Can the IRS’ Required Minimum Distributions Guide Drawdowns?

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Headshot of Alicia H. Munnell

is a columnist for MarketWatch and director of the Center for Retirement Research at Boston College.

As a result of the shift from defined benefit plans to 401(k)s, Baby Boomers will be the first generation that must decide how much of their savings to spend each year in retirement.  They need a strategy that best balances the risk of outliving their wealth against the cost of unnecessarily restricting their consumption.  It is a tricky calculation; Boomers need some relatively simple rule of thumb.  A recent paper from the Center for Retirement Research at Boston College suggests that the Internal Revenue Service’s rules for Required Minimum Distributions (RMD) for 401(k)/IRA balances might serve as a reasonable guide.  The paper shows that the RMD approach stacks up pretty well against the traditional rules of thumb.

Up until now, the three most common rules of thumb have been relying on the income produced by the assets, calculating withdrawals based on life expectancy, and adopting the so-called “4-percent rule.”  Each has significant problems.

Using interest only can work for wealthy individuals, but has serious drawbacks for people who lack substantial retirement savings.  One disadvantage is that people die with their initial assets intact, which may be fine for those who want to leave a bequest, but in other cases it unnecessarily restricts retirement consumption.  Another drawback is that the desire for income may lead retirees to over-invest in high dividend stocks, losing the benefits of portfolio diversification. 

Basing withdrawals on life expectancy has two significant drawbacks.  First, the calculation involves applying a sophisticated equation, which may be beyond the capacity of many.   Second, retirees face a high probability – a 50-percent chance – that they will outlive their savings.   

Under the 4-percent rule, the retiree each year withdraws 4 percent of the initial balance.  The advantage is that the retiree has a low probability of running out of money.  The downside is that such a rule does not permit retirees to periodically adjust consumption in response to investment returns.  For example, if returns are less than expected, the retiree should respond by reducing consumption to preserve the assets – a fixed 4-percent withdrawal is not consistent with such flexibility.

An alternative strategy is to base withdrawals on the RMD rules, which the IRS requires when individuals reach age 70½ and each year thereafter.  The IRS makes no claim that the RMD, which is designed to recoup deferred taxes, is the basis of an optimal drawdown strategy.  Yet an RMD approach satisfies four important tests of a good strategy.  First, like other rules of thumb, it is easy to follow.  The IRS stipulates withdrawal percentages based on tables of life expectancies.  A withdrawal schedule at younger ages – percent of assets withdrawn, by age – can be based on the same life tables used for the RMD rules.  Second, it allows the percentage of remaining wealth consumed each year to increase with age, as the retiree’s remaining life expectancy decreases.  Third, as consumption is not restricted to income, the household is less likely to chase dividends and is more likely to have a balanced portfolio.  Fourth, consumption responds to fluctuations in the market value of the financial assets, because the dollar amount of the drawdown is based on the portfolio’s current market value.

To determine which real-world strategy would produce the best possible outcome, the paper compares the various rules of thumb, including the RMD approach, with an optimal wealth drawdown strategy.  The results show that the RMD approach does about as well as the other strategies and actually outperforms the 4-percent rule.  Given that it also has the four desirable characteristics described above, the RMD approach should be viewed as an alternative viable strategy.