Thursday, October 27, 2016

Focus on Your Spending Budget in Retirement–Not How Much You Can Withdraw from Your Investment Portfolio

It seems like every other week some retirement expert, financial planner or investment firm is coming out with their recommendation for the best withdrawal strategy to use to tap one’s savings in retirement.  The new and improved strategy may be “fixed”, “variable,” or a hybrid of the two.  It may be a “safe” withdrawal rate (as contrasted with one that is unsafe?)  It may have “guardrails.”  It may involve using the Excel PMT financial function.  It may be a rate that retirees should “feel free” withdrawing, or it may be one of the many approaches that adjusts the 4% Rule in some manner to supposedly make it better.  I refer to these systematic withdrawal approaches as “rule of thumb” (RoT) approaches.

All of these RoT approaches miss the point.  The point of the exercise is to determine approximately how much you can afford to spend each year while meeting your financial objectives, not how much to withdraw.  Sometimes adding the amount you can withdraw under these RoT approaches to other income you may be receiving for a given year will give you something close to a reasonable spending budget for that year, and sometimes it won’t.

The current widely-followed practice of first determining how much can be withdrawn from savings and then adding that amount to other available income for the year is just bass-ackward and, in my opinion, should be changed.

The process recommended in this website involves

  • first determining a reasonable spending budget based on sound actuarial principles and 
  • then subtracting other available income for the year to determine how much, if any, should be withdrawn from accumulated savings.
Thus, the reasonable actuarially-developed spending budget and the other income you may be receiving during the year determines how much you should  withdraw from your accumulated savings, not some RoT approach that doesn’t even consider how much other income you may or may not be receiving that year.

Under the Actuarial Approach, withdrawals from savings may be much greater than or much less than withdrawals suggested by RoT approaches, and this situation may change over the period of retirement.  An example of the former situation is when income in retirement is deferred (such as when Social Security or income from an anticipated home sale is deferred).  An example of the latter situation is when income in retirement is front-loaded (such as when a retiree works in part-time employment or receives other income for a temporary period of time).

Note:  It is certainly possible that the annual income from various sources in retirement may even temporarily exceed the year’s actuarially calculated spending budget.  In that event the withdrawal from accumulated savings for that year will be negative.  In other words, instead of withdrawing and spending x% from savings that year as the retiree may do under a RoT approach, under the Actuarial Approach she would actually be saving to fund future spending needs.

If you (or your financial advisor) are currently using a RoT approach to develop your spending budget, I strongly recommend that you change your mindset (as suggested in the graphic above) and consider the Actuarial Approach as a better alternative.  At a minimum, we encourage you to compare the spending budgets developed under your approach with that developed under the Actuarial Approach and make sure you are comfortable with any significant differences.

For those of you still wondering about the graphic above:  No I am not calling for a small change (20 cents) in practice.  I am calling for a paradigm shift.