Saturday, June 27, 2015

You Can Save During Retirement, Too

My last few posts have encouraged readers to develop a reasonable spending budget in retirement each year by aggregating specific expense components.  For example, in our post of June 7, Don’t Just Tap your Savings; Develop a Reasonable Spending Budget, our hypothetical retiree, Mary, separated her total budget into the following components:
  • Essential non-health-related expenses
  • Essential health-related expenses
  • Bequest motive/end-of-life long-term care
  • Other unexpected expenses, and
  • Non-essential expenses
Mary had different investment and desired payout strategies for these various components.   Therefore, she treated them differently in her planning. 

After our post of June 12, Good Time for Retirees to Stress Test Their Investment/Spending Strategies, in which we discussed some statistics that predict a bear market will likely be coming at some point in the future, I received an email from Colin from Massachusetts suggesting that it might be wise for Mary and other retirees to possibly “beef-up” their “other unexpected expenses” budgets during bull market periods in anticipation of future bear markets.  I agree.

Even though retirement is generally a period of “decumulation” rather than savings accumulation, there is no requirement for you to spend all your experience gains during good times.  The concept of having a “rainy day” fund still applies to retirees.  Therefore, if you do experience gains from investment experience or from spending less than your budget, you may want to consider where you stand in the current economic cycle and put some of those gains aside in the “other unexpected expenses” component of your total spending budget in anticipation of a future bear market.

Thanks again to Colin from Massachusetts for his suggestion.  I am always happy to pass along good ideas from my readers.

Wednesday, June 24, 2015

Will “Ratcheting” the 4% Rule Make it Less Insane?

Long-time readers of this blog know that I have no love for the 4% Rule.   It has a number of deficiencies when compared with the Actuarial Method advocated in this website, including:
  • It doesn’t coordinate well with other fixed-dollar sources of retirement income such as pension income, immediate income annuities or deferred income annuities. 
  • It doesn’t anticipate a specific bequest motive.
  • There is no spending flexibility from year to year.
  • There is no adjustment process for actual experience, spending deviations or changes in assumptions about the future.
  • After the initial year, it is not based on how much assets you have or on how long you expect to live.
  • It is a “set and forget” strategy that requires the retiree to have faith that it will work in the future based on analysis of historical returns that may have absolutely nothing to do with future returns. 
  • It doesn’t accommodate a retiree’s desire to have different spending pattern objectives for different components of the retiree’s overall spending budget.
  • It requires the retiree to invest at least 50% of accumulated assets in equities, irrespective of the retiree’s risk preferences.
Notwithstanding recent research from David Blanchett, Michael Finke and Wade Pfau showing that a safe withdrawal rate for a 30-year retirement based on a forward looking model (rather than historical returns) that reflects current low interest rates and relatively high price/earnings ratios in equities is closer to about 2.4%-2.8% for a portfolio with 60% equities, Michael Kitces is back with his variation of the 4% Rule based on historical returns.  In his new article entitled, “Ratcheting the 4% Rule for saner retirement spending”, Mr. Kitces notes that based on his analysis of historical periods, the 4% Rule would have generally resulted in significant underspending that in most cases would leave “a huge amount of wealth left over.”  As a result, he proposes that a retiree increase spending by 10% of the spending called for under the 4% Rule whenever the retiree’s account balance exceeds more than 150% of the initial account balance.  He further proposes that if the account balance continues to remain high thereafter, the retiree can continue to apply further increases every three years.  He indicates that these spending increases can be “ratcheted” up without much concern about subsequent declines. 

Thus, rather than looking at the current economic environment, Mr. Kitces looks into his rear-view mirror and encourages a new retiree to invest at least 60% of her portfolio in equities and withdraw 4% of her assets in her initial year of retirement with inflation increases each year thereafter.  She can blissfully ignore actual investment experience.  If her assets become too high in the future, she can increase her spending, apparently without much concern for having to reduce spending later on. 

I have no problem with dynamic spending strategies (ones that can go up or down).  I advocate a dynamic strategy.   If you are not going to insure a significant portion of your wealth through lifetime annuity products, and you invest in risky assets, I believe you are going to have to live with a certain amount of variability in spending.  But I don’t think in today’s current economic environment, you can withdraw something like 4% of your initial accumulated savings (with subsequent inflation increases) over a 30-year period and realistically expect to never have to decrease your spending.   Retirees should be very cautious about using the 4% Rule with Mr. Kitces’ ratcheting modification.  The research by Blanchett, Finke and Pfau noted above showed a less than 60% success rate (i.e., a greater than 40% failure rate) over a 30-year period for the 4% Rule based on their forward looking model and 60% investment in equities, and that is before application of any “ratcheting” increases advocated by Mr. Kitces. 

Thursday, June 18, 2015

Managing Risks in Retirement through Diversification of Retirement Income Sources

Many of the posts and articles on this site (as well as retirement research) suggest retirees consider managing risks in retirement by adding a combination of (i) lifetime pension/insurance annuity products and (ii) withdrawals from a managed portfolio of assets to the benefits received from Social Security.  Because annuity products such as single premium immediate annuities (SPIAs) and deferred income annuities (DIAs) pool mortality risk and share mortality gains among survivors in the pool, these vehicles can be more efficient in managing longevity risk than withdrawals from a managed portfolio.  These products can also be more effective in managing investment risk.  On the other hand, withdrawals from a managed portfolio can preserve spending flexibility, provide liquidity to meet unplanned expenses, serve as a hedge against inflation, and can provide a bequest motive, which may not be as easily accomplished with annuity products.   Therefore, depending on the relative size of a retiree’s accumulated savings, the existence or non-existence (and relative size) of a pension benefit and the amount of the retiree’s Social Security benefit, the best approach to managing retirement risks may be this partial annuity (or pension)/partial withdrawal approach. 

As illustrated in several of my most recent posts, retirees may want to separate their total spending budget into several smaller components, including for example, essential health-related expenses, essential non-health-related expenses, other unexpected expenses, non-essential expenses and bequest motives/other end of life expenses.   Investment and payout strategies for these various component budgets could easily vary.  For example, retirees may select more conservative investment (such as annuity products) and payout strategies for assets supporting essential expenses while employing more aggressive investment and payout strategies for assets supporting non-essential expenses.

If a retiree elects to use a partial annuity (or pensions)/partial withdrawal approach and either does or does not separate total spending into smaller components, it is important that the withdrawal strategy applied to invested assets be appropriately coordinated with payments expected to be received under the pension/annuity in order to meet the retiree’s spending objectives.  Note that with the exception of the Actuarial Approach recommended in this website (and possibly the actuarial approach developed by David Blanchett, John Mitchell and Larry Frank), none of the more commonly-advocated withdrawal approaches make any attempt at all to properly coordinate with fixed dollar pensions or lifetime annuity products that a retiree may have.  This failure to properly coordinate is, in my opinion, a serious deficiency for withdrawal strategies such as the 4% Rule (or any of its many variations), the required minimum distribution rules (RMD), any safe withdrawal rate (SWR) approach, the Annually Recalculated Virtual Annuity (ARVA) approach or even the Guyton Decision Rules inexplicably touted by Dr. Wade Pfau, the author of the “Efficient Frontier” retirement research noted above which advocated the combined use of annuities and withdrawals. 

Two recent articles got me started on this post.  The first article, Government Policy on Distribution Methods for Assets in Individual Accounts for Retirees--Life Income Annuities and Withdrawal Rules, by my friend and former business colleague, Mark Warshawsky, compares historical outcomes of 100% investment in annuities vs. 100% investment in a balanced portfolio of equities and fixed income assets with withdrawals made under the 4% Rule.  Based on historical simulation of asset returns, interest rates and inflation, Mark concludes that the 100% annuity strategy beats out the 100% investment strategy.  He uses this conclusion to make several retirement-related government policy recommendations.  For the most part, I found this to be good research, but I would have liked Mark to include comparisons of combined partial annuity/partial withdrawal strategies, and I am not a big fan of the 4% Rule. 

The second article, by the aforementioned Dr. Pfau, entitled 7 Risks of Retirement Income Planning, indirectly makes a pretty compelling argument for combining annuity products and investments to address all of the risks discussed in this article.