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Dispatches Level3 Passive Portfolio Retired Investor

Level3 Withdrawal Strategy Goes Into Defensive Mode

Following last year’s bear market, AAII’s Level3 withdrawal strategy calls for retirees to withdraw from their defensive (“safe”) assets and not equities in 2023.

by Charles Rotblut | January 2023

Charles Rotblut leads a class in AAII's new Essential Investing Video Course. Go to https://www.aaii.com/ves for more information and to subscribe.

Following last year’s bear market, AAII’s Level3 withdrawal strategy calls for retirees to withdraw from their defensive (“safe”) assets and not equities in 2023. The strategy’s defensive mode gets switched on because the S&P 500 index was more than 5% below its record high of 4,796.56 as of mid-December 2022.

The Level3 withdrawal strategy was created by AAII founder James Cloonan to help retirees stay invested in assets that offer the greatest potential for long-term wealth growth while being able to satisfy their current funding needs and minimize real risk.

The approach incorporates growth and defensive assets. A high allocation to growth assets like equities is maintained to allow a portfolio to grow at a rate faster than inflation. Defensive assets are those that are safe, from the standpoint of a drop in actual value. Such assets include short-term Treasuries, certificates of deposits (CDs) and money market funds.

The defensive allocation is established during the four-year period leading up to retirement. Each year that the S&P 500 starts within 5% of its previous high, one year’s worth of expected withdrawals ($50,000 in the example here) is shifted from equity to defensive. When market conditions are down, like at the start of 2019, postpone transfers. Then make up the difference once the market has recovered (as is shown with the larger 2020 and 2021 transfers in the table).

Once retired, withdrawals are taken from the equity allocation if the market is within 5% of its previous high. If the S&P 500 is more than 5% below its high at the start of the year, withdrawals are taken from the defensive portion. Cloonan recommended making the decision to withdraw from equity or defensive assets on January 1 of each year due to the wide availability of year-end data.

Table 1. Level3 Retirement Withdrawal Approach

At press time, the S&P 500 was down approximately 18% from its record high. Barring any substantial year-end rally, we expect that the Level3 withdrawal strategy will go into defensive mode on January 1, 2023. Retirees following this strategy should consider taking withdrawals from their safe assets in 2023, instead of their equity allocation.

Should the S&P 500 end 2023 at 4,557 or higher (a level of at least 95% of the previous record high—4,796.56 × 0.95 = 4,557), retirees should resume taking withdrawals from their equity holdings. Retirees should also begin the process of replenishing their safe assets in 2024 and 2025.

Pre-retirees should consider postponing shifting dollars from equities to their defensive assets at the start of 2023, as was the case in 2019 following 2018’s decline. Larger transfers to defensive assets should then be considered for 2024 and 2025.

Discussion

JOHN L from NJ posted over 3 years ago:

Running the Level 3 withdraw strategy using historical data starting in 1872, I discovered that the survival of the retirement portfolio is improved by reducing the size of the defensive assets. In fact, eliminating the defensive assets and investing in 100% equity leads to the least number of failures historically (retirement portfolio not surviving 30 years). Volatility mitigation (diversification into bonds) is very expensive.


DAVE G from TX posted over 3 years ago:

John L, volatility mitigation is what lets people sleep at night that can't afford to see their portfolio down by 40%. Now that short-term bonds are paying over 4%, turning off the dividend reinvestment of your ETFs or mutual funds and owning 20% bonds paying 4% can go a long way to having enough income even in bad years. What also helps me is to withdraw money on a quarterly basis rather than withdrawing the whole amount once a year.


JOHN L from NJ posted over 3 years ago:

Dave G - I agree. You either sleep well or eat well. Unfortunately, with inflation running at 7% and stocks in a bear market; investing in 4% bonds and not reinvesting dividends will destroy purchasing power in the long run. And potentially lead to old age poverty.


H from FL posted over 3 years ago:

John L. Good all-around points. I reinvest my RMD's 100% in equities, sleep well and eat well!


DAVE G from TX posted over 3 years ago:

Over the last 3 months (Sept to Dec) the CPI-U has gone up exactly 0.0%. Just like the stock market inflation data is subject to volatility as well. I am eating and sleeping well also, as both our SS payments went up by 9.4% while our Medcare insurance went down by 3%.


ROBERT A from NC posted over 3 years ago:

A lot of things keep me up at night, but market volatility isn't one of them. The thought of earning a measly 4% on my assets and having it taxed as ordinary income--especially in this inflationary environment--scares the living fool out of me! I'd never get a wink of sleep! Volatility is FAKE risk. I've been a buy-and-hold, 100% equity investor all my life. Because of that, I'm now in a position where I don't have to worry about market ups and downs because the returns from my equities have trounced those from any other asset class. If the market declines by 80%, I'll weather it. I'm not about to sell my highly appreciated equities, pay taxes on them, and then buy bonds.


Don P from USA posted over 3 years ago:

I like your approach of using RMD from Equity when YE S&P 500 is within 5% of ALL TIME High and Defensive when YE S&P is more than 5% from ALL TIME High : my question is equity transfer to defensive pure nondividend stocks ?


CHARLES R from IL posted over 3 years ago:

Don,

Defensive assets are those not subject to financial market risk. They include cash, CDs and money market accounts.

-Charles


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