Saturday, January 24, 2015

The Perfect Withdrawal Amount?

Recently two faculty members of the Trinity University Department of Finance and Decision Sciences and an independent financial advisor released a paper entitled, "The Perfect Withdrawal Amount:  A Methodology for Creating Retirement Account Distribution Strategies."  From my perspective, the approach set forth in this paper has many positives and a few potential negatives.  Not surprisingly, I agree with aspects of the approach that are similar to the Actuarial Approach recommended in this website and generally disagree with the aspects of the approach that are dissimilar. 

Items of Agreement.  The authors recommend a (dynamic) process involving annual redetermination of the amount to be withdrawn based on accumulated savings, assumed rates of future return, age, risk preference and amount of bequest motive at time of redetermination.   As I, the authors are critical of safe withdrawal approaches and variations of safe withdrawal approaches that incorporate "adaptive rules."  The Actuarial Approach basically follows the same process recommended by the authors.  In addition, it develops a budget that is coordinated with other annuity/pension income.  In fact, it develops what the authors call a "Perfect Withdrawal Amount" (or perhaps "Better than Perfect" if the retiree has other fixed dollar annuity income) each year.  The only difference is that the Actuarial Approach uses deterministic assumptions where risk preference is varied through the use of more or less optimistic assumptions for longevity, future investment returns and inflation.    In addition, I recommend the use of a smoothing algorithm to keep budgets from being too "jumpy" from year to year. 

Items of Disagreement.  The authors model future investment experience using a Monte Carlo approach and the paper refers to historical equity performance from 1957 to 2013.  It is not clear whether this data  has been adjusted for inflation or to reflect the current economic environment.  As I indicated in my post of July 15, 2014, while Monte Carlo modeling appears to be more sophisticated than deterministic projections, it is no better at projecting the future, and in fact could be much worse if the data is not properly adjusted.  The authors use the period 1957 to 2013.  As an example of how that period may not properly reflect the current economic environment,  let's take a look at the prime rate charged by banks on short-term loans to businesses (available in Table H15 of the Federal Reserve System historical interest rates).  Over the 33-year period of 1969 to 2001 (about 58% of the period used by the authors), the average prime rate was in excess of 9% per annum.  By comparison, the rates for every year since 2008 have been 3.25%.  Running a model 20,000 times with what could be questionable data does not give me a good feeling about the reasonableness of the projections.  By comparison, the recommended investment return assumption for the Actuarial Approach is selected to be somewhat consistent with interest rates inherent in current fixed immediate annuities available on the market (with the understanding that higher investment returns generally come with higher levels of risk that should be discounted).

Bottom Line. 
Depending on the data used to model future experience, the author's approach may produce a reasonable annual withdrawal amount.  Care should be taken to make sure that the effects of future inflation have been considered to the retiree's satisfaction.  I would suggest comparing withdrawals under this approach with the withdrawals determined under the Actuarial Approach, with reasons for significant differences in results explained to the retiree.