Several Wade Pfau Posts

A first for me this week--An individual actually asked me why I hadn't posted on this site in over two weeks.  Of course it was just Bob, a fellow Baritone in my singing group, but I will take his comment as encouragement (which is unusual for Bob as he is usually all over me for singing the wrong notes and/or the wrong dynamics).  

Readers of this blog will know that I frequently refer them to Wade Pfau's Retirement Researcher Blog for excellent discussions of retirement income issues.  This past week, Wade posted two more such discussions.

In his March 27 post,   he has listed and classified known retirement income strategies.  Readers with good eyes will see that the Actuarial Approach recommended in this website resides in the bottom box as a Variable Spending strategy residing under the general classification of Probability-Based Approaches.

In his March 24 post, Wade refers to two of his articles discussing risks in retirement and presents a Taxonomy (classification) of Retirement Risks.  I would add "not spending enough" to the lower right hand quadrant of his chart as this risk can be almost as problematic as spending too much.

As I have mentioned several times in this blog, it would not be unreasonable for a retiree to manage these risks in retirement by diversifying their sources of retirement income.  For many retirees, I believe the best approach involves combining Social Security, life insurance annuity (or long-term care) products or pensions, with a good systematic withdrawal strategy.   

Shopping Around for Withdrawal Strategies That Will Give You a Higher Withdrawal Rate?

As discussed in our post of March 1, the JP Morgan withdrawal strategy produces a higher withdrawal rate than the withdrawal strategy recommended in this site when our recommended assumptions are used.  Several readers commented that this was a big plus in the JP Morgan column, especially for individuals who want to front-load spendable income earlier in retirement or for others who have lifestyle spending goals that simply aren't achieved by using more conservative withdrawal strategies.  We caution retirees against selecting a withdrawal strategy simply because it produces a higher initial withdrawal rate.

The withdrawal approach set forth in this website produces a total retirement spending budget that is designed to remain constant in inflation-adjusted dollars if all input assumptions are correct and the spending budget is actually spent each year.  That part of our approach is just simple math.  Our approach also gives the retiree a recommended process for dealing with the inevitability that the input assumptions will not be correct or actual spending will differ from the budget amounts.  To make it a little easier for some to use our approach, we have recommended what we believe to be fairly conservative input assumptions:  currently 5% nominal investment return, 3% desired increases/inflation and an expected payment period until age 95 (or life expectancy if later).

If the withdrawal rate using our approach with recommended assumptions is lower than desired,  a retiree is free to change the recommended input assumptions to reach a higher withdrawal rate using any kind of rationale the retiree chooses (i.e., I can earn an annual investment return greater than 2% real, I won't live longer than my life expectancy, I can live with retirement income that decreases in inflation-adjusted dollars, etc.).  The retiree can also simply choose to spend more than the budget amount and live with the consequences.  Retirees should of course note that higher initial withdrawals will mean lower subsequent withdrawals, all things being equal, and there are no guarantees when you choose to fund some or all of your retirement through periodic withdrawals from accumulated savings, irrespective of the withdrawal strategy you use.  

Follow-Up to JP Morgan Post

Several individuals took me to task for criticizing JP Morgan's conclusion that "greater lifetime income through... pensions and/or lifetime annuities allows individuals to increase both their withdrawal rates and equity allocations."  While this may appear to be a "logical" conclusion, particularly for investment allocations, the math just doesn't support this conclusion as it applies to withdrawals rates.  Retirees who desire reasonably constant spendable income in retirement, should decrease, not increase, withdrawal rates from accumulated assets as the amount of their fixed immediate life annuity/pension income increases, all things being equal.

As an example, Let's go to the "Excluding Social Security 2.0" spreadsheet on this site.  If we enter $1,000,000 in accumulated savings, $0 immediate life annuity, 5% annual investment return, 3% per annum desired annual increases, 30 year payout period and $0 bequest, we get an initial withdrawal rate of 4.34%.  If we assume 3% inflation, the inflation-adjusted run out tab shows that annual withdrawals are expected to remain constant over the expected 30-year payout period.

However, if we input a fixed immediate payment of $20,000 per year, the initial annual withdrawal rate drops from 4.34% to 3.75% to keep total annual spendable income (withdrawals from accumulated savings plus annual annuity payment) constant in real dollar terms over the expected 30-year payout period.

Finally, if instead of $20,000 per year fixed annuity payment, we input $40,000, the initial annual withdrawal rate drops from 3.75% to 3.15%.

JP Morgan's Dynamic Withdrawal Strategy

JP Morgan has recently released its research on dynamic retirement income withdrawal strategies entitled, "Breaking the 4%Rule". 

As someone who has frequently ranted on this website against the 4% Rule and encouraged the use of a dynamic retirement income withdrawal strategy, I recommend this paper to readers of this blog.  In many ways, the expressed goals of the JP Morgan withdrawal strategy are similar to the goals of the withdrawal strategy suggested in this website.  The JP Morgan paper also combines its withdrawal strategy with an investment allocation strategy, which I do not address in this website as I have no investment expertise.

In addition to attempting to carefully balance lifestyle risk and longevity risk, JP Morgan also attempts to "maximize how much utility value investors receive from their withdrawals."  This utility value maximization is also not something that I address in my recommended withdrawal strategy.

Some concerns I have with the JP Morgan Strategy:

The withdrawal schedule is significantly more aggressive than withdrawal rates recommended in this website.  For example, JP Morgan specifies an initial 5.9% withdrawal rate for a 65 year old with $1,000,000 in accumulated savings and $50,000 in "lifetime income".  Based on the assumptions recommended in thiswebsite and zero bequest, I get a withdrawal rate of 3.45% using the Excluding Social Security 2.0 spreadsheet if I assume $30,000 of the $50,000 of lifetime income is in the form of a fixed immediate annuity (with the remaining $20,000 payable from Social Security).  The main reasons the JP Morgan withdrawal rate is so much higher is that their model assumes higher future investment returns, lower future inflation, a shorter payout period and does not anticipate using accumulated assets to provide for future inflation adjustments to fixed payment "lifetime income."  If comparable assumptions are used for both models, I would anticipate results to be very similar for the initial year's withdrawal.

Additionally, the JP Morgan strategy does not appear to have relatively constant inflation adjusted retirement income as a goal.  Therefore, all things being equal, their withdrawal strategy would be expected to be more volatile from year to year than the approach recommended in this website when measured in inflation adjusted dollars.

Because the JP Morgan paper was critical of the performance of the 4% Rule in volatile markets, "especially when a portfolio loses significant value during the early years of retirement" I decided to calculate spending budgets and remaining assets under the JP Morgan strategy and the Steiner Actuarial Approach (using recommended assumptions and smoothing methodology) for a hypothetical retiree where asset returns are somewhat unfavorable.  The two graphs below  compare retirement spending budgets (withdrawals from accumulated savings + Social Security + fixed pension) and remaining assets under the JP Morgan Dynamic Strategy with the Steiner Actuarial Approach for someone retiring at age 65 with $1,000,000 in assets, $20,000 in annual Social Security and $30,000 in fixed pension/life annuity income (for a total of $50K) of "lifetime income". 

I assumed about a 0% average annual rate of return for this hypothetical retiree's first five years of retirement with the following randomly chosen rates of investment return:  year 1: -15%,  year 2: 2%, year 3: 5%, year 4: -5% and year 5: 15%.  I also assumed 3% inflation each year.  I used the withdrawal rate table included in the JP Morgan article to determine withdrawal rates and I interpolated between relevant wealth and age factors.  I ignored the fact that inflation increases in the retirees Social Security benefit would increase the retirees "lifetime income" and thus perhaps slightly increase the retiree's withdrawal rate under the JP Morgan approach.  I also assumed that the JP Morgan withdrawal rate tables (and the Steiner recommended assumptions) would remain unchanged for the entire 5 year period.  For each approach, I assumed that the annual budgeted amount determined under the relevant approach would be spent during the year.

Comparison of Budget Amounts In Inflation-Adjusted Dollars

Comparison of Remaining Asset Amounts

The graphs show that based on this assumed investment experience,  the JP Morgan strategy produces a spending budget that is somewhat more volatile (when measured in inflation adjusted dollars) than the Steiner Actuarial Approach.  Because it is more aggressive than the approach in this website (based on recommended assumptions), it produces higher spending budgets each year and therefore lower remaining assets at the end of the five year period.  Is the JP Morgan strategy better than the Steiner Actuarial Approach?  I don't believe its use of Monte Carlo simulations or utility value maximization necessarily make the JPMorgan strategy superior.  If comparable assumptions are used, results under the two methods can be comparable, and the smoothing algorithm in the Steiner Actuarial Approach results in more real dollar stability in the retiree's spending budget from year to year.   The Steiner approach is also readily available on this website.