Rules for Portfolio Withdrawals

Managing portfolios in your working years or in retirement is best done systematically. Here are my five easy to follow rules for withdrawing monthly living expenses from the test portfolios.

Part of the inspiration behind this blog is to have a practice run for investing while in the decumulation phase before I’m actually in the declumulation phase. The portfolios are possibilities, and I want to see what it would be like if each were my portfolio when I’m in retirement.

To simulate this, I have decided to use the same rules to manage all the portfolios so that I can see how each portfolio does under the same conditions. In this case, it’s the much debated 4% rule, or the idea that you can pull 4% of your portfolio (inflation-adjusted) to live on. I also wanted to be sure that my withdrawal processes were realistic for how I would want to manage my finances in the drawdown phase, namely with clear rules and without too much need for fussing about (mainly, not too much rebalancing). I do review the portfolios monthly in order to share the ups and downs, though looking towards my own retirement, I will probably just do so quarterly when I get to that stage.

I began tracking these portfolios in July of 2021, with a hypothetical $1,000,000 in each portfolio. I allocated money into the chosen ETFs at the correct proportions at the start of the experiment (please see the various explainers of the portfolios linked in the “Track Progress” post pinned on the home page).

Since I’m aiming for an annual 4% withdrawal rate and the portfolios are tracked on a monthly basis, this works out to…

Rule #1: Start by taking $3,333 from each portfolio every month. This is the 4% rule in action, which works out to 1/3rd of 1% every month. The purpose of this exercise is to simulate the process of withdrawing for retirement, and 20 minutes of my time every month is about as much work on it as I would want to do. Since the value of $3,333 will decrease over time and we need to adjust for the cost of living, we refer to…

Rule #2: Adjust the target withdrawal amount every quarter to account for inflation. So, at the start of the 3rd quarter of 2021 when these test portfolios started, the withdrawal figure was $3,333. By August, the inflation rate was 5.3% for the preceding twelve months, so a monthly rate of .44%. The withdrawal rate from August were then upped to $3,333*1.0044%, or $3,348.

For figuring out inflation rates, I use the US Inflation Calculator website, which is based on Consumer Price Index data. I take the annual inflation figures in the most recent month and then divide by twelve to get the monthly figure (or rather, a close enough number, since I’m not dealing with the compounding figure, which is actually a bit less, actually). The money for the withdrawal will come from…

Rule #3: Preferably, the quarterly withdrawal is first addressed through dividends received. In each quarterly update, I will see what dividends have been paid out in the previous quarter and apply that money first towards meeting withdrawal goals. An exception to this will be…

Rule #4: Threshold rebalancing. In any quarter, if an asset has climbed to more than 25% over its ideal proportion in the portfolio, the quarterly living expenses will come from this fund first. For example, if real estate were meant to be 10% of the portfolio and it was actually 12.7% (or 27% over its ideal) before withdrawals, the quarterly expenses would come from this account (if two or more, then from the highest one only). If there is no fund that is 25% over its target, and dividends aren’t enough to cover the quarterly withdrawal, then we have…

Rule #5: After dividends, withdraw from the two best performers at the following rates: 70% of the remainder from the highest overall and 30% from the second highest. Example: assuming a withdrawal amount of $3,400 for a given quarter, that $1,000 in dividends were received, and there were no threshold rebalancing event, the other $2,400 to complete the withdrawal would be made as $1,680 from the highest and $720 from the next. The other assets in the portfolio would be left unchanged. This rule is slightly amended for the Classic 60/40 and 100% Equities portfolios. Since they each have only two assets, 100% will come from the highest.

By best performer, it means the one with the highest growth relative to its original allocation in the portfolio. If Asset A is slated to be 5% of the portfolio but is now 7%, it is 40% above its allocation (7-5=2, and 2 is 40% of 5). If Asset B is slated to be 20% of the portfolio but is now 22%, it is also 2% above its target, but that is just 10% off (2 as a percentage of 20). In this case, Asset A would be the "better" performer and would be the one to draw from.

By applying these same rules to all the portfolios, hopefully we’ll have an apples-to-apples comparison of how they’ve done in a realistic scenario.

Rules for Threshold Rebalancing

Following the paper by Kitces, which relayed Daryanani’s finding that threshold rebalancing using a 20% tolerance band in relative terms has promise as a way to improve portfolios, I’ll apply this rule to all portfolios.

First off, all the former rules for withdrawals remain. I will make withdrawals from the assets in the portfolio to satisfy living expenses. If, after those withdrawals, any asset is either 20% above or below its target allocation (again, in relative terms, so for an asset targeted to be 30% of the portfolio, I’ll rebalance into/out of it if it is below 24%/above 36%), those assets will be rebalanced. This is not portfolio-wide rebalancing.

If there is just one asset that has passed the threshold, either above or below, then I will rebalance with the two farthest from ideal on the other side (example: A is +22%, but there are no assets that are more than 20% under. In this case, I’ll balance A with B and C, which are, let’s say, 17% and 15% below their target allocations, respectively). I take from two to spread out the impact for assets that aren't meeting the threshold rule.

To prevent selling too much of an asset and putting it under its allocation going forward, there is a “sell cap” that limits the amount sold to the amount scheduled for purchase. In other words, you take the lower of the two amounts for buy and sell so that you never sell so much to make something that was higher, go under.