Saturday, April 18, 2015

Your Withdrawal Strategy Should be Coordinated with Other Sources of Fixed Retirement Income

If you have accumulated savings and a fixed dollar pension benefit or life annuity, your accumulated savings need to do double duty when it comes to maintaining a constant real dollar annual spending budget in retirement.  Your accumulated savings need to 1) fund inflation increases on the portion of your spending budget attributable to your accumulated savings and 2) fund inflation increases on the portion of your spending budget attributable to the fixed dollar pension or life annuity.  If you have fixed dollar sources of retirement income, the withdrawal strategy you use needs to be adjusted to perform this double duty or you will find that your annual spending budget will likely decrease over time as a result of inflation.  The higher the rate of future inflation and the larger percentage of your spending budget attributable to fixed dollar income, the bigger this potential problem will be. 

The standard withdrawal strategies like the 4% rule, any safe withdrawal rate rule, the Required Minimum Distribution (RMD) rule, or any of the variations of these rules, were not designed to coordinate with other fixed dollar sources of income.  I was therefore surprised to read that when asked in a recent Barron’s article which spending strategy has the most potential, Dr. Wade Pfau said,

“I’m leaning toward some combination of an income annuity and a method used by [Cornerstone Wealth Advisors’] Jonathan Guyton, whose model I simulated. It’s a complicated set of rules but adjusts spending based on the market, limiting the fluctuations in the withdrawal amount to only 10%, and only when absolutely necessary.”

I was not at all surprised that Dr. Pfau advocated purchase of an annuity as an investment strategy that mitigates longevity risk and enable retirees to be somewhat more aggressive with respect to investment of their remaining assets.  I was, however, surprised that Dr. Pfau advocated using the Guyton Rules for determining withdrawals from the remaining assets.  First of all, I am not that impressed with the Guyton Rules (which are basically a variation of the safe withdrawal rule approach).  Secondly, and more importantly, the Guyton rules fail to coordinate with a fixed income annuity to provide constant spending budgets in retirement.  See my post of July 3, 2014 for my cautions about using the Guyton Rules even if a retiree has no fixed income retirement sources of income. 

The graph below shows total spending budgets for a hypothetical 65 year old male retiree with $1,000,000 in accumulated savings and a $20,000 per year Social Security benefit.  Let’s assume the retiree decides to follow Dr. Pfau’s suggestion and determines that his essential income level is about $50,000.  Therefore, he decides to purchase an immediate fixed income annuity of $30,000 per year (to supplement his Social Security benefit of $20,000 per year).  At current annuity purchase rates, this purchase is expected to cost him $458,716 ($545 of monthly benefit per each $100,000) leaving him $541,284 in accumulated savings.  

(click to enlarge)
The retiree uses the Guyton Rules to determine withdrawals from his accumulated savings with a beginning withdrawal rate of 5.5%.  In the first year, his total spending budget is $79,771 (.055 X $541,284 = $29,771 from accumulated savings + $30,000 from the annuity + $20,000 from Social Security).  Under the Actuarial Approach and the current recommended assumptions, his initial spending budget would be $65,762 ($15,762 from accumulated savings + $30,000 from the annuity + $20,000 from Social Security), assuming no amounts to be left to heirs. 

Let’s further assume that actual future experience is exactly follows the recommended assumptions—4.5% annual investment return and 2.5% inflation (and exactly the budget amount is spent each year).  Under these assumptions, the Actuarial Approach produces a constant real dollar budget of $65,762 per year while the spending budget under the Guyton Rules plus annuity approach produces a declining real dollar budget from year to year.  In fact the real dollar spending budget expected under these assumptions at age 89 is only about 61% of the initial spending budget.  As noted above, this decline could be worse for higher levels of inflation or for strategies involving a higher relative portion of the budget being used to purchase the fixed income annuity. 

Most withdrawal strategies for situations that don’t involve fixed sources of retirement income have constant real dollar income throughout retirement as an objective.  It doesn’t make sense to me to change that objective just because you add fixed dollar retirement income.   At the very least, retirees should be made aware of this potential inconsistency. 

Dr. Pfau has many readers of his blog (many, many times the number who visit this site) and has published many fine articles.   He is a revered academic scholar in the retirement area.   In light of his influence, I encourage him to “lean” away from using the Guyton Rules (or any other approach that does not reasonably coordinate with the fixed income annuity) when fixed dollar annuity/pension benefits are present in a retiree’s portfolio.