Better Budgeting with the IRS/RMD Table? — Part II

Several of our readers have asked us to comment on the recently released 145-page report entitled Optimizing Retirement Income by Integrating Retirement Plans, IRAs and Home Equity, authored by Dr. Wade Pfau, Joe Tomlinson, FSA and Steve Vernon, FSA.  The report is a collaboration between the Stanford Center on Longevity and the Society of Actuaries.  Since the report was authored by two actuaries and reviewed by many actuaries (including me), our readers wondered how the recommended strategy contained in this report compares with the Actuarial Approach we advocate here at How Much Can I Afford to Spend in Retirement.  Unfortunately, the two strategies contain some significant differences that may or may not be successfully explained by desires to appeal to different target audiences.  

The authors advocate what they call the “SS/RMD Spend Safely in Retirement Strategy.”  For those who do not want to wade through all 145 pages in the full report, the strategy is summarized in Steve Vernon’s shorter 19-page marketing piece entitled, “How to ‘Pensionize’ Any IRA or 401(k) Plan.”  Briefly, the approach anticipates deferring commencement of Social Security until age 70 and using a Systematic Withdrawal Plan (SWP) known as the IRS/Required Minimum Distribution (RMD) rule to determine annual withdrawals from the individual’s (or couple’s) account balances.   

We discussed the potential downsides of using the IRS/RMD approach recommended by the authors in our post of October 3, 2017.  The reasons we are not big fans of using this approach include:

• 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
  

Feel free to read our October 3 post if you want more explanation of these reasons for not liking the IRS/RMD approach, as we will not be repeating them in this post.

We will, however, take another shot at explaining why we believe the IRS/RMD SWP is generally pretty conservative, more so even than the Actuarial Approach with recommended assumptions.

Contrary to the author’s statement that “the account balance in taxable retirement accounts (such as traditional IRAs and 401(k) accounts) is divided by the participant’s life expectancy to determine the minimum required withdrawal amount for the coming year,” the denominator in this calculation is generally the joint life expectancy of the participant and a hypothetical beneficiary ten years younger than the participant.  In addition to the participant’s account balance being divided by this conservative joint life expectancy, the withdrawal rate is developed utilizing a 0% discount rate.  Thus it produces a significantly smaller annual withdrawal than anticipated under the Actuarial Approach, all things being equal.  We recommend annuity based pricing to determine a person’s (or couple’s) spending budget, and our approach is frequently criticized as being too conservative.  The table below, however, clearly shows that the IRS/RMD approach is even more conservative than the Actuarial Approach.

(click to enlarge)

 
This conservatism does, of course, make it a “safer” approach, but potentially at the cost of not spending enough, not providing adequate income in retirement, and leaving a larger-than-desired estate.  Note that for comparison purposes, the table assumes that the individual’s account balance is the individual’s only asset.  Also note that the table compares withdrawal rates for individuals, and the comparisons could be closer for couples, particularly for couples with significant differences in ages.

Conclusion

The authors argue that their Spend Safely strategy is a straight-forward solution for “ordinary workers” who lack the skills necessary to understand the math that may be involved with retirement planning.  This may be true.  However, we don’t believe that the Spend Safely strategy is truly an “optimal solution”, particularly for Intelligent Numbers People (INPs) who aren’t afraid to do a little number crunching to get a better answer.  The Actuarial Approach is a flexible process that provides “data points” that can be used to help individuals and couples make better financial decisions and help them achieve their financial goals in retirement.  Its basic principles can be applied globally.  The Spend Safely strategy, on the other hand, is an inflexible rule of thumb approach, appropriated from Internal Revenue Service regulations that were designed to force retirees with pre-tax accumulations in U.S. qualified defined contribution plans and IRAs to take distributions from these plans so that the U.S. government could collect its taxes.

As we indicated in our post of October 3, even though we are not big fans of the IRS/RMD approach to help individuals make spending decisions in retirement, we have no problem if defined contribution plan sponsors wish to offer something like this approach as a distribution option in their plans.