Thursday, March 31, 2016

Planning for Constant Real-Dollar Spending in Retirement—Is It Setting the Bar Too High?

Determining how much assets you will need in order to afford to retire is not an easy exercise.  It involves making many assumptions about the future, and as Yogi Berra said, “it is tough to make predictions, especially about the future.”

In his article, Why Most Retirement-Income Plans Lead to Over-Saving and Over-Working, Jonathan Guyton argues that the use of static withdrawal approaches that are designed to keep withdrawals constant in real dollar terms from year to year overstate future spending requirements/ future desired spending levels and thus overstate how much savings is needed to retire and to meet future spending objectives.  Guyton points to research by David Blanchett that shows real dollar spending generally decreases with age at least until very old age when medical related costs kick in.

While over-estimating future spending requirements/desires is certainly one way to inflate estimated assets needed for retirement, there are other ways to do this, including:

  • Underestimating future investment returns 
  • Overestimating future inflation 
  • Overestimating the period of retirement 
  • Underestimating the value of retirement assets 
  • Underestimating actual future spending vs. budgeted spending
Thus, it can be somewhat risky for a retiree to focus on one planning assumption as a justification to reduce total retirement savings.  Starting retirement with lower assets and not adjusting spending will increase the retiree’s chances of having to reduce spending levels later on.  Having said that, I don’t have a big problem with Mr. Guyton’s proposed solution (Approach #1) of using different assumptions for the future expected growth (and possibly the expected period) of essential and non-essential expenses when calculating the assets a retiree may need to support such expenses.  In fact, the new tab in our Actuarial Budget Calculator spreadsheet, “Budget by Expense Type”, allows users to do just that (and not just at retirement, but throughout retirement as conditions change). 

Mr. Guyton brushes aside the issues of how possible long-term care expenses and increased medical costs might affect current spending budgets, and he ignores unexpected expenses completely.  It is important for retirees to make sure that these possible costs are adequately addressed before moving on to how to deploy their assets for essential and non-essential budgets.

Readers may wish to use our spreadsheet to model the example Mr. Guyton’s includes in his article.  If I input $1,750,000 in accumulated savings, $40,000 in Social Security benefits, our recommended assumptions and no bequest motive, the spreadsheet calculates a present value of future spending budgets of $2,669,494.  Going to the Budget by Expense Tab and inputting 0s for long-term cost and unexpected expense reserves, $80,000 for essential non-health expenses (and 2.5% annual increases), $15,000 for essential health expenses (and a 3.5% annual increase), the remaining present value for non-essential expenses would be $437,712, or $25,715 per year (with 0% increases) over a 30-year period.  Thus, the total initial spending budget would be $120,715, which is approximately the couple’s initial desired spending budget.

In order to reach the couple’s initial desired spending budget with initial accumulated savings of $1,600,000, I would have to lower the future increase assumption for essential health related expenses from 3.5% to 2.5% and reduce the period of non-essential expenses from 30 years to 20 years.  As indicated in our post of November 30, 2015, it is certainly possible to change the assumptions about the future to achieve/rationalize a higher current spending budget.  In the end, however, it is up to you to decide what is reasonable for your particular situation and how much risk you are willing to assume.

Saturday, March 26, 2016

Developing a Reasonable Spending Budget is More Than Just “Tapping” Your Retirement Savings

Thanks to Nelson from Maryland for referring me to Nuveen Investments’ recent report entitled, Managing Retirement Income Through Economic and Market Cycles.  This report presents five decision rules to guide retirees when making withdrawals from accumulated savings during retirement.  The Nuveen decision rules are very similar to the decision rules developed by Jonathan Guyton and William Klinger in their October, 2004 Journal of Financial Planning article, a description of which can be found in Dr. Wade Pfau’s 2013 Advisor Perspectives article.
Nuveen Investments appears to have added a new High Inflation Rule (that limits inflation increases to 6%), and their Flat Market Rule (Guyton’s Capital Preservation Rule) appears to apply over the entire retirement period, while Guyton’s rule does not apply during the 15 years preceding the “maximum planning age.”  Other than these possible differences, the two sets of decision rules appear to be identical in application. 

As I have indicated in several prior posts, I’m not a big fan of the Guyton Decision Rules.  In my April, 2015 post on the Guyton decision rules, I said,

“They are unresponsive to changes in expected future investment returns (nominal or real), changes in expected future levels of inflation (as inflation may affect fixed dollar income components of a retiree’s portfolio), or changes in expected life expectancy.   As previously mentioned, the Guyton Decision Rules do not coordinate with fixed income annuity/pensions and they do not directly consider a bequest motive.  If experience is unfavorable, the retiree can run out of accumulated savings if the rules are blindly followed.   For example, under the Actuarial Approach, a 5.5% withdrawal rate for a retiree with a 30-year expected retirement period with no other sources of retirement income is consistent with an investment return assumption of 6% per annum and an inflation assumption of 2% annum (assuming the retiree desires constant real dollar spending in retirement).  If actual experience is less favorable than these assumptions, real dollar withdrawals under the Guyton Rules will be reduced frequently prior to reaching the 15-year cut-off mark (real dollar withdrawals are expected to be reduced in the 9th year even if experience exactly follows these assumptions).  After the 15th year, there are no cut backs, but there is a risk of running out of money.  Alternatively, if experience is more favorable than these assumptions, it is unlikely that withdrawal rates under the Guyton Rules in later years will fall as low as 4.6%, the approximate threshold for increasing withdrawals under Guyton’s “prosperity rule.”  Therefore, a retiree who experiences favorable experience will likely underspend relative to his objectives.  Finally, my actuarial training causes me to seriously question any approach that doesn’t periodically match assets with liabilities…. under a reasonable set of assumptions about the future.”
In addition to the above concerns from my April 26, 2015 post, I am bothered by recommended savings- “tapping” approaches that appear to ignore retiree needs to establish reserves for long-term care or other unexpected expenses. 

Notwithstanding my feelings about the Guyton/Nuveen Decision rules, I don’t have a problem with a retiree who wants to smooth his or her spending budget (or actual spending) from year to year within reasonable limits.  I just believe that the Actuarial Approach (with or without reasonable smoothing) provides a better approach than the Guyton/Nuveen decision rules for (1) developing an initial spending budget and (2) keeping subsequent year’s spending budgets on the right track. 

A person who is also concerned about encouraging retirees to develop reasonable spending budgets is Henry K. (Bud) Hebeler.  I have included Bud’s website in my list of “other calculators and tools” section for years.  Recently Bud released a budget planning tool for retirees who are “adverse to using a computer” (but apparently are not adverse to using a computer to surf the internet).  Bud calls his tool, “Pencil and Paper Retirement Planning for those already retired.”
While Bud’s low-tech worksheet (and his instructions) encourages retirees to establish reserves for future unexpected expenses, I didn’t see any mention of reserving for potential long-term care costs or bequest motives.  He also recommends the IRS Required Minimum Distribution (RMD) rules for determining withdrawals from accumulated savings (which is not my favorite either).  In general, however, spending budget results produced by Bud’s spreadsheet are probably not that different from results you might develop using the Actuarial Approach (his results may be a bit more conservative).  Of particular interest (at least to me) was Bud’s adjustment of fixed dollar pension/annuity income to reflect the fact that these sources of retirement income are subject to inflation risk.  In developing his pencil and paper spending budget, Bud recommends that the current amount of such income be multiplied by a percentage determined by taking the retiree’s age and dividing by 100.  This is consistent with what I said in my previous post that if you want your future spending budgets to remain constant in real dollars, you are going to have to save some of your accumulated savings, fixed dollar pension or Social Security benefits to fund those future cost of living increases.  The default option under the Actuarial Approach is to reduce withdrawals from accumulated savings for this purpose, but Bud’s approach (to reduce the fixed dollar pension) may also be valid.  For those retirees who have fixed dollar pensions and want to use a Guyton/Nuveen type approach (or some other rule of thumb approach) for withdrawals from accumulated savings, you might want to consider adjusting your fixed dollar pension in the manner Bud suggests.  Note, however, that Bud does not include a suggested approach for how to deal with non-immediate annuities.

Friday, March 4, 2016

Are you a Retired Boomer with a Large Fixed Dollar Pension? One more Reason to Ignore Rule of Thumb Withdrawal Advice.

This is another in a continuing series of posts illustrating why it is important to develop a reasonable spending budget in retirement rather than simply relying on a Rule of Thumb (RoT) strategy to “tap your savings.”  The inspiration for this post is a recently released research report by Ameriprise which paints a fairly bright financial picture for retired Baby Boomers (at least based on the group they surveyed, which included individuals with at least $100,000 in investable assets). According to the report, the average pension received by those in the survey group who had already retired, was approximately $3,200 per month, or about $38,400 per year.  

The surveyed Boomers in Ameriprise’s report were aged 55 to 75 in November, 2015. While not a big deal, technically we Baby Boomers will reach ages 51 to 70 in 2016. But, the purpose of this post is not to nit-pick Ameriprise’s report. The purpose is to discuss how the existence of a large fixed dollar pension benefit in a retiree’s portfolio can affect how much should be withdrawn from the retiree’s accumulated savings.

If you are a retired Boomer (or you are a non-Boomer retiree) and you have a large fixed dollar pension (and/or large amounts of fixed dollar life annuities), well, hey, congratulations! It is certainly better to have large pension/annuities than small ones (or none), all things being equal. On the other hand, these fixed dollar pension/annuities are subject to inflation risk, and if you want your spending budget to remain constant in real dollar terms throughout your expected period of retirement, you will either need to save some of your pension, Social Security or some of your accumulated savings so that you can provide yourself with cost-of-living increases on your fixed dollar pension in your later years. The alternative is to spend all your income each year and live on fewer real dollars as you get older. 

Let’s go to the Actuarial Budget Calculator for an example. Let’s assume Renee Retiree is 65 years old. Her Social Security benefit is $20,000 per year and her fixed dollar pension benefit is $40,000 per year. She also has accumulated savings (not dedicated for long-term care or unexpected expenses) of $300,000. She wants to leave $200,000 to her daughter upon her death. She also wants her spending budget to remain constant in real dollars as she ages. 

Inputting Renee’s information and the recommended assumptions in the Actuarial Budget Calculator V1.1 spreadsheet in this website, we see that Renee’s assets (including the present value of her Social Security benefits and the present value of her pension benefits) total $1,440,623 and the present value of the amount she wishes to leave to her daughter is $53,400 leaving her $1,387,223 as the present value of her future spending budgets. Spread over 30 years with 2.5% annual increases, this produces a first year spending budget of $60,347. Renee goes to the Inflation-Adjusted Runout tab and sees that if all assumptions are realized, her inflation adjusted spending budget will remain at $60,347 each year. If she fully spends her pension and her Social Security benefit in her first year, she will need to withdraw just $347 from her accumulated savings to spend her first year spending budget.  Note that this first year withdrawal represents just 0.12% of her accumulated savings. By comparison, the 4% Rule strategy would have had Renee withdraw 4% of her accumulated savings, or $12,000 and her first year spending budget would have been $72,000. This is fine if Renee’s goal was to have a constantly decreasing real dollar spending budget, but she didn’t.

RoT strategies don’t coordinate with other sources of income. They are just designed to spend down accumulated savings. Therefore, they are generally inferior to the Actuarial Approach when it comes to helping the retiree develop a spending budget that is consistent with their spending objectives. 

Some retirement experts note that the Required Minimum Distribution (RMD) rules may require higher percentage distributions from qualified plan or IRA assets than may be anticipated under the Actuarial Approach. And while this may be true, it is largely irrelevant. The RMD rules dictate how much must be withdrawn from tax-advantaged accounts; not how much must be spent. There is no requirement for a retiree to spend amounts withdrawn from these accounts, nor spend total amounts received from Social Security or pensions.