How to Choose the Best Retirement Income Strategy

In the competition among retirement-planning methodologies, systematic withdrawals have been winning the battle against the essential-discretionary approach. But given today’s low interest rates, the essential-discretionary approach may work better for many clients, especially if single-premium immediate annuities (SPIAs) are used.

Systematic withdrawals rely on traditional assets such as bonds and stocks, and all retirement needs are funded from a single portfolio. With the essential-discretionary approach, the client's spending needs are divided into those two categories — essential and discretionary — and separate portfolios are used to fund each one.

The case for systematic withdrawals

Jonathan Guyton and Michael Kitces, two thought leaders in financial planning, both strongly advocate systematic withdrawals. They gave a series of video interviews in 2011 at The American College on withdrawal methods, and Wade Pfau, professor of retirement income at that institution, recently featured them on his blog here and here.

Research on systematic withdrawals originated with planner Bill Bengen's development of the 4% rule in the early 1990s. He used historical data and demonstrated that, if the initial withdrawal rate were set at 4% of savings and the dollar amount of subsequent withdrawals increased with inflation, one could be highly confident that the savings would last for at least 30 years.

However, this approach, which has been used in research, would be too inflexible if applied in practice. In the videos, both Kitces and Guyton make the point that systematic withdrawals should not be viewed as a "set it and forget it" method. Instead, withdrawals should be adjusted based on emerging investment experience. Guyton has helped make the method more practical for planners by developing and testing decision rules to adjust for investment experience as described here.

Among the advantages Kitces and Guyton cite for systematic withdrawals are that the method treats all retirement savings as a single source of funds that can be managed to best meet retirement needs and that the focus can be on managing spending to maintain overall lifestyle rather than on just meeting subsistence needs.

Where the debate begins

Although Guyton and Kitces make a compelling case for systematic withdrawals, there is considerable debate among researchers about whether this is the best approach for generating retirement income. Central to the debate is whether the 4% rule is still viable in an environment of low interest rates and lower-than-historical-return prospects for stocks. Economists tend to favor splitting retirement expenses into essential and discretionary and using products such as SPIAs to fund the essential expenses. SPIAs provide an income that will be available to pay for essential expenses regardless of the length of life.

Guyton and Kitces do not argue that annuities are bad products, but they note that clients often resist them. They also express concern about splitting expenses into essential and discretionary, when in reality people try to maintain a lifestyle that includes both. But at the foundation of their advocacy for systematic withdrawals is their belief that withdrawal rates of 4% and higher are still feasible despite the challenging investment environment.