Wednesday, February 4, 2015

Don’t Focus on a Single Assumption When Determining Your Annual Withdrawal--All Three Matter

In his recent article, "How Retirement Plans Vastly Underestimate Inflation",  Henry (Bud) Hebeler , states, "Almost every retirement planner has a default inflation rate of 3%. That can be a terrible mistake."  He goes on to say, "[assuming 3% inflation is] just plain wrong considering post-World War II results as well as the way the Feds have been printing money and current jittery foreign economics. I personally believe that it would be a lot better if people used something like 4.5% which is a little more conservative than the post-World War II average."
I appreciate the passion expressed by Bud in his article, but as one who currently recommends a 3% inflation assumption, I feel obligated to push back on Bud on this one. 

Readers of this site will know that the annual withdrawal rate determined under the Actuarial Approach, or most any other reasonable dynamic withdrawal approach is a function of three assumptions: (1) future asset investment return,  (2) future inflation and (3) future longevity.  To focus on one assumption while ignoring the other two, as Bud has done, is a fools game.  I'm not going to argue with Bud about the wisdom of using historical inflation averages to project future experience in this different environment.  He may be right,  but that it not the point. 

Yes, it is more conservative to assume higher levels of future inflation, all other things being equal, but higher assumed levels of inflation combined with even higher levels of assumed investment return and/or shorter life expectancies can produce withdrawal rates that are more aggressive (higher) than assumption combinations that involve lower assumed rates of inflation.  If there are no other fixed income annuity/pension sources of income that need to be coordinated within the spending budget, it is generally sufficient to focus on real (after-inflation) levels of investment return, not nominal levels.  In these situations, what should matter most to a retiree is the level of withdrawal produced by the combination of assumptions, not whether one of the three assumptions appears to be somewhat out of line with historical experience.

I am also a little surprised to see Bud fanning the inflation fires so quickly after writing his article of January 16, 2015  (discussed in our January 22 post), where he recommended withdrawals based on a 5% investment return, 3.5% inflation and IRS Publication 590 life expectancies.  This combination of assumptions produced a 5.5% withdrawal rate for a 65-year retiree compared with the 4.3% withdrawal rate under the Actuarial Approach using the recommended combination of assumptions. 

There is one summary statistic that a retiree can look at to obtain a measure of how conservative or aggressive her assumptions are in combination--the withdrawal rate for the current year produced by her withdrawal strategy (the amount to be withdrawn from accumulated savings divided by the beginning of year accumulated savings).  The following table shows withdrawal rates produced by the Actuarial Approach under the 2015 recommended combination of assumptions at various ages (assuming no coordination with other fixed annuity/pension income and no bequest motive).  Withdrawal rates at the indicated ages that are higher than those shown in the table are based on assumptions that are more aggressive in combination than the 2015 recommended assumptions.  Withdrawal rates at the indicated ages that are lower than those shown in the table are more conservative in combination, all things being equal.

Having said the above, I will concede that if a retiree is developing a spending budget that involves coordinating significant amounts of fixed income annuity/pension income or  real dollar bequest motive into her budget, the nominal accuracy (and not just the real relationship) of  the assumptions for investment return and inflation can be important.