think this was confusing for many investors who didn’t really understand that the 7% fund would most likely experience a significant loss of principal over time. This is only speculation on my part, but the 7% payout fund did gather 8 times the assets as the 3% payout fund, even though 3% is a more realistic number for most folks. Vanguard now says that 4% is best for the “typical retirement period of 20–30 years”.)

It’s not just how much you save, it’s when you save that matters. The best time to start is now. This is the power of compounding returns, which this single chart will help you visualize:

• Susan (grey) invests $5,000 per year from age 25 to 35 ($50,000 over 10 years) and stops.
• Bill (green) invests $5,000 per year from ages 35 to 65 ($150,000 over 30 years).
• Chris (blue) invests $5,000 per year from ages 25 to 65 ($200,000 over 40 years).

You’ll note that Susan still ends up with more money than Bill, even though he invests three times as much money over 30 years, all because Bill starts late. Susan and Chris start out the same, except that Susan stops after 10 years while Chris keeps going. Chris only invests $100,000 more than Susan, but ends up with $500,000 more money in the end. A 7% annual return is assumed.

The chart is from a JP Morgan slide deck for their asset managers, via Business Insider.

I’m also reminded of Warren Buffett and his Snowball biography – “Life is like a snowball. The important thing is finding wet snow and a really long hill.”