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.