According to a study of retirement withdrawal strategies, one of the more popular retirement drawdown methods is often the least-efficient way to go to maximize lifetime income for a retiree, while a simple rule used by the Internal Revenue Service works quite well.

The report, “Optimal Withdrawal Strategy for Retirement Income Portfolios,” conducted by Morningstar, measured five different drawdown strategies in various case studies. The real lesson from the analysis is that plans that dynamically adjust for changes in both market and longevity beat more traditional methods. It also concluded that investors should reevaluate how much to withdraw every year based on these two variables. A sophisticated simulation that takes both variables into account and is run every year is best.

Also See: VIDEO: Rethinking Retirement Withdrawal Strategies

But the recently released study found that the IRS method that takes at least one variable – longevity --  into account is a good option if an investor doesn’t have the simulation capability through an advisor or a 401(k) managed account program.

“The optimal withdrawal strategy incorporates mortality probability where the projected distribution period is updated based on the mortality experience of the retiree (or retirees) and the withdrawal percentage is determined based on maintaining constant probability of failure,” the study stated. “This approach best replicates how a financial planner would (or at least should) determine the available income from a portfolio for each year during retirement,” the report’s authors concluded. In fact, Morningstar uses one such method in its own 401(k) advice engine product.

What’s more, after analyzing the five methods, the study found that at a couple of popular methods were in fact, poor choices for clients.

The well-known 4% rule -- in which the first year withdrawal rate is set at 4%, followed by inflation-adjusted withdrawals in subsequent years -- addresses neither market performance nor longevity. The authors call this the “Constant Dollar” approach, based on the idea that a portfolio can maintain a constant withdrawal rate or constant dollar amount either in real or nominal terms for a fixed period, such as 30 years. The authors concluded that it “is often the least efficient way to maximize lifetime income for a retiree.”

The Endowment Approach, which the report’s authors call the “constant percentage approach,” is the simplest. It withdraws the same percentage of the account balance annually.

A third method, the Constant Failure Percentage, is designed to maximize withdrawals to the highest extent possible without causing the entire portfolio payment plan to fail. This is based on the idea of the probability of failure. Withdrawal amounts, which vary depending on the equity allocation of the portfolio as well as the year, are determined in order to keep that probability of failure constant through time. The problem with this strategy is that without updating, it doesn’t account for longevity well enough.

However, a fourth strategy, the Required Minimum Distribution (RMD) method used by the IRS, does a better job of accounting for longevity. The IRS defines these distributions as generally the “minimum amounts that a retirement plan account owner must withdraw annually starting with the year that he or she reaches 70 and ½ years of age, or, if later, the year in which he or she retires.” The distribution is calculated “by dividing the prior December 31st balance of that IRA or retirement plan account by a life expectancy factor that the IRS publishes” in separate tables, the federal agency states on its website.

The final approach, the Mortality Updating Failure Percentage, combines the Constant Failure Percentage and the RMD method. In this scenario, the annual withdrawal rate is based first on the number of years remaining, then calculated based on keeping a constant probability of failure for that period. It did the best job of accounting for both market returns and longevity.

To come up with the framework for evaluating different strategies, the team headed by David Blanchett, Morningstar’s new head of retirement research, came up with a metric called the “Withdrawal Efficiency Rate” (WER), which compares the withdrawals received by a 65-year-old male and female couple by following a specific strategy to what could have been received had the retirees had “perfect information” at the start of retirement. They tested it across the five withdrawal strategies through Monte Carlo simulation analysis. #