Monday, April 25, 2016

Please Call Off the Search for a Safe Withdrawal Rate

I know that I sound like a broken record on this issue, but as long as retirement experts keep touting safe withdrawal rates (the 4% Rule, etc.), I will continue to warn my readers that these approaches may not be consistent with their spending objectives in retirement.  While not necessarily advocating the use of a safe withdrawal rate in his latest article, “The 4% Rule And The Search For A Safe Withdrawal Rate”, Dr. Wade Pfau points out that “75% of surveyed financial planners either ‘always’ or ‘frequently’ use systematic withdrawals with their clients. [So] They care about the safe withdrawal rate.” 
For the umpteenth time, I will summarize some of the major downsides using a safe withdrawal rate approach:

  1. It doesn’t coordinate with other sources of income (particularly fixed dollar sources like pensions) 
  2. It ignores certain types of expenses such as long-term care expenses, other unexpected expenses and bequest motives. 
  3. It doesn’t distinguish between different types of future expenses, so there is no ability to assume different rates of future increases for different types of expenses and no ability to consider variations in the retiree’s aversion to risk for different types of expenses. 
  4. It is designed to “draw-down” accumulated savings; not be part of a “bigger picture” spending budget 
  5. It is a “set and forget” strategy that requires faith that future investment experience will duplicate historical investment experience (or adjusted historical investment experience). 
  6. It assumes that each year’s retiree spending will exactly equal the safe withdrawal amount. 
  7. It assumes that the retiree will invest at least 50% of accumulated savings in equities and maintain at least this percentage in equities throughout retirement.  
  8. It contains no adjustment mechanisms to keep future spending on track if investments fail to earn rates assumed in the model (or investments earn more than assumed) or if actual spending deviates from the safe withdrawal amounts.
Perhaps the best way to illustrate the short-comings of a safe withdrawal rate approach and how those short-comings are handled under the Actuarial Approach, is to look at an example.   Let’s assume Roberta Retiree is 65 years old and a renter with no home equity, she receives a $40,000 annual fixed dollar pension in addition to her $20,000 annual Social Security benefit and has $300,000 in accumulated savings.  She would like to leave $200,000 at her death to her daughter.  She has no long-term care insurance.  She wants to determine her 2016 spending budget. 

Roberta enters her information and the recommended assumptions for 2016 into the Actuarial Budget Calculator.  It tells her that the present value of her assets are $1,540,623 and when reduced by the present value of the amount she wants to leave to her daughter leaves a present value of her future spending budgets of $1,487,223.

Roberta then goes to the “Budget by Expense Type” tab.  She inputs $100,000 as her reserve for future long-term care expenses (using the methodology described in our January 12, 2016 post, assuming 4.5% future annual cost increases and reflecting only 60% of the expected present value since other expenses will be reduced if and when Roberta enters a long-term care facility).  She also enters $50,000 for the present value of her unexpected expenses. 

She determines her 2016 non-medical essential expenses to be about $40,000 per year and she believes those expenses will stay relatively constant in real dollar terms in future years, so she enters the recommended inflation assumption of 2.5% per annum for the expected increase for this expense type.  The total present value budget attributable to her current and future non-medical essential expenses is $919,494.  She enters $6,000 for essential medical expenses with a 4.5% future increase assumption giving her a total present value budget for this item of $180,000.  This leaves her with a $229,728 total spending budget for non-essential, discretionary expenses.  She decides that she can live with the same dollar amount of non-essential expenses each year, so she inputs a 0% increase assumption for this item, giving her a 2016 non-essential spending budget of $13,966.

Roberta’s total spending budget determined using the Actuarial Approach (excluding any amounts attributable to long-term care or unexpected expenses) is $59,496.  Note that this amount is $504 less than the sum she expects to receive during 2016 from Social Security and her pension.  Thus, under the Actuarial Approach, in order to meet her spending objectives on an expected basis throughout her retirement, she must actually save $504 of her 2016 pension (or Social Security) in addition to spending $0 from her accumulated savings.  By comparison, the 4% Rule would tell her to go ahead and spend $16,000 of her accumulated savings in 2016 in addition to her pension and Social Security. 

The Actuarial Approach (and the Budget by Expense Tab) also tells Roberta approximately how much of the present value of her assets are dedicated to each expense type.  If she is more concerned about her essential expense budgets, for example, she can choose to invest assets dedicated to those budgets more conservatively than assets dedicated to non-essential expenses.  Or, at the end of 2016, she can transfer assets from one expense-type budget to another depending on actual experience during the year.

Most importantly, the Actuarial Approach tells Roberta where she stands each year depending on her actual spending and actual investment performance.  Roberta can always choose to smooth her budgets or spending from year to year, but she doesn’t have to rely on blind faith in historical investment results (or restrict actual spending) to develop a reasonable spending budget each and every year of her retirement. 

Because of all the unknowns involved, determining a spending budget can sometimes be more art than science.  If you a greater than average risk taker, you can always spend more of the present value of your assets now rather than later (with the risk that you may have to spend less later).   However, don’t be misled into thinking that just because retirement experts refer to an approach as a “safe withdrawal rate” approach that it is necessarily safe or without risk.