Achieving a Higher Safe Withdrawal Rate with the Target Percentage Adjustment
David M. Zolt (Journal of Financial Planning)
Nice article by Mr. Zolt, who is a financial planner and another member of the Society of Actuaries.
"A much higher initial withdrawal rate than previously thought possible can be achieved without increasing the probability of failure as long as the retiree reduces or eliminates the inflation increase for years indicated by the Target Percentage™. The Target Percentage is developed and used to determine whether the portfolio is ahead of or behind target at any point during retirement. If the portfolio is ahead of target, the full inflation increase is taken in that year. If the portfolio is behind target, the inflation increase for that year is reduced or eliminated."
I like the approach suggested by Mr. Zolt because it is not as static ("set and forget" as defined by Wade Pfau) as the traditional safe withdrawal rate method. Adjustments to withdrawals are made (as frequently as annually) to take into account "good" and "bad" years and to keep the spending plan from veering off the tracks.
Note that Mr. Zolt's approach (or something similar) can easily be accomplished using the suggested process and spreadsheet found on this website. As an example, let's assume that a retiree would like to have a higher initial withdrawal rate and is comfortable with future increases of CPI minus 1% rather than full CPI increases. Let's further assume that she believes the best estimate assumptions for future experience are 5% annual investment return, 3% per year inflation and a 30-year withdrawal period. Also assume no annuity income and no bequest motive. The retiree runs the New and Improved Spending Calculator on this site with her best estimate assumptions which determines an initial withdrawal rate of 4.34%. She doesn't like that rate and determines that she can live with lower inflation protection (1% per year less), so she inputs 2% annual desired increases in the spreadsheet (but retains the 3% inflation assumption to measure the potential effect on future inflation-adjusted withdrawals). This yields an initial withdrawal rate of 4.92%, which is much more to her liking (about 13% higher compared with Mr. Zolt's 10%). She also looks at the inflation-adjusted runout tab on the spreadsheet and sees that if experience is exactly as assumed, her withdrawals will decrease in inflation adjusted dollars (by almost 25% in year 30).
As discussed in the original March, 2010 article in this website, our hypothetical retiree needs to employ an algorythm (rules) to adjust for actual experience and changes in assumptions and other input items each year. She likes Mr. Zolt's basic approach so she decides that she will use the following rules to determine subsequent year's withdrawals:
For this purpose, the preliminary withdrawal rate is the rate produced by running the spreadsheet at the beginning of the year based on assumptions and new asset data as of that date (and presumably continuing with desired increases of CPI minus 1%), the expected withdrawal rate is the rate for year two shown in Column M of the previous year's run-out tab and the corridor could be something like 95% to 105% of the expected withdrawal rate.
Note that I am not necessarily advocating this approach. I'm only illustrating that something similar to what Mr. Zolt suggests can be accomplished with the tools set forth in this website.
Mr. Zolt has graciously provided the following spreadsheet for those who would like to build their own target percentages. [Target_Percentage_Calc_2013_05_24.xls]
DoL Proposes to Include "Lifetime Income Illustrations in Benefit Statements
(Groom Law Group, May 9, 2013)
The Department of Labor recently published an Advance Notice of Proposed Rulemaking (ANPRM) soliciting comments on their proposals to mandate inclusion of lifetime income illustrations for 401(k) plan participants and other defined contribution plans. This Groom Law Group summary is a good explanation of the proposed changes to current requirements.
Here is a link to the DoL's ANPRM
Here is our response to the ANPRM
Is the 4% Rule Folly?
(AdvisorOne, April 29, 2013)
Another excellent article by Michael Finke, professor and coordinator of the doctoral program in personal financial planning at Texas Tech University debunking the 4% Rule. Mr. Finke criticizes the "shortfall analysis" used to develop the 4% Rule and concludes that use of this rule by individuals or advisors has a tendency to result in a more conservative spending strategy than necessary. Mr. Finke says, "That money in the bank [at death] over and above the desired legacy is the money left on the table in the game of retirement living."
Finke refers to a 2008 study by Olivia Mitchell and others which estimated, "that the average retiree could improve expected happiness in retirement by as much as 50% by adopting a blended annuitization and investment strategy."
Why 4 Percent Annual Withdrawals are Still Safe
David Ning (US News, April 17, 2013)
"But with the original 4% annual withdrawal rate already too low for many people to sustain a comfortable lifestyle, what is a future retiree to do?" Ning argues that the 4% rule is still conservative and appropriate as long as you are willing to adjust your future spending to reflect actual investment experience and you are also willing to eliminate unnecessary expenses.
Since I have ranted against the 4% rule in previous posts, readers may be somewhat surprised to know that I'm not in violent disagreement with Mr. Ning's post. Using the spending calculator on my site (Version 2.0) and inputting $500,000 of accumulated savings, $0 immediate or deferred annuity income, 30 year payment period, 5% investment return, 3% inflation and no amounts left to heirs, you get a spend rate for the first year of 4.34% of the accumulated savings. Note, however, that if you change the immediate annuity amount to $15,000, you get an initial spend rate of 3.45%.
The reason I'm not too upset with Mr. Ning's post is that he suggests that you can't blindly follow the 4% rule as intended by its inventor. Of course Mr. Ning does not provide any guidance as to how your spending budget should be adjusted for actual investment experience.
So, I suggest rather than simply pulling a percentage out of the air, you need to 1) do the math based on your personal situation and 2) make adjustments in the future as outlined in the original March, 2010 article (actuarial approach) on this site in order to keep your spending plan on track.
Society of Actuaries Committee on Post Retirement Needs and Risk
While mostly focused on providing pre-retirement planning information for "actuaries and other professionals with an interest in modeling and conducting research regarding individual financial risks and needs after retirement", this site does contain some useful information for individuals who are trying to develop a budget in retirement.
While some retirees may find recent articles regarding "middle market retirement strategies" somewhat unfocused and confusing, some of the earlier material, particularly several of the issue briefs contained in the "Managing Retirement Decisions" are understandable and potentially helpful.
The committee makes excellent points in their material regarding the importance of planning for "shocks", such as unexpected health problems or entering a nursing home. In addition, some of their material discusses the use of home equity to supplement income in retirement.
Planning your retirement: The best ways to generate lifetime income
Steve Vernon (CBS Moneywatch, April 15, 2013)
Thanks again to Steve Vernon for mentioning my simple online tool (which has been subsequently updated to Version 2.0) in his April 15 blog post as one of the recommended systematic withdrawal approaches (Retirement Income Generator #2).
While Steve mentions three different types of Retirement Income Generators (RIGs), it is important to remember that retirees don't have to utilize just one of the three RIGs. As each type of RIG has advantages and disadvantages, you may wish to apply one of the RIGs to a portion of your accumulated savings and another RIG to the remainder of your accumulated savings. For example, you could buy an immediate annuity (or deferred annuity) with a portion of your accumulated savings and use a systematic withdrawal approach with the remainder of your savings. And my simple online calculator will enable you to see what the effect of such "RIG mixing strategies" will have on your expected income in retirement.
Taking the Mystery Out of Retirement Planning
(Department of Labor)
Kudos to the U.S. Department of Labor, Employee Benefits Security Administration for attempting to provide education on retirement planning. This site contains an online calculator which follows the booklet prepared by the DoL with the same name published in February, 2010. Unfortunately, its focus is primarily on helping individuals who are about 10 years from retirement with their planning rather than helping retired individuals determine a spending budget. Here is the link to the booklet
The following are some of the features of the online tool that I found disappointing:
After laboriously completing the many input items, the spreadsheet compares the present value of future expected income with the present value of future expected expenses. This is useful in determining an overall shortfall or surplus, but it doesn't tell you how much you can spend each year.
In determining the present value of future expected income, Social Security amounts are not indexed with assumed inflation. As far as I can tell, this is just an error in the program.
If you are over age 70, the program doesn't work for you. I guess retirement planning is no longer a mystery after age 70.
The program uses an assumption for inflation of 3.5% per year for non-health expenses and 7% per year for health related expenses with no flexibility to adjust those assumptions.
If you are currently retired and have a fixed immediate annuity, the program does not allow you to input a fixed deferred annuity. Also, there is no way to reflect a bequest motive, and the retirement period is fixed in the program to end at age 95.
The program converts accumulated savings into fixed (non-cpi indexed) payment amounts at retirement.
The booklet provides links to other online savings calculators that are also primarily focused on pre-retirement savings accumulation rather than post-retirement decumulation.
If you use this tool, don't use commas in your input items as the program will reject them.
"Much like retirement investing, a suitable withdrawal strategy likely will be unique to an individual’s situation. After all, not everyone is going to have the same wants and needs in retirement. A number of other variables also can impact a withdrawal strategy’s success, such as number of years in retirement, other income sources, portfolio value and even asset allocation."
The SMART 401K site includes a good spending calculator that shows how long a given level of accumulated savings will last based on assumptions and desired spending levels you specify. It does not tell you how much you can spend each year, but you can work backwards to get basically the same results obtained using the spreadsheets in my website (small differences result from different assumed timing of withdrawals).
As noted in the original article on my site, the actual spreadsheet used in the process is not as important as the discipline required to review results at least once a year and make reasonable adjustments for changes in experience and assumptions.
How to Draw Down Your Nest Egg: 3 Alternatives to the 4% Rule
(Time, March 22, 2013)
This article refers to the three alternatives to the 4% Rule discussed in the WSJ article of March 1, 2013 (see below). While these three alternatives are potentially better than blindly following the 4% Rule, it is important to realize that any approach that does not reflect your personal financial situation and changes in it from year to year is less likely to be successful. You need to crunch your numbers at least once a year in order to keep your spending budget on target.
Another article encouraging retirees to use a good retirement calculator and revisit it each year to determine annual withdrawals.
Mr. Updegrave develops a 4% withdrawal strategy (with annual inflation increases) for a retiree with $500,000 in accumulated savings who is age 65 and wants his money to last for 30 years. He assumes inflation of 2.5% per annum and some (undisclosed) assumptions for future returns on equities and bonds.
When determining annual withdrawals, it is important to consider other sources of retirement income that may not be indexed with inflation as well as the impact future inflation may have on total spending amounts, particularly if you want your total annual spendable income to keep pace with inflation.
Using the V2.0 spreadsheet on this site and inputting 4% investment return, 2.5% inflation, $500,000 of accumulated savings and zero for annuity income and amounts to heirs, we get an initial withdrawal rate of 4.08%, which is reasonably consistent with Mr. Updegrave's calculation. However, if we also input that this retiree has an annual fixed dollar pension of $10,000 per year (immediate annuity), we get an annual withdrawal of 3.55% from accumulated savings. Similarly, if we input a $10,000 deferred annuity and 10-year period of deferral, we get an annual withdrawal percentage of 4.92%.
If we assume a 6% annual investment return and 4.5% annual inflation and no annuity amounts, we get a withdrawal rate of 4.07% (just about the same as in the lower inflation environment assumed by Mr. Updegrave), but inputting a $10,000 immediate annuity drops the withdrawal rate to 3.25% under this scenario and inputting a $10,000 deferred annuity results in a 4.67% withdrawal rate.
Bottom line: Make sure the retirement calculator you use reflects your financial situation (including other annuity income and bequest plans) and you understand the implications of the assumptions you input (or that are built into the calculator)
Say Goodbye to the 4% Rule
(Wall Street Journal, March 1, 2013)
What to do when the old math doesn't add up? This Wall Street Journal article offers three alternatives to the 4% Rule. Two of the three have already been discussed on this website and the third is just a variation of the safe withdrawal rate approach. I continue to believe that the best answer to this question is to recalculate your withdrawal budget every year using data and assumptions that reflect your personal financial situation as advocated in this website.
Wade Pfau's Retirement Research Blog
February 19, 2013
Guest Post: Ken Steiner on how Actuaries Think About Retirement Income
Developing A Retirement Spending Strategy--An Actuarial Approach
by Ken Steiner, Fellow, Society of Actuaries, Retired
Paper Poses New Withdrawal Rate Method
(Plansponsor, February 8, 2013)
Another paper on the same theme from Blanchett, Finke and Pfau (see "The 4 Percent Rule is Not Safe in a Low-Yield World). While I applaud the work of these gentlemen in showing that using the 4% rule, or any other "safe" withdrawal rate may be dangerous, I find that the authors are simply demonstrating the weaknesses of relying on the Monte Carlo method to determine an initial withdrawal rate that is subsequently increased by inflation. Yes, the assumptions they use for expected future experience are more sophisticated than those used in previous studies (they assume expected interest rates will rise in the future rather than remain constant). But, even this more sophisticated model makes no adjustment for possible future experience that deviates from assumed experience (or actual spending). In the Plan Sponsor article, Blanchett says, I acknowledge that this [model] may not be relevant in five years when bond yields are [assumed to be] higher." I also had to laugh when I read, "the average person running these [Monte Carlo] simulations is getting a falsely successful picture." No average retiree I know is running Monte Carlo simulations in her spare time.
How Much Can You Withdraw From Your Savings
(January/February 2013 Money magazine (page 116) -- No Link)
"Best move: Recalculate your withdrawals every year to take into account your current account balances and the fact that your nest egg doesn't have to support you for as long."
"With a decision this big, you don't want to blindly stick to the 4% rule or any other rigid system..."
"As a practical matter, though, recalculating your withdrawal rate this way can be quite complicated. So unless you're working with a financial planner capable of doing the number crunching for you, your best bet is to go to an online tool like T. Rowe Price's Retirement Income Calculator every year, plug in your most up-to-date information, and adjust your withdrawals up or down as necessary."
I couldn't agree more with this advice from Money magazine. And the online tool "like" T. Rowe Price's that you should use is located right here in this website. See related link below for a discussion of some of the weaknesses of the T. Rowe Price tool.
When I questioned Dr. Pfau about what he and his co-authors meant by the statement, "clients may wish to consider their retirement income strategies more broadly than relying solely on systematic withdrawals from a volatile portfolio" in the paper "The 4% Rule is Not Safe in a Low-Yield World" (see below), he responded by referring me to this new paper to be published in the February issue of The Journal of Financial Planning.
The paper uses Monte Carlo simulations and "current market" assumptions to determine an efficient frontier of investment allocations that best meet the two competing financial objectives for retirement defined by Dr. Pfau: "satisfying spending goals and preserving financial assets." He examines allocations involving six different types of investments. Based on his methodology and assumptions, he concludes that the efficient frontier for a hypothetical 65-year old couple consists of combinations of stock and fixed single premium immediate annuities.
This is another excellent paper from Dr. Pfau that should be useful in helping retirees develop or refine their investment strategy. However, the approach suggested doesn't appear to provide guidance on how adjustments are made in later years for deviations from the spending plan, actual investment experience, changes in health or changes in initial assumptions. Perhaps he anticipates that the client and financial planner will meet periodically to re-run the model and make appropriate adjustments. In any case, I look forward to further research by Dr. Pfau using this model, particularly inclusion of qualified longevity annuity contracts in the investment allocation mix.
I worked for many years with Steve at Watson Wyatt Worldwide (now Towers Watson). Steve is a fellow Fellow of the Society of Actuaries and is very passionate about helping people prepare for and prosper in their retirement years. Steve has written four books on retirement planning. His most recent book is entitled "Money for Life." It is an excellent book, and I'm not just saying that because he is my friend or because he refers to my website on pages 145-148 of the book. You can learn more about Steve's work on his website "Rest-of-Life.com," and I recommend that you read his excellent blog articles for CBSMoneywatch.
The 4% Rule is Not Safe in a Low-Yield World
(Social Science Research Network, January 15, 2013)
The authors put what is hopefully the final nails in the coffin of the 4% Withdrawal Rule, and make a compelling argument for avoiding any "safe" withdrawal rate strategy. They conclude that, "The success of the 4% rule in the U.S. may be an historical anomaly, and clients may wish to consider their retirement income strategies more broadly than relying solely on systematic withdrawals from a volatile portfolio."
As noted elsewhere on this website, I agree with the authors that the 4% Rule (or some other specific "safe" withdrawal rate) does a poor job of balancing the dual needs of retirees to maintain lifestyle spending and preserve financial assets. Retirees need a spending plan that is flexible, reflects actual spending and investment experience and reflects individual circumstances (such as existence of other lifetime income through defined benefit plans or immediate or deferred annuity contracts as well as any bequest motives). Fortunately, the actuarial approach outlined in this website can help you meet these needs.