Better Budgeting with the IRS RMD Table?

In his recent Advisor Perspectives article, Joe Tomlinson touts the benefits of using a “variable” or “dynamic” strategic withdrawal plan (SWP) like the “endowment SWP” rather than a “fixed” SWP like the 4% Rule.   According to Mr. Tomlinson, “The general superiority of variable over fixed withdrawals applies regardless of the type of [investment] sequence.”  Under an endowment SWP (for example, x% of each year’s accumulated savings), withdrawals may fluctuate from year to year based on actual investment performance or actual spending for the previous year, while under a fixed SWP, withdrawals are not based on actual investment performance or actual spending, and are generally just increased from one year to the next by inflation (with the hope that the money doesn’t run out).  There are, of course, many hybrid SWPs that combine elements of both approaches and/or smooth the individual’s withdrawals from year to year.

In addition to advocating variable SWPs over fixed SWPs to mitigate sequence of return risk, Mr. Tomlinson’s research demonstrates that the IRS Required Minimum Distribution (RMD) SWP improves retirement outcomes over a flat percentage endowment SWP.  He indicates that this is accomplished “in very approximate terms… by dividing savings by expected remaining life.” He notes, “One can attempt exact calculations using an appropriate actuarial table and assumed investment returns, or a simpler approach is to rely on the IRS requires [sic] minimum distribution (RMD) tables.”

The Actuarial Approach we recommend in this website, which is also a variable approach, uses the more “exact actuarial calculations” referred to by Mr. Tomlinson; that is, it uses the present value of the future lifetime planning period with desired annual future increases.  And while the IRS RMD SWP may be a tad simpler than the Actuarial Approach, we believe that doing the more exact actuarial calculations is definitely worthwhile and can improve retirement outcomes even more.  This is why our website tagline reads, “The spending budget website for intelligent retirees and pre-retirees (and their financial advisors) who aren't afraid to do a little number crunching to get the right answer.”  The following paragraphs discuss why we believe you or your financial advisor may be making a mistake using the “simpler” IRS RMD SWP advocated by Mr. Tomlinson to determine your spending budget in retirement or to determine when you should retire or how much you should be saving for retirement.  Our reasons may be summarized as:

• The IRS RMD SWP is quite conservative 
• SWPs frequently do not coordinate well with other sources of retirement income 
• SWPs generally do not adequately recognize non-recurring expenses in retirement and do not anticipate different rates of increase in future recurring expenses 
• SWPs generally don’t permit “budget shaping” to meet individual retirement goals, and 
• SWPs generally don’t do a particularly good job of helping you with pre-retirement planning
  

The IRS RMD SWP is quite conservative

The IRS didn’t design its Required Minimum Distribution table to be used as a spending budget tool for retirees.  The rules were designed to force retirees with pre-tax accumulations in qualified defined contribution plans and IRAs to take distributions from these plans so that the government could collect their income taxes.  And by the way, just because you are required under these rules to make minimum withdrawals, you aren’t required to spend the money when you do.   Determining how much you can afford to spend each year is an entirely different matter.

Because the required minimum distribution under the IRS RMD rules are determined assuming a 0% real discount rate and a very conservative mortality table, the distribution periods in the IRS tables produce lower withdrawals at every age than the more exact Actuarial Approach.

The following chart compares real dollar spending under:

• the IRS RMD rules vs. 
• the Actuarial Approach

We used the same person in Mr. Tomlinson’s straightforward example (female age 65 with $1,000,000 in accumulated savings and a Social Security benefit of $30,000 per year), and we assumed exact realization in the future of our current Actuarial Budget Benchmark recommended assumptions (4% investment return assumption, 2% inflation, 31-year lifetime planning period and 2% annual desired increases in future spending budgets).  We also ignored, as Mr. Tomlinson did, long-term care costs, unexpected expenses and bequest motives, and we assumed, as Mr. Tomlinson did, that the hypothetical person would spend exactly her spending budget each year (at the beginning of each year).   For ages prior to 70, we assumed a 3.5% per year annual rate of withdrawal under the IRS RMD SWP.

click to enlarge

The chart shows that the hypothetical female’s total spending budget is consistently higher in real dollar terms under the Actuarial Approach than under the IRS RMD approach. Yes, we understand that it is highly unlikely that the assumptions about the future that we made to develop this chart will be exactly realized every year for the next 25 years.   But, that is not the point here.  The point is to illustrate the clear relationship between the two lines, as both of these approaches are variable approaches and, absent any smoothing, these two lines will move up and down in tandem with actual investment performance.  Under these assumptions for the future, the hypothetical person’s accumulated savings at the end of her 89th year are $716,896 under the IRS RMD approach as compared with $243,171 under the Actuarial Approach.  Therefore, if one of her goals is to maximize retirement income and not leave significant bequests, as Mr. Tomlinson indicated, she would be much better off using the Actuarial Approach.  

The chart also shows that for much of her expected period of retirement, her spending is expected to increase in real dollar terms under the IRS RMD approach as she ages under the assumptions selected.  Such increases in real dollar spending may also not be consistent with her retirement goals.  She may desire a more level (or even front-loaded) expected spending pattern.

SWPs frequently do not coordinate well with other sources of retirement income

Retirement spending goals generally involve how much you can afford to spend, not how to “tap” your accumulated savings.  SWPs in general and the IRS RMD approach specifically are concerned only with how to tap your accumulated savings and not the bigger picture of your total spending.   As we have discussed many times, (most recently in our post of August 8, 2017), SWPs may not work very well if you have other sources of income that aren’t paid for the entire duration of retirement (like part-time employment or QLACs) or are not paid in a manner consistent with your desired future increases in spending budgets (like fixed dollar pension benefits or life annuity payments).   For couples, other sources of income may commence or cease at different times.  In these instances, you may not be able to develop a reasonable spending budget by simply adding other sources of income for the year to the SWP amount for that year.  To smooth out these discontinuities and produce a more reasonable spending budget, the Actuarial Approach takes the present value of income from other sources and spreads it over the individual’s (or couple’s) future lifetime using the same spreading factor (and same desired increases) used to spread your accumulated savings.  Therefore, if you like how the Actuarial Approach spreads your accumulated savings, you will love how it spreads the present value of your income from other sources to develop a more reasonable spending budget.

SWPs like the IRS RMD approach don’t consider your non-recurring expenses and they don’t anticipate different rates of increases for different types of expenses.
Retirement experts constantly bombard us with admonitions to be sure to worry about increasing health-care costs, unexpected expenses and long-term care costs when we do our retirement planning.  Despite these admonitions, SWPs like the IRS RMD approach generally focus only on your recurring spending in retirement and not these non-recurring expense items.  By comparison, these items are addressed directly using the Actuarial Approach.

SWPs generally don’t permit “budget shaping” to meet individual spending goals

As discussed in our previous two posts, the Actuarial Approach can be used to shape your spending budget to better meet your spending needs in retirement.  For example, you can “front-load” your travel expenses by treating them as non-recurring, or you can plan on decreasing spending budgets in real dollars as you age consistent with the “go-go, slow-go and no-go” phases of retirement noted by many retirement researchers.

SWPs don’t do a particularly good job of helping with pre-retirement planning

Unlike SWPs that focus on helping you tap your savings after retirement, the same basic principles used in the Actuarial Approach can help you plan for your retirement.  It can be used to develop a spending/savings budget consistent with your retirement goals and keep you on track as experience deviates from your assumptions.

Conclusion

While the IRS RMD SWP may be a better approach than the 4% Rule and other fixed SWPs for purposes of “tapping your savings”, neither of these SWPs can hold a candle to the Actuarial Approach in terms of helping you develop a reasonable spending budget and make other financial decisions.  Unfortunately, financial planning is relatively complex and not always adequately addressed by simple rule of thumb approaches.  We encourage you to utilize the basic actuarial principles inherent in the Actuarial Approach and do the number crunching necessary to obtain the right answer for you based on your specific situation and your specific financial goals.

We have no problem with Mr. Tomlinson’s suggestion that fund companies keep the IRS RMD rules in mind when developing managed payout options for their clients (particularly those with tax qualified accounts.  We firmly believe, however, that financial advisors can do a much better job for their clients by employing the more “exact actuarial calculations” inherent in the Actuarial Approach rather than by using IRS RMD tables.