O , N -
RESEARCH
RETIREMENT
CAN RETIREES BASE WEALTH
WITHDRAWALS ON THE IRS’
REQUIRED MINIMUM DISTRIBUTIONS?
B W S A W*
* Wei Sun is an assistant professor at the Hanqing Advanced Institute of Economics at Renmin University in Beijing,
China. Anthony Webb is a research economist at the Center for Retirement Research at Boston College. This brief, which
is adapted from a longer paper (Sun and Webb ), provides general guidance that may be useful in many circumstances.
However, a household’s specific investment or financial planning strategy should be based on its personal circumstances.
The authors strongly recommend that households obtain appropriate financial advice prior to making any decisions.
Introduction
As (k) plans have largely replaced traditional pen-
sions, baby boomers have become the first genera-
tion that must decide how much of their savings to
spend each year in retirement. Boomers must find a
strategy that best balances the risk of outliving their
wealth against the cost of unnecessarily restricting
their consumption.
This brief, which is adapted from a recent paper,
explores the possibility of basing withdrawals on the
Internal Revenue Service’s rules for Required Mini-
mum Distributions (RMD) for (k)s and IRAs. The
analysis compares an RMD strategy with existing
rules of thumb and with a pattern of optimal with-
drawals.
The discussion proceeds as follows. The first
section details the rules of thumb, including the
proposed RMD strategy. The second section defines
an optimal strategy, which serves as a benchmark
for comparing the rules of thumb. The third section
provides the results of this comparison. The fourth
section suggests a way to modify the RMD strategy
to bring it closer to the optimal. The final section
concludes that the RMD strategies oer retirees a
reasonable trade-o of the benefits and risks inherent
in spending down one’s retirement savings.
Rules of Thumb for
Asset Drawdown
People adopt rules of thumb for drawing down their
assets because rules are relatively simple to follow.
This section describes the traditional rules of thumb
and then discusses the potential for an RMD strategy.
Traditional Rules of Thumb
Three traditional rules of thumb include relying on
the investment earnings produced by the assets,
calculating withdrawals based on life expectancy, and
adopting the so-called “-percent rule.”
Spend interest only. Some retirees use the straight-
forward strategy of leaving the principal in their
retirement accounts untouched and spending only
the dividends on stocks and the interest on bonds
or certificates of deposit. This strategy can work for
wealthy individuals, but has serious drawbacks for
people who lack substantial retirement savings. One
disadvantage is that, when they die, they will leave be-
hind all of their initial wealth plus capital gains. This
strategy may be desirable for those who want to leave
a bequest, but in other cases it unnecessarily restricts
retirement consumption.
Center for Retirement Research
Another drawback to the “interest only” strategy
is that a retiree’s income – and consumption – are dic-
tated by his asset allocation. The retiree then runs the
danger that the tail (the desire to consume) may begin
to wag the dog (investments), resulting in a portfolio
allocation that does not minimize the risk for any
given level of expected return on the portfolio. That
is, the retiree may over-invest in dividend-yielding
stocks, losing the benefits of portfolio diversification.
Base withdrawals on life expectancy. A second
draw-down strategy used in retirement is to spend all
financial assets over one’s life expectancy, as predicted
by life tables. The equation for calculating annual
withdrawals under this strategy is:
Annual withdrawal = ___________ x wealth
r
– ( + r)
-t
where r is a risk-free interest rate on the investments
and year t is the remaining life expectancy.
This strategy has two significant drawbacks. First,
the above equation is not a simple calculation for
most people. Second, retirees face a high probability
– a -percent chance – that they will outlive their sav-
ings and be forced to rely solely on Social Security.
Adopt the 4-percent rule. A third strategy is to
spend a fixed percentage of one’s initial retirement
savings. For example, under the so-called -percent
rule advocated by some financial planners, the retiree
each year withdraws percent of that 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 in a given
year, the retiree should respond by reducing con-
sumption to preserve the assets – a fixed -percent
withdrawal is not consistent with such flexibility.
Required Minimum Distributions
An alternative strategy is to base withdrawals on the
IRS’s Required Minimum Distributions (RMD), a
percent of assets that individuals are required to with-
draw each year starting at age ½.
The IRS makes
no claim that the RMD, which is designed to recoup
deferred taxes, is the basis of an optimal draw-down
strategy. Yet an RMD approach satisfies four impor-
tant tests of a good strategy.
First, like other rules of thumb, it is easy to follow.
The IRS stipulates withdrawal percentages based
on life expectancy tables.
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 (see Figure ). Second, the RMD strategy
provides a superior way to manage wealth, because it
allows the percentage of remaining wealth consumed
each year to increase with age, as the retiree’s remain-
ing life expectancy decreases. Third, since consump-
tion 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.
F . R M D
P A, A
Source: Authors’ calculations based on IRS tables for Re-
quired Minimum Distributions (see U.S. Department of the
Treasury, ); annual percentages are in the Appendix.
0
4
8
12
16
65 70 75 80 85 90 95 100
To determine which real-world strategy would pro-
duce the best possible outcome, the rules of thumb
can be compared with an optimal wealth draw-down
strategy.
An Optimal Draw-down
Strategy
Managing retirement wealth involves trading o the
enjoyment of spending one’s assets on consumption
against the risk of spending too much and prema-
Issue in Brief
turely depleting one’s resources. The household’s
goal is to optimize this tradeo – in economic jargon,
to maximize the expected utility of consumption.
This analysis uses the example of a married couple
in which the spouses are the same age and both
retire at .
The husband receives Social Security
benefits of $, annually, and the wife receives
$, through a spousal benefit, for a total house-
hold income of $, per year.
Assume that the
household has $, in financial assets, excluding
the equity in their house.
The investment options
include stocks and risk-free bonds.
Each year the
household decides how to allocate its assets between
stocks and bonds and how much to take out of its
account. The model yields a draw-down pattern that
maximizes the expected utility of consumption.
The Horse Race
The next step is to conduct a horse race in which the
benefits generated by the optimal draw-down strategy
are compared with the benefits of the traditional rules
of thumb. This comparison uses a measure called
Strategy Equivalent Wealth (SEW). The number for
each strategy is the factor by which the dollar value of
the household’s wealth, at age , must be multiplied
so that the couple is as well o as a household that
follows the optimal strategy. The optimal strategy has
an SEW of , and the SEWs for the suboptimal strate-
gies are, by definition, greater than .
Figure shows the results for the retired couple.
For the rules of thumb, the SEW factors range from
. for the life expectancy strategy – the best – to .
for the -percent rule – the worst. Interestingly, the
RMD approach, with an SEW of ., performs better
than the -percent rule. In dollar terms, the couple
would need about $, more – or percent (.
minus .) of their $, savings – to be persuad-
ed to use the -percent rule instead of the RMD strat-
egy. The RMD approach also has advantages over the
other rule of thumb strategies, as discussed earlier,
that are not captured in the SEW calculations. For
example, the RMD approach is easier to follow than
the life expectancy strategy. And the RMD approach
does not provide a temptation to chase dividends as
does the interest only strategy.
1.49
1.39
1.36
1.29
0.0
0.5
1.0
1.5
2.0
F . D- S, S
E W (SEW)
Source: Webb and Sun ().
-percent rule
Required minimum
distribution
Spend interest,
dividends only
Spend assets over
expected lifetime
Optimal
Making Good Better
A potential criticism of the RMD rule is that it results
in relatively low consumption early in retirement.
While this outcome might be optimal for some
households, particularly those fearful of rising health
care costs, others might prefer greater consumption
at younger ages when they are better able to enjoy it.
This result could be achieved by a modification to the
RMD rule, namely to consume interest and dividends
(but not capital gains), plus the RMD percentage of
financial assets. To illustrate, a -year-old couple
with financial assets of $, who received $,
of interest and dividends in the last year, would spend
$,: the $, in interest and dividends, plus .
percent (the age Annual Withdrawal Percentage
under the RMD strategy) of $,. In contrast, a
household following the unmodified RMD rule would
spend just $,.
Figure on the next page compares the SEW of
the modified RMD strategy with the SEWs of the
strategies reported in Figure . At ., it outper-
forms all the alternatives, including the unmodified
RMD rule. The disadvantage of the modified RMD
rule is its greater complexity. Although (k) and
IRA statements report interest and dividends, house-
holds must extract this information and perform the
Center for Retirement Research
necessary calculations to determine their withdrawal
amount. One solution might be for (k) and IRA
statements to report the amount available for spend-
ing under the modified RMD rule.
1.49
1.39
1.36
1.29
1.03
0.0
0.5
1.0
1.5
2.0
F . D- S I
M RMD, S E W
(SEW)
Source: Webb and Sun ().
-percent rule
Required minimum
distribution
Spend interest,
dividends only
Spend assets over
expected lifetime
Optimal
Modified required
minimum distribution
Conclusion
Rather than attempt the complex calculations neces-
sary to arrive at an optimal strategy for drawing down
and spending their retirement savings, retirees rely
on easy-to-follow rules of thumb such as the -percent
rule advocated by some financial planners. This brief
suggests that the IRS’ Required Minimum Distribu-
tion rules may be a viable alternative. For financial
and practical reasons, the eectiveness of the alterna-
tive RMD strategy compares favorably to traditional
rules of thumb. And a modified RMD strategy does
even better.
Endnotes
Devising a retirement spending and investing plan
requires, among other things, estimating longevity,
trading o spending early in one’s retirement years
against saving money for old age, and choosing how
much to invest in risky stocks, which oer higher
expected returns in exchange for greater risk.
One other solution to the draw-down issue is to
buy an annuity that provides a guaranteed regular
income sucient to meet the household’s essential
expenses, investing any remaining assets. However,
retirees have resisted buying annuities, perhaps out
of a desire to retain liquidity as protection against
unexpected medical costs. Other proposed explana-
tions for the lack of enthusiasm for annuities include
the presence of a bequest motive, unattractive annuity
pricing due to adverse selection, and various behav-
ioral biases. See Brown () for an overview of the
literature.
A Google search for “-percent rule” and “retire-
ment” produced more than , hits. Also see
Bengen ().
Failure to take the Required Minimum Distribu-
tions results in a -percent tax on the required
withdrawal amount.
The IRS’ RMD distribution table reflects estimates
of the joint life expectancy of couples in which the
spouse is years younger than the account holder.
It should be noted that while the IRS requires the
withdrawals, it does not require retirees to spend their
withdrawals.
The paper on which this brief is based also provides
utility functions and comparisons of draw-down
strategies for couples in which the wife is six years
younger, as well as for single men and single women.
If the husband dies, the wife would begin collect-
ing Social Security survivor benefits, which would pay
$, and result in a reduction in total household
income.
Households with fewer financial assets may view
them as a liquidity backstop for emergency expendi-
tures, rather than as an income source. Households
with more financial assets may have bequest require-
ments that are an important consideration in their
decumulation plans.
The assumed real interest rate for the risk-free
bond is percent, which is above current rates but
approximates the long-run average rate.
The utility function is discounted by the couple’s
rate of time preference, assumed to be percent.
The SEW results vary depending on the number
of individuals and on various assumptions. For more
detailed results, see Sun and Webb ().
References
Bengen, William P. . “Determining Withdrawal
Rates Using Historical Data.” Journal of Financial
Planning (): -.
Brown, Jerey. . “Understanding the Role of An-
nuities in Retirement Planning.” In Overcoming
the Saving Slump: How to Increase the Eectiveness
of Financial Education and Saving Programs, edited
by Annamaria Lusardi. Chicago, IL: University of
Chicago Press.
Sun, Wei and Anthony Webb. . “Should House-
holds Base Asset Decumulation Strategies on
Required Minimum Distribution Tables?” Work-
ing Paper -. Chestnut Hill, MA: Center for
Retirement Research at Boston College.
U.S. Department of the Treasury, Internal Revenue
Service. . Individual Retirement Arrangements.
Publication . Washington, DC.
Issue in Brief
APPENDIX
A W P
R M D S
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Note: Individuals are required to follow the RMD rules
during the calendar year in which they reach age ½. The
withdrawal schedule for younger ages used in this analysis
is calculated based on the same life tables used for the RMD
rules.
Source: Webb and Sun ().
Issue in Brief
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RESEARCH
RETIREMENT
