It is also important to remember that most systematic withdrawal strategies produce a spending budget. As with any other budget, you are free to deviate from the budget and spend what you feel is an appropriate amount. Some systematic withdrawal strategies (like the Actuarial Approach recommended in this website) automatically adjust for such deviations. Other approaches may not.
As promised in my post of October 9, this post will discuss the systematic withdrawal approach suggested by David Zolt in his recent Journal of Financial Planning article. Readers can also find more details about his approach in his website.
In summary, Mr. Zolt uses a Hybrid safe withdrawal/actuarial approach. He incorporates Monte Carlo modeling using historical returns from 1926-2013 and then uses a deterministic approach similar to the Excluding Social Security V 2.0 spreadsheet in this website (which he calls the Target Percentage Test) to monitor whether spending remains on track during retirement. In general, if the proposed withdrawal in any year, measured as a percentage of remaining accumulated assets, falls below the Target Percentage, Mr. Zolt's approach would require the retiree forgo that year's cost of living increase. His most recent article proposes another alternative to forgoing the entire cost of living increase if the test is failed.
The first case study in Mr. Zolt's recent article describes how his approach could work for a couple, both age 63 with $650,000 in accumulated retirement assets, total Social Security benefits of $3,000 per month and a fixed dollar $1,000 per month benefit from a pension plan. Based on his Monte Carlo analysis, Mr. Zolt determines that this couple has a "superb" chance of making the money last with an initial withdrawal rate of 5.7% if they are willing to forgo cost-of-living increases whenever the proposed withdrawal for the year measured as a percentage of accumulated assets exceeds the Target Percentage for this couple. By comparison, if we input this couple's data in our Excluding Social Security V 2.0 spreadsheet and use our recommended assumptions , we would get an initial withdrawal rate of 3.57%. There are two reasons why Mr. Zolt's initial withdrawal rate is much higher than ours for the same couple: 1) We use different assumptions for future experience and 2) The Actuarial Approach attempts to keep total retirement income (including income from the fixed dollar pension) constant from year to year in real dollars.
Using Mr. Zolt's Target Percentage spreadsheet, we can determine that if payments are to last 32 years and increase by 3% per annum, the couple's assets must earn a minimum of 7.7% per annum. Tables 1 and 2 below compare spending budgets every five years produced by Mr. Zolt's approach (assuming the target percentage is determined using 7.7% investment return, 3% cost of living increases and payment for 32 years) vs. the Actuarial Approach (using recommended assumptions) assuming future experience is either 5% investment and 3% inflation (Table 1) or 7.7% investment return and 3% inflation (Table 2). Table 3 compares spending budgets assuming future experience of 7.7% per annum and 3% inflation, but changes the assumptions used under the Actuarial Approach to 7.7% investment return and 3% inflation while Table 4 assumes future experience of 5% per annum and 3% inflation, but the assumptions used under the Actuarial Approach are changed to 5% investment return and 0% inflation. Under all four tables, the retired couple is assumed to spend exactly the spending budget under either approach each year.
Under the assumptions for future experience in Table 1, spending budgets decline significantly in real terms under the Target Percentage Approach. The couple's money does, however, last the entire 32 years. Under the Actuarial Approach and recommended assumptions, spending budgets remain constant from year to year in real dollar terms. Under the assumptions for future experience in Table 2, spending budgets decline somewhat under the Target Percentage Approach as the approach does not adjust spending from accumulated savings to make up for inflation erosion of the fixed dollar pension benefit. Under the Actuarial Approach (using recommended assumptions), the more favorable investment experience produces significant increases in the spending budget in later years.
The purpose of Tables 3 and 4 is to illustrate that similar results can be achieved under the Actuarial Approach by varying assumptions used to determine the annual spending budgets from the recommended assumptions.
Which approach is right for you? There is no easy answer to this question. Both approaches are dynamic in that spending budgets may need to be increased or decreased during retirement since both approaches involve annual checking to see how last year's spending budget increased with inflation compares with an actuarially determined target. The Actuarial Approach using recommended assumptions assumes future investment returns will be 2% real, while Mr. Zolt's approach uses a real rate of return closer to 4.7%. His approach also does not consider the effects of inflation on other fixed dollar income (such as pensions or annuity contracts) or amounts desired to be left to heirs. There is nothing mathematically superior about either approach. While Mr. Zolt's approach can be made more conservative by using more conservative target percentages, his reliance on historical rates of return makes his approach less conservative (more likely to involve decreasing real dollar spending budgets in future years) than the Actuarial Approach (which tends to tie investment return assumptions more closely to interest rates inherent in current immediate annuity contracts). This may be ok for some retirees, as long as they understand that higher amounts spent early in retirement mean smaller spending budgets later, all things being equal. Other retirees, however, may be less concerned if the spending budget increases in later years as a result of more favorable than assumed experience. Being a retired actuary, I tend to favor the more conservative approach. But, in the end, the bottom line of this post is the same as its title, and it is up to you to determine how conservative you want to be in determining your spending budget (and your actual spending) from year to year.
