A Breakdown of the Systematic Withdrawal Approach

Preparing for retirement can look different for every investor. And when it comes to a retirement income strategy, there’s no one-size-fits-all approach. So what type of plan may be the right choice? 

The systematic withdrawal approach and the bucket strategy are popular options for retirement income planning. With a deeper understanding of these approaches, investors can avoid common assumptions—and make better decisions for the future.

Morningstar researchers assess the systematic withdrawal approach to four major bucket strategies: the cash flow reserve bucket strategy, two variations of the three buckets strategy, and the time bucket strategy.

To read the full research report, download a copy here. 

The systematic withdrawal approach assumes that investor’s spending will remain relatively consistent with adjustments only for inflation. Retirees fund their financial needs every month proportionally from both the equity and bond assets, and the portfolio is rebalanced according to a predefined decision rule.

• Simplicity: The approach is relatively easy to execute, helping investors better understand their financial decisions.
• Flexibility: Investors can adjust withdrawal amounts and schedules.
• Predictable cash flow: A systematic withdrawal plan most closely approximates the consistent paychecks that people grow accustomed to during their working years.
• High plan success rate and ending wealth: The approach indicates a potential to offer consistent retirement income while preserving capital.

• Investor behavior: Behavioral biases, like making hasty decisions during market volatility, may affect a withdrawal strategy.
• Shortfall risk: The combination of fixed withdrawals and the potential for negative market performance can increase shortfall risk—the possibility that a portfolio’s return will fall short, leading retirees to run out of money before the end of their life.
• Sequence risk exposure: This occurs when retirees must liquidate depressed assets in a bad market at the beginning of retirement.
• Limited growth potential: While the approach provides a stable income stream, it can limit long-term growth potential due to its structure of regularly withdrawing a fixed amount.

In comparison, the basic idea of bucket strategies is to establish multiple asset buckets with different levels of risk and funding purposes. By separating assets to fund near-term financial needs and to generate long-term capital growth, investors may be more comfortable investing in a risky portfolio with higher growth potential. 

Our study analyzes the following bucket strategies.

The cash flow reserve bucket strategy places one year of retirement spending in a cash bucket and the remaining assets invested in other buckets with an asset allocation matched to the client’s risk tolerance.

The three buckets strategy consists of multiple "accounts" for different time horizons or financial goals. Our study had two variations:

• Strategy A: Bucket 1 is filled with cash and used to fund the first year of retirement spending. Bucket 2 invests in long-term bonds and holds funds worth five years of retirement spending. Bucket 3 is filled with equities and set aside for asset growth.
• Strategy B: Bucket 1 is filled with cash and used to fund the first two years of retirement spending. Bucket 2 invests in long-term bonds and hold funds worth five years of retirement spending. Bucket 3 is filled with equity and set aside for asset growth.

The time bucket strategy divides the portfolio into four buckets that cover equal amounts of retirement periods with a legacy bucket for other goals.

Morningstar researchers assess and compare the performance of these strategies in different areas.  

Through this lens, the time bucket strategy stands out slightly from the other strategies. Specifically, this strategy has a viable monthly retirement spending of $6,206 at an 85% funding success rate, while the systematic withdrawal approach viable monthly retirement spending is $5,898.

As there’s no rebalancing within the buckets, the overall asset allocation increases to 100% equity after year 10 when the first two buckets are retired.

Yet, the systematic withdrawal approach provides $2,343 more in viable monthly spending than the cash reserve bucket strategy. One explanation for why the cash flow reserve strategy underperforms is the opportunity cost of always placing one year’s worth of retirement income in cash. 

Given the limitations of the decision rules in our bucket strategy modeling, it may not be surprising that the two variations of the three buckets strategies provide the lowest viable spending.

The sequence of investment returns can add risk to household financial outcomes. Some bucket strategies may improve financial outcomes by preserving depressed assets, particularly in the beginning of the decumulation phase. 

The time bucket strategy offers the highest spending under bad conditions at all success rates. On the other hand, the differences in viable spending amount narrow between what’s provided by the systematic withdrawal approach, cash reserve bucket strategy, or the three buckets strategy.

The relatively benign impact of the sequence risk here may be because our analysis is based on 150 hypothetical retirement starting dates that have the worst first six-month returns in the historical data. We assume a monthly withdrawal, which minimizes the impact to the investment portfolio even when it is depressed.

When an investor’s near-term spending is affected by the current market performance, it can lead to an irrational decision to withdraw from the equity market.

Under the systematic withdrawal approach, investor overreaction during a bad market significantly reduces the viable spending amount in all scenarios. In the case where an investor exits the equity market after a negative 20% quarterly return, their monthly retirement spending could be reduced by almost $2,000, equivalent to a $24,000 reduction in annual spending.

When accounting for investor overreaction, outcomes from the systematic withdrawal strategy are lower than what’s provided by the cash flow reserve bucket strategy and the three buckets strategy. This supports the behavioral benefit of a cash flow reserve bucket strategy. Even if these strategies produce a lower viable spending amount, it could be valuable if investors are prone to behavioral bias. 

When companies understand what matters to investors, it can be easier to help them prepare for retirement and overall build their financial well-being. 

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