Uncle Sam may have cracked the code for the optimal income withdrawal percentage in retirement.
The Internal Revenue Service's formula for required minimum distributions — the amount that individual retirement account holders and participants in qualified plans must take after reaching 70Ĺ — can form a reasonable basis for sustainable income withdrawals.
A new brief from the Center for Retirement Research at Boston College suggested that not only does the IRS' RMD perform as well as the traditional option of living on stock dividends and interest, but it also outperforms the tried-and-true 4% rule. The rule assumes that most retired clients can spend up to 4% of their nest egg annually, adjusted for inflation, without worrying about running out of money.
Researchers analyzed a hypothetical married couple of 65-year-old retirees. The husband receives a Social Security benefit of $12,000 annually, while the wife receives $6,000 through a spousal benefit, making their total household income $18,000 per year. Excluding the value of their home, the couple also holds $250,000 in financial assets invested in a mix of stocks and risk-free bonds, with an allocation that changes with age, realized returns and the assumed coefficient of risk aversion.
The bonds have an assumed real interest rate of 3%, while stocks are assumed to have a real return of 6.5%.
Tweaking the RMD formula so that withdrawals for the couple begin at 65, the retirees pull a growing percentage of assets each year for their income, starting at a rate of 3.13% and then going as high as 15.87% at 100.
To compare this strategy with others, the paper used a measure called Strategy Equivalent Wealth, which represents the factor by which the dollar value of the couple's wealth at 65 must be multiplied so they are as well off as a household that follows the optimal strategy. Researchers gave the optimal strategy an SEW of 1, while those that are suboptimal are greater than 1.
The 4% rule had an SEW of 1.49, making it the worst method out of the four strategies analyzed. The RMD formula came in slightly better with an SEW of 1.39, while living on interest and dividends had an SEW of 1.36. Basing withdrawals on life expectancy had an SEW of 1.29. A modified RMD strategy that would consume interest and dividends, plus the RMD percentage, fared best, with an SEW of 1.03, according to the CRR's research.
The success of the RMD strategy lies in its simplicity and the fact that it reduces the temptation to chase down dividends, according to the paper. However, its use of actuarial data is also a factor: The IRS intended IRAs — at least at the very beginning — to help people save for and live in retirement, and not for savers to turn the accounts into estate-planning vehicles, according to Eric Smith, a spokesman for the IRS.
The agency's life expectancy tables assume that a 55-year-old today will live to 84.6.
“As a general rule, the goal is to get [to life expectancy] using everything up,” Mr. Smith said. “The original concept of the IRA was to give people who didn't have access to a workplace retirement plan a simplified option for saving for retirement.”