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how the existence of a large fixed dollar pension benefit in a retiree’s portfolio can affect how much should be withdrawn from the retiree’s accumulated savings.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.