Tuesday, January 21, 2014

Comparison of Four Withdrawal Strategies Based on Recent Experience

In my previous post of January 16, I stated my belief that each of the three systematic withdrawal options examined in the Stanford/SoA study was inferior to the actuarial approach advocated in this website.  While I was critical of the three approaches for not even attempting to focus on total retirement income by coordinating with annuity income that the retiree may currently have or expect to have in the future, I think that each of the three approaches have shortcomings even if the retiree has no other sources of income.  In this post, I will illustrate those shortcomings with an example that uses historical investment and inflation experience from 1998 to the present. 

Let's assume that Rachel retired on her 65 birthday on January 1,1998.  At that point, she had $500,000 in accumulated savings in addition to her Social Security benefit.  Since she was single with no children, she had no desire to leave money to heirs.  She wanted to maximize her income in retirement, particularly in her younger retirement years (when she wanted to travel more).  On the other hand, she did not want to outlive her savings.  She decided to invest the assets not budgeted for spending each year 25% in large cap equities, 25% in mid-cap equities, 25% in mid-term bonds, and 25% in short-term bonds (which she rebalanced at the end of each year).  Unfortunately, Rachel died in a car accident on January 1, 2014.  She had just turned 81. 

The graph shows withdrawals under the three different strategies discussed in the previous post compared with withdrawals under the actuarial approach advocated in this website.  All amounts are shown in 1998 dollars.  In using the actuarial approach, Rachel looked at annuity purchase rates in 1998 and decided to determine her first year's withdrawal assuming 7% investment return, 4% inflation and death at age 95.  In 2004, when interest rates had decreased somewhat, she changed the assumptions to 6% investment return, 4% inflation and in 2009 she changed to the now recommended assumptions of 5% investment return, 3% inflation.  She also used the recommended smoothing algorithm. 

None of the four strategies would have been successful in meeting Rachel's objective to die with only a small amount of assets remaining.  She expected to live well past age 81 and her investments did much better than she assumed (on average).  Following the actuarial strategy, she would have died with $626,635 remaining.  But this approach was better than the other three approaches in meeting Rachel's objective, as she would have $786,436 remaining under the IRS Required Minimum Distribution approach, $804,358 under the Constant 4% approach and $827,504 under the 4% Rule.

And while the 4% Rule produces a ruler-flat inflation adjusted withdrawal pattern, it failed to maximize Rachel's desire to maximize spending.  The other two approaches also failed to maximize spending and their withdrawal patterns were much less stable from year to year than under the actuarial approach.  Based on experience from 1998 to 2014, the clear winner of the four approaches in terms of meeting Rachel's objectives is the actuarial approach.