The Problem with Systematic Withdrawal Plans

Systematic withdrawal plans. They’re the most commonly used retirement income strategy. But, just because something is popular doesn’t mean it’s good. As almost every parent has said to their child at one point or another, “If all your friends jumped off a bridge, would you jump too?”

Over the course of my 23-year career spent specializing in retirement planning, I’ve come to hate systematic withdrawal plans (SWPs). And, if you’re concerned about protecting your retirement income and preserving as much of your retirement nest egg to pass along to your loved one, you should too!

What got you here, won’t get you there

Chances are that you have built your retirement nest egg based on the concept of making regular, periodic contributions to your retirement account; for instance, having a percentage of your payroll deducted and invested into your 401(k) each payroll period. This concept, called dollar-cost averaging (DCA), was based on a very sound investment strategy where, in a fluctuating market, your set investment amount would buy you more shares when prices were low and fewer shares when prices were high.1

Does this mean that, similarly, simply flipping the switch and reversing the process 180 degrees makes good sense? In my opinion, absolutely not!

To understand why I am so adamant about systematic withdrawal plans, let’s take a look at how they work.

How systematic withdrawal plans work

The fundamental idea behind a systematic withdrawal plan is that you invest your portfolio across a broad array of asset classes. This portfolio allocation is designed to generate the highest average annual return, given your tolerance for taking investment risk. For most people, that means your portfolio will end up near the standard retirement allocation of 60% equities and 40% fixed-income and cash.

To begin generating income using a SWP, all you need to do is fill out a form and instruct your investment firm how much money you want to receive and how often. These withdrawals are then set to occur at a set periodic cadence, selected by you, for instance monthly. These sales will then occur automatically, regardless of what is going on with the market.

Once established SWPs are set up so that these automatic sales liquidate, proportionately, from your portfolio holdings. The assumption is that, over time, the SWP will generate an average rate of return required to supply your needed income during retirement.

Where systematic withdrawal plans fall short

So, while systematic withdrawal plans remain one of the most popular ways to generate retirement income, there are a few problems with SWPs that you need to be aware of:

• Sequence of return risk. Prior to retirement, you most likely looked at your portfolio’s average rate of return to whether your retirement savings, growing at that average rate of return, would provide you with enough money to retire. But, as a retiree, your interest shifts from average rate of return to annual rate of return. It hardly matters that your retirement savings averaged 8% per year when, in your first year of retirement, you lost 20%. In this case, the sequence of returns has put you in a big hole. This loss early in retirement, even if made up for later, has put you on a lower retirement income glide path. It may take a long time to get out of that hole.

•  Focus on the wrong goal. The use of a systematic withdrawal plan simply doesn’t fully align with your goals in retirement. In the context of your financial plan for retirement, your biggest risk is that you might run out of money before you run out of time. Unfortunately, time is not a factor in the math of systematic withdrawal plans.

  For example, let’s assume you, or your advisor, position you in the ever-popular 60/40 stock-to-bond portfolio. This allocation is applied to all your retirement income needs. So, the money you need for year one is invested in the same 60/40 allocation as the money you will need for year 25 of retirement. The role of stocks and bonds becomes muddled. As a result, quite often, your bond holdings do nothing to dampen short-term volatility. They simply act as a drag on your portfolio’s return to create the illusion of protecting your portfolio from the sequence of return risk.

Over the next few blog posts, I’ll take you on a deeper dive into the potential pitfalls associated with systematic withdrawal plans for those who seek a dependable retirement income strategy. I’ll also introduce you to, what I believe to be, a more reliable and secure strategy for turning your retirement assets into the income you need to survive retirement.

The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but is intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax, or personalized financial advice. Please consult a legal, tax, or financial professional for information specific to your individual situation.