End of Year Reminder--Time to Determine Spending Budget for Next Year
It's that time of the year for many of us retirees to determine our spending budget for next year. You may also wish to take this opportunity to revisit your investment strategy. I will illustrate how easy this process is with an example retiree, Richard.
Richard retired last year at this time at age 65. At that time, he used about 20% of his accumulated savings to buy an immediate life annuity that pays him $15,000 per year. At the beginning of 2013, he had $800,000 left after his annuity purchase. He inputted the assumptions recommended in our October 11, 2013 post (5% interest, 3% inflation, 30 years expected payout period (95-65) and $10,000 as the desired amount of assets at death) into the spreadsheet in this website, to determine a total spendable amount (excluding Social Security) for 2013 of $45,179 ($30,179 from accumulated savings and $15,000 from the annuity). He deposited $30,179 in his non-interest bearing spending account and decided to invest half of the remaining assets ($769,821) in equities and the other half in a variety of fixed income investments. During 2013, Richard spent exactly the amount in his spendable account plus the $15,000 from the annuity.
Easy Steps to Determine Richard's Spending Budget for 2014
The first step in the process is gather asset data as of the end of 2013. Richard's equity investments yielded almost 29% during 2013 and his fixed income investments yielded about 1%, so his end-of-year assets are $884,909 (compared with expected end-of-year assets from the previous year's calculation of $808,312, or an asset gain for 2013 of $76,597).
The second step in the process is to determine a preliminary spending value for 2014 by inputting new amounts into the spreadsheet on this website. If the same assumptions and amounts are used as last year except using $884,909 for accumulated savings and 29 years for expected payout period, Richard's preliminary 2014 spendable amount is $49,947 ($34,947 + $15,000).
The third step in the process is to apply the smoothing algorithm discussed in our October 11, 2013 post to the preliminary spending value. Richard determines that the Consumer Price Index has increased by about 1.3% during 2013. Therefore, he determines his 2014 spendable amount as last year's total spendable amount ($45,179) increased by 1.3% ($45,766), but not less than 90% of the preliminary 2014 total spendable amount of $49,947 (.9 X $49,947 = $44,952). Since the corridor value is lower than last year's value increased with inflation for the year, it does not apply and Richard's total spendable amount for 2014 is $45,766 ($30,766 from accumulated savings and $15,000 from the annuity).
Richard plans to transfer $30,766 of his accumulated savings in his spending account and rebalance the remainder ($854,143) so that he has 50% in equities and 50% in fixed income investments. He recognizes that because he has the annuity and Social Security, his actual investment mix is weighted more heavily in fixed income than equities, but he is comfortable with that result.
New Research On Variable Spending Strategies (Like the One Recommended in This Blog)
In this December 10 article, Dr. Pfau compares the spending paths created by two variable withdrawal strategies: The Guyton Decision Rules and the Blanchett actuarial approach discussed in our November 20 post. Unfortunately, Dr. Pfau's compares what is essentially a spending smoothing algorithm (Guyton) with year-by-year application of Blanchett's spreadsheet calculator without application of any smoothing of the results. However, as Dr. Pfau revealed in his article, Mr. Blanchett, "would almost certainly incorporate a moving average approach to smooth out the cash flows."
As I said in my original 2010 article (available in the articles section), the most important step in the five step general actuarial process to developing an estimate of how much you can spend each year involves periodic calculation of the theoretically correct spendable amount (using the simple spreadsheets found in this website, or Mr. Blanchett's spreadsheet or some other more "robust" calculator) and application of an algorithm to smooth actual experience as it occurs. See our post of October 11, 2003 for our recommended smoothing algorithm.
Dr. Pfau concludes that, "More research about variable withdrawal rates should look to build in a smoother spending path with changes only made when thresholds are crossed, and to more carefully calibrate the relationship between withdrawal rates and age." I agree and encourage Dr. Pfau to look at the approach recommended in this website.
Follow Up to July 23, 2013 Post--Delaying Commencement of Social Security
The consulting firm October Three has written a nice article about the potential financial advantages of delaying commencement of Social Security benefits until age 70. Readers of this blog will remember that we discussed this strategy and pointed readers to a spreadsheet on our site that would enable retirees to use their accumulated savings to "bridge" the period from age of retirement until age 70 (or some other age) in our post of July 23rd of this year.
Using that spreadsheet, information for the example retiree in the October Three article, accumulated savings of $500,000 and the recommended assumptions described in this website (5% investment return, 3% inflation and survival until age 95), readers can confirm that if the example retiree retires at age 62 uses his accumulated savings as a Social Security bridge and defers commencement of his Social Security benefit until age 70, he can expect (under the recommended assumptions) to have total lifetime real retirement income of $39,130 per year starting at age 62 using the delay strategy vs. $35,655 per year if he commences Social Security at age 62. As can be seen in the spreadsheet runout tab, at age 70 he will be expected to have $305,906 of accumulated assets at age 70 under the delay strategy as compared with $514,533 under the non-delay strategy (commencing Social Security and level withdrawals from accumulated savings at age 62). The example retiree has essentially used a total of $240,804 of his accumulated savings to purchase a higher Social Security benefit commencing at age 70. To see the calculations using the delay strategy follow this link. Note that the estimated Social Security benefit commencing at age 70 has been increased by 3% per year for eight years of assumed CPI increases.
October Three argues that, "Rather than annuitizing retirement wealth, participants can get a much better deal by spending down retirement assets and deferring Social Security." While I like the article, I will have to reserve the right to pick a small bone with October Three over their use of "much better" here, as our post of September 22, 2013 shows comparable increases in total retirement income through combinations of self-insuring and purchase of deferred annuities (immediate, delayed or deferred).
When considering the delay strategy, readers will also want to factor in other considerations, such as comfort in spending a significant amount of accumulated savings in the early years of retirement, taxation of Social Security benefits, possible future changes in Social Security law and possible changes in general interest rates/investment returns.
David Blanchett Develops Simple Formulas and Spreadsheet to Approximate Dynamic Prudent Withdrawal Rate Approach
In Mr. Blanchett's recent article in the Journal of Financial Planning, Simple Formulas to Implement Complex Withdrawal Strategies, Mr. Blanchett develops "simple" formulas that approximate the results achieved by the more complicated Monte Carlo modeling anticipated in developing Prudent Withdrawal Rates discussed in my post of September 10, 2013. In addition, Mr. Blanchett further simplifies the process by providing an Excel spreadsheet that enables users to input a few items and develop their own simplified Prudent Withdrawal Rates. Here is the link to his spreadsheet.
http://www.davidmblanchett.com/tools
I compared withdrawal rate percentages produced by Mr. Blanchett's spreadsheet assuming 50% equities, total portfolio fees of 0.20% and a 75% Target Probability of Success with the withdrawal rates produced by the Excluding Social Security 2.0 spreadsheet on this site for payment periods of 10, 15, 20, 25 and 30 years (using the recommended assumptons for investment return and inflation), and the results were very close (within .03 percentage points) for payment periods of 30, 25 and 20 and relatively close for payment periods of 15 years and 10 years.
As mentioned in my September 10 post, I support the dynamic "actuarial" approach proposed by Messrs. Frank Sr., Mitchell and Blanchett, and I believe that Mr. Blanchett's simplification is a very useful addition to make their approach more accessible to financial planners and other users.
I will point out that Mr. Blanchett's spreadsheet is most useful to a retiree who has no other sources of retirement income or bequest motives as it does not coordinate with other sources of retirement income, such as annuities, and it does not provide for leaving a specific amount to heirs. To reflect such items, you may have to use their more complicated model, or the simple spreadsheet set forth in this website.
Vanguard Introduces Its Modification of the 4% Withdrawal Rule
Readers of this blog will note that I devote a fair amount of energy ranting against the 4% Withdrawal Rule (and other "Safe" withdrawal rates) as retirement decumulation strategies. In addition, I'm generally not all that impressed with proposed modifications to the 4% Rule designed to somehow make it more workable. Vanguard recently announced its proposed modifications in a paper entitled, "A More Dynamic Approach to Spending for Investors in Retirement." They suggest a two-step process for determining an annual spendable amount payable from accumulated savings: Step 1: Take X% of end-of-the-previous-year accumulated savings. Step 2: Subject the result of Step 1 to a corridor, the ceiling of which is (1+Y%) of the spendable amount from the previous year and the floor of which is (1-Z%) of the spendable amount from the previous year, where "X" depends on the "planning horizon" and investment philosophy and "Y" and "Z" are arbitrarily chosen upper and lower limits (they suggest a value of 5 for Y and 2.5 for Z). Readers of the paper who get as far as Appendix 3 will note that the example set forth in this appendix describes a slightly different approach than the approach described in the body of the paper, which I am assuming is an error).
While the Vanguard modification of the 4% Rule does make the approach more dynamic (i.e., it reflects actual investment experience to some degree), I believe this approach to be inferior to the actuarial approach suggested in this website for the following reasons:
As is the case for most "safe" withdrawal rate strategies, it defines success as not outliving accumulated assets. It does not adequately address the risk of under spending.
It doesn't attempt to provide constant real dollar spendable income in retirement.
It doesn't coordinate with other forms of retirement income such as immediate or deferred annuities and it doesn't reflect bequest motives.
With all the adjustments required for different planning horizons and investment philosophies, it is not appreciably simpler than the actuarial approach set forth in this website (particularly if you use the assumptions and algorithm I recommended several posts ago).
Use Our Spreadsheet to Estimate How Much Deferred Annuity to Purchase
In his September 24, 2013 article, "Why Retirees Should Choose DIAs over SPIAs", Dr. Wade Pfau reaches the conclusion that "Deferred-income annuities (DIA's) work even better than SPIA's, by providing more liquidity and better longevity protection at a lower cost." Previously, combinations of single premium income annuities (SPIAs) and equity investments had been Wade's Efficient Frontier champions.
Wade mentions two risks using DIAs: 1) Over or underestimating future inflation and the associated impact on a fixed annuity amount payable many years in the future and 2) running out of accumulated savings prior to commencement of the deferred annuity.
If you decide to purchase a deferred annuity with some of your accumulated savings and self-manage the remainder, you can use the "Excluding Social Security V 2.0" spreadsheet on this website to help you model future experience and coordinate the withdrawal of your self-managed assets with the fixed amounts payable from the annuity to try to achieve constant real dollar total withdrawal/annuity payments. The Runout tabs show total combined withdrawal/payments each year under the input assumptions. The risk of buying too little or too much deferred annuity can also be mitigated to some degree by spreading the purchases over a number of years.
Gotbaum Tells Council Lump-Sum Cash-Outs Are Like Cigarettes: Legal but Bad for You
Pension Rights Center
In this article, the head of a federal government agency implies that most people aren't very smart when given a choice between an annuity and a lump sum in a defined benefit plan. He indicates that since 1997, more than two out of three people have taken the lump-sum option instead of an annuity when given a choice. Therefore he concludes that more government regulation is needed to prevent you from making the "bad" lump sum choice.
This thinking appears to be shared by representatives of the Department of Labor who continue their push to make it more difficult for people to take "bad" lump sums from defined contribution plans.
Never mind that recent research from Felix Reichling and Kent Smetters questions the supposed superiority of the annuity choice. And never mind that recent research from Frank Sr., Mitchell and Pfau (see previous post) suggests that it may make financial sense to rollover the lump sum to an IRA and purchase an annuity at a later date. And never mind that rolling over the lump sum to an IRA, buying a longevity annuity with a portion of the proceeds and self-managing the remainder of the assets may help you better manage risks in retirement by diversifying your sources of retirement income.
Bottom line--Don't worry. When it comes to your retirement, your federal government knows what is best for you.
Life Expected Income Breakeven Comparison Between SPIAs and Managed Portfolios
by Larry Frank Sr., John B. Mitchell and Wade Pfau
A tip of my hat to Messrs. Frank Sr., Mitchell and Pfau for publishing this fine (and very thorough) paper. The authors use a sophisticated Monte Carlo simulation approach to conclude that many retirees may find it financially beneficial to delay purchase of a single premium life annuity until a later age and self-manage their retirement assets until such age.
"The paper provides insight and guidance for the retiree decision making between whether to annuitize or manage their retirement savings." While the authors' analysis examined this decision on an "either or" basis, it would be interesting to see their analysis for partial SPIA annuitization/partial self-management strategies (which could affect investment allocation decisions) or strategies that involve purchase of single premium deferred annuities (sometimes referred to as longevity annuities).
If you have read even a few of my prior blog posts, you will know that I am not a big fan of "set and forget" Safe Withdrawal Rates determined using Monte Carlo simulations. As indicated in the authors' paper, the authors advocate a dynamic approach, described as follows:
"The newer camp is more dynamic with annually recalculated, serially connected, simulations to arrive at a Prudent Withdrawal Rate (PWR) that is sustainable given current conditions. Client annual reviews include annual updates to the simulation data to reflect 1) period life table changes and changes in personal health, 2) current portfolio value, 3) latest market data series, and 4) current year feasible spending needs. The dynamic school provides an ongoing method to address how often and by what method "revisiting" the PWR and making corrections to it recognizing that markets affect the safety of withdrawals and that time allows the PWR to increase."
Thus, while the authors use Monte Carlo simulations, they are using an approach that is similar to the actuarial approach advocated in this website. In discussions with Mr. Frank Sr., he even refers to his approach as an "actuarial" approach. Since it is so similar, he makes it very difficult for me to find fault with it.
This paper is a practical application of the previous work done by Messrs. Frank Sr., Mitchell and Blanchett in three papers that describe in more detail their dynamic approach. Links to these excellent papers may be found in Mr. Frank Sr.'s website and blog "Better Financial Education.com".
Renaming The Outcomes Of A Monte Carlo Retirement Projection
(Nerd's Eye View, August 14, 2013)
When explaining outcomes of a Monte Carlo retirement projection for a safe withdrawal rate strategy, Mr. Kitces suggests replacing the phrase "probability of failure" with "probability of a mid-course correction" and replacing "probability of success" with "probability of accumulating excess assets." He implies that this "framing" will help facilitate good decisions.
Does renaming the outcomes of such a projection, as advocated by Mr. Kitces, improve the safe withdrawal rate strategy or is he just putting lipstick on a pig? In his article, Mr. Kitces implies that the safe withdrawal rate approaches he anticipates aren't really the "set-it and forget-it" approaches anticipated by Bill Bengen, the inventor of the 4% Rule. He implies that a safe withdrawal rate strategy needs to be revisited periodically to make sure that the client's spending plan remains on track (assets don't shrink too rapidly nor grow too large). If this is true, however, there seems to be little gained by doing all those calculations that comprise a Monte Carlo projection over doing a simple deterministic projection (except perhaps the impression of more precision). In both instances incorrect projections of future experience need to be adjusted for actual experience.
Even though it employs a deterministic projection, I continue to believe that the actuarial approach outline in this website is superior to the "set-it and forget-it" safe withdrawal rate strategies. Once Mr. Kitces describes how the approach he anticipates actually determines how and when mid-course adjustments are made, I might be more open to endorsing it.
Retirement Planning in an uncertain world
Steve Vernon (CBS Moneywatch, August 7, 2013)
Another excellent post from my friend and fellow Fellow of the Society of Actuaries. Steve succinctly outlines the risks involved in planning for retirement in today's world and suggests the following two-step strategy:
It would not be unreasonable to address the risks Steve outlines by employing some combination of (i) guaranteed lifetime income (immediate or deferred annuities, annuities from defined benefit pension plans and Social Security, including deferring commencement of Social Security to effectively buy increased lifetime income protection as discussed in my previous posts) and (ii) periodic withdrawals from self-managed assets.
The actuarial approach outlined in my website enables you to coordinate the spend-down of your self-managed assets with your guaranteed lifetime income and allows you to make the periodic adjustments Steve refers to "in the event that your forecasts are wrong."
The Power of Diversification and Safe Withdrawal Rates
Geoff Considine (Advisorperspectives.com, July 30,2013)
Mr. Considine argues that the 4% Rule is still a valid decumulation strategy provided the retiree's assets are invested in a more diversified portfolio than originally anticipated by Bill Bengen, the rule's inventor.
The 4% Rule. In the first year of retirement, withdraw 4% of your accumulated savings. In each year thereafter, withdraw no more and no less than the first year amount increased by measured inflation since the first year. Make no adjustments for actual investment performance and hope that the assumptions underlying the Monte Carlo analysis performed to determine the "safeness" of the rule pan out and that you die prior to exhaustion of accumulated savings (without leaving too much behind).
Weaknesses of the 4% Rule.
It doesn't accommodate a payout period other than 30 years without adjustment.
It doesn't accommodate a different investment approach without adjustment.
It doesn't accommodate a desire to leave a specific bequest at death
It doesn't accommodate a flexible spending schedule (for example if needed for unanticipated medical expenses or to use more assets early as a means to delay Social Security benefits as discussed in the previous post)
It doesn't coordinate with other fixed income payments such as immediate or deferred life annuities or payments from defined benefit plans
It doesn't adjust for actual emerging experience.
Plan on Living to 95
In my previous post, I referred once again to withdrawal strategy risk--the risk of either withdrawing too much or too little each year. If we only knew when we were going to die, planning would be so much easier. Some retirees believe that it is sufficient and appropriate to base withdrawals on their current life expectancy. As we will see in this post, the very significant downside of this strategy is that withdrawals may not keep pace with inflation (or may even decrease in dollar amount) if you have the good fortune of outliving the life expectancy you used for planning purposes when you first retired. Based on the Society of Actuary mortality tables, it is much more prudent to assume that you will live to your mid-90s (unless you have already reached your 90s) rather than use published life expectancies when developing your spending budget.
The exhibits below are based on Society of Actuaries Annuity-2000 male mortality tables with mortality projection. These tables are available in this website at this link. In both exhibits, the hypothetical retiree is assumed to have $500,000 at retirement at age 65 and desires to have constant real dollar withdrawals throughout retirement. In the first exhibit, the individual retiring at age 65 assumes he will live exactly the number of years equal to his life expectancy (in this case 21.9 years). Every fifth year thereafter he adjusts his spending plan based on his revised life expectancy. His assets are assumed to grow at 5% per year and inflation is assumed to be 3% per year. He is assumed to use the methodology outlined in this website for his withdrawal strategy with no other annuity income and no amounts left to heirs at death.
The first exhibit shows that if he lives to age 80, his annual withdrawal will only be 75% of his initial withdrawal in real dollar terms and if he lives to age 85, his annual withdrawal will only be about 54% of his initial withdrawal in real dollar terms.
By contrast, if his withdrawal strategy is such that he can live with a 30% chance of outliving his savings (by assuming that he will die at age 93 for the first 15 years, 94 if he makes it to 80 and 95 if he makes it to 85), he will be able to keep his spending constant in real dollar terms for 15 years. Even if he takes this more conservative approach, however, he is still at risk of lower real dollar withdrawals after age 80. But arguably he may be in a better position at his advanced ages to live with decreased real dollar retirement income.
According to the Society of Actuaries tables, Females generally have a 30% chance of living to approximately 95 until they reach age 80, at which time their expected age at death increases past age 95 in much the same way as anticipated for males.
3 reasons retirees don’t spend
Adam Wolf (Marketwatch, July 2, 2013)
In my March, 2010 article describing the actuarial process set forth in this website, I discussed several risks associated with not sufficiently annuitizing accumulated retirement savings. I talked about withdrawal strategy risk-- the risk of either withdrawing too much or too little each year. Most experts focus on the risk of withdrawing too much, but in this article, Mr. Wolf focuses on the risk of withdrawing too little.
I agree with Mr. Wolf that, "Knowing your options can help you enjoy the retirement you saved so hard to provide for." And knowing the options of How Much Can I Afford To Spend In Retirement is what this website is all about.
Risky Business: Living Longer Without Income for Life
(American Academy of Actuaries, June 19, 2013)
A discussion paper released by the American Academy of Actuary’s Lifetime Income Risk Joint Task Force. "The discussion paper focuses on the issue of ensuring retirees secure income that lasts their entire lifetime and discusses potential solutions through changes in education, plan design, and federal retirement policy."
"What can be done to lower these [unnecessarily high hurdles to finding the right lifetime income solutions] and better prepare current and future retirees to secure and manage their lifetime income needs."
It is nice to see the Academy taking action on this important topic.
The discussion paper advocates expanding financial literacy and education for prospective retirees, refocusing plan design on lifetime income needs and implementing Federal retirement policies to support lifetime income needs.
While I believe that investing some or all of a retiree's accumulated retirement savings in a life insurance annuity product can be part of a reasonable retirement strategy, it appears to me that the discussion paper over-emphasizes the use of these products relative to other approaches. While managed structured-income payments are briefly mentioned as a source of lifetime income, the paper points out that such approaches are not guaranteed, and they are not included as part of the paper's discussion of potential solutions through changes in education, plan design and federal retirement policy.
While a good start, I would like to see the Academy take a broader view of the potential solutions to the problems facing current and future retirees. My specific recommendations to the Academy in this regard include:
These are just approximate amounts of accumulated savings needed based on the assumptions above. Changing any of these assumptions would change the multiples needed. For example, if a person had defined benefit income or had fixed annuity income, the amounts needed would be reduced. In addition, if a person decided to purchase a life annuity with some or all of her accumulated savings at retirement, multiples of pay needed may be less as insurance company pricing is based on an assumption of death closer to average life expectancy. In addition, Social Security benefits may replace lower or higher percentages than assumed for this table.
But the bottom line is that if you don't have other significant pension income and you want to approximately maintain your standard of living in retirement, you probably don't need to be terribly concerned about the problem of "over-saving" until your accumulated savings start to exceed something like ten times your current compensation.
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
http://www.gpo.gov/fdsys/pkg/FR-2013-05-08/pdf/2013-10636.pdf
Here is our response to the ANPRM
http://howmuchcaniaffordtospendinretirement.webs.com/EBSA_benefit_statement_proposals.pdf
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
www.dol.gov/ebsa/pdf/nearretirement.pdf
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.
Steve Vernon
http://restoflife.com/
http://www.cbsnews.com/2741-505146_162-1348.html
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.
Author argues that under his assumptions and the Monte Carlo method, a couple planning for 30 years of retirement invested 70% in equities and 30% in medium duration Treasuries has an 80% probability of not outliving their $1 million retirement savings if they withdraw $55,000 in the first year of their retirement (and increase that amount by inflation each year). While his assumption for annual investment return on equities is shown as a "more reasonable" 6%, this is a real (after inflation) rate of return assumption on equities, and therefore his nominal investment return assumption on equities is approximately 9% per year, based on his assumed inflation assumption of 3% per annum. If you input a 30-year life expectancy, 7.65% investment return (70% at 9% and 30% at 4.5%) and inflation of 3%, you will get a first year withdrawal rate of about 5.9% in the spendable calculator on this website. So, a $55,000 initial withdrawal from $1 million of accumulated savings may be reasonable for a 30-year retirement period if you plan to be invested 70% in equities throughout your retirement and you believe you will achieve a 6% real rate of return on those assets. Retirees who feel somewhat less bullish about equity investments may wish to run the spreadsheets and develop withdrawal strategies based on lower real rate of investment return assumptions.
The authors from Vanguard remind us that the 4% Rule isn't really a simple rule--the 4% rate of withdrawal needs to be adjusted for life expectancies different from 30 years and different investment mixes (as well as inflation after retirement). They also note that it is unlikely that retirees actually follow the 4% rule for their entire retirement, stating, "more realistically, retirees continue to monitor their portfolios and spending, adopting some level of flexibility to account for changes in market returns and unplanned spending needs."
The withdrawal rates contained in Figure 2 of the Vanguard paper are reasonably consistent with withdrawal rates using the spreadsheet on this website with assumptions of 5% investment return, 3% inflation, no annuity income and no amounts left to heirs. Of course, retirees with annuity income and/or plans to leave significant amounts to heirs may have to make additional adjustments to the Vanguard withdrawal rates shown in Figure 2. Alternatively, we would suggest that you simply use the spreadsheets and methodology contained in this website.
My snarky reply to the question posed by the title of this paper is, "Of course they can, but should they?" Apparently, they used "should" in their working paper, so they felt they couldn't use it in this follow-up paper.
The authors compare several common withdrawal strategies with what they define as an "optimal withdrawal strategy." Based on their comparisons and assumptions, they conclude that the IRS rules for Required Minimum Distributions (RMDs) and a modified version of RMDs outperform the other commonly used approaches (including the 4% withdrawal rule discussed in this site).
While I'm not a big fan of the 4% withdrawal rule for many of the same reasons noted by the authors, I'm not ready to buy that RMD or modified RMD approaches are either easier to implement or more "optimal" than the approach set forth in this website. In developing their optimal strategy, the authors ignore a number of factors that may be important to retirees, including:
- Stability of total retirement income from year to year in real dollars (or flexibility to have increasing or decreasing real income from year to year).
- Coordination of the withdrawal strategy with other sources of retirement income, such as annuities
- Desire to leave inheritance
Therefore, while I agree with the authors that the RMD approach has the advantage (over the 4% rule) of automatically adjusting for actual experience, there are several downsides to this approach that may not please all retirees. Retirees should be skeptical of any withdrawal strategy (even the one suggested in this site) that claims to be "optimal."
The 4% Withdrawal Rule? Really? Is this the best advice the financial expert community has to offer? Withdraw 4% (or some other "safe" withdrawal percentage) of your accumulated savings in your first year of retirement and then blindly increase that amount for inflation for the rest of your life (or until you spend all your savings, whichever comes first). You do this without adjustment for actual investment experience, actual price inflation, changes in heath or variations in amounts withdrawn. Am I the only one who finds the 4% Withdrawal Rule crazy? If you want to self-insure some or all of your retirement, you need to use an approach (such as the one described in this website) that adjusts for actual experience.
Fidelity issues "age-based savings guidelines" concluding that a typical person retiring at age 67 should accumulate at least 8 times final annual pay to secure an 85% replacement income in retirement.
Based on our understanding of the assumptions noted in this news release and the methodology outlined above, we have confirmed Fidelity's 8 times final pay calculation, but caution individuals who may rely on this study that one of the assumptions made by Fidelity may be overly optimistic and therefore understate the accumulated savings needed. Fidelity has assumed that accumulated savings will earn a REAL rate of return of 5.5% per annum, or a nominal return of almost 8% per year based on their assumed rate of inflation of 2.3% per annum. Individuals planning for retirement or developing spending strategies in retirement may wish to utilize a more conservative annual investment return assumption.
A nice article by Steve Vernon showing that amounts produced by popular retirement savings calculators vary dramatically. Steve is an actuary I worked with for many years. He writes well-reasoned retirement articles for CBS MoneysWorth. Here is a link to his recent articles.
http://www.cbsnews.com/2741-505146_162-1348.html?tag=contentBody;correspondant
One of the big problems in determining how much of your accumulated savings you can spend each year in retirement results from the necessity of having to plan on living well into your 90s to make sure that you have enough money in case you actually live that long. While this risk can be managed by buying an immediate annuity, many retirees balk at using most of their accumulated savings to purchase an immediate annuity when what they want is an annuity that starts at a later age. However, the government's current minimum distribution rules under Section 409 of the Internal Revenue Code made purchases of annuities that deferred commencement after age 70 in qualified defined contribution plans or IRA's difficult. In a welcomed change of policy, the new proposed rules would permit a specified portion of accounts in such plans to be used to purchase a "Qualified Longevity Annuity Contract" (QLAC) without affecting the minimum distribution rules for the remainder of the account.
Under the proposed regulations, premiums for the QLAC could not exceed the lesser of 25% of the account balance or $100,000. The QLAC would provide for distributions to start at some date in the future but not later than when the contract holder attained age 85. No benefits could be provided under the QLAC after the contract holder's death other than life annuities payable to designated beneficiaries.
More detail can be found in the proposed regulations published in the Federal Register on February 2 of this year. It is important to note that under the proposed rules, QLACs will not be available (and therefore cannot be used) until the proposed regulations are finalized.
Excerpt: "But here's the real lesson: Retirement planning -- or rather, good retirement planning -- is never really finished. Ideally, your particular plan is open to new ideas and research and, as such, is able to evolve."
Comment: Not a bad article, but one that does demonstrate that when you plan for retirement, you need to pay attention to:
1) the tax treatment of various sources of income (and make sure that you treat them consistently), and
2) whether or not sources of income increase with inflationIn the example in the article, the author determines that the retiree will need $600,000 of taxable accumulated savings (like a 401k plan) to replace pre-retirement standard of living. However, if we assume a 20% effective tax rate on all income sources, 3% inflation and a 5% return on assets, the net annual income target of $63,600 ($5,300 per month) becomes $79,500 before taxes and $59,100 after subtracting Social Security. In order to generate annual real income of $59,100 per year for a 25 year period, the spreadsheet above indicates that the retiree would need to have about $830,000 in accumulated savings, not $600,000.
Comment: Under this rule, the authors suggest building an income floor with 85% of accumulated assets, investing the remaining 15% of "surplus assets" aggressively in a portfolio with a 3x leverage factor and transferring assets from the surplus asset fund annually if it grows to be larger than 15% of total accumulated assets.
Comment: Her solution to 4% rule problems--Take out 3.5% in initial year and skip inflation increases if market goes south.
Comments: Comprehensive (64 pages) review of academic literature focusing on combinations of annuitization and self-managed drawdown strategies. Pages 48-54 provide considerations for a person "contemplating self-managing some or all of his/her retirement assets" (i.e., the individuals for whom this website has been designed). Most of the considerations noted by the authors in these pages can be addressed using the simple spreadsheet and the process set forth in the March, 2010 article above.
Interesting read. Stochastically testing three spending strategies using proprietary data and assuming a 50% equity/ 50% bond investment mix (rebalanced each year), the Vanguard Investment Strategy group determines that the "percentage-of-portfolio" approach with limits on annual increases or decreases in the previous year's amount is preferable to the other two approaches studied. Article implies that a 4.75% initial withdrawal rate is reasonable for a 35-year payout period and the 50%/50% investment mix (implying about a 3.5% real annual rate of investment return using the "Excluding Social Security" spreadsheet above). There appear to be some mixed messages in this article as the authors state that maintaining a flexible spending plan is key, but recommend a plan that is not flexible, and they fail to address how their recommended plan should be adjusted for adverse (or favorable) experience.
Take-away for retirees and those close to retirement: If you saved 16.62% of pay each year for 30 years preceding retirement, are targeting a 30-year pay-out period, invested 60% equities/40% fixed income pre-retirement (and intend to keep this investment mix post-retirement with annual rebalancing), received pay increases each year equal to the increase in inflation, then historical data shows that you can withdraw whatever you need each year after retirement to have inflation adjusted income from accumulated savings of 50% of your final year's pay. The 16.62% figure refers to what was needed in the worst-case scenario from the historical data. If some of these assumptions don't apply, you need to make necessary adjustments in your withdrawal rate. Table 1 of Pfau's paper provides hints for adjusting for experience different from base assumptions.
Good article. Two comments:
- The article asks (but does not answer) the question, "How much is enough for retirees to live on?" I hope that visitors to this site realize that they can use the simple spreadsheet to "back into" how much accumulated savings they will need to produce their desired level of real annual income in retirement.
- This is another article that raises concerns about the 4% Withdrawal rule. "Critics say such guidelines should not be blindly followed. The 4% rule 'just doesn't work' when investments are tumbling, says Stezfand [Director of Financial Security] of AARP."