In this website, we make a distinction between withdrawals from a portfolio of assets (tapping one’s savings) and developing a spending budget (based on total assets and total spending liabilities). Other retirement experts tend to blur these two terms. To make today’s illustrations easier, we are only going to focus on withdrawals, but our conclusion also applies equally well to using the Actuarial Approach to develop a spending budget based on total assets and liabilities.
Zero Withdrawals
SORR is not generally a concern if one is not withdrawing funds from investments. If no withdrawals are being made, the sequence (or order) of investment returns won’t really affect the size of one’s assets at the end of the measurement period. What does affect the end-of-measurement-period assets is the average annual rate of return during the period. To illustrate, lets assume the following three sequences of investment returns all designed to earn approximately the same average annual rate of 4% per annum over a hypothetical five-year measurement period:
Sequence #1. Year 1: 4%, Year 2: 4% Year 3: 4% Year 4: 4% Year 5: 4%
Sequence #2. Year 1: -15%, Year 2: -5%, Year 3: 10%, Year 4: 15% Year 5: 19.1%
Sequence #3. Year 1: 10%, Year 2: 15%, Year 3: 3%, Year 4: -10%, Year 5: 3.75%
Let’s assume we have a 65-year-old male with $300,000 of assets in his IRA. Table 1 below shows that if he does not withdraw from his IRA for the next five years, the three different sequences of returns described above will have no effect on his IRA account balance at the end of five years. All three investment scenarios produce the same ending asset value of $364,996 (within rounding).
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Fixed vs. Dynamic Withdrawals
Now let’s take a look at what happens if we start withdrawing amounts from his IRA during this measurement period. Table 2 above shows withdrawals and end of year asset values determined using the 4% Rule (a fixed approach) under the three investment sequences above, and Table 3 shows withdrawals and end of year asset values determined under the Actuarial Approach/ABB (a dynamic approach). The ABB withdrawal amounts can be confirmed using our Actuarial Budget Calculator (ABC) for single retirees and its 5-year projection tab.
Since withdrawals under the 4% rule do not depend on actual investment experience, they are unchanged by investment scenario. Withdrawals are assumed to increase by 2% inflation each year. Under this approach, withdrawals are constant (in real dollars) and assets at the end of the 5-year period will depend, not only on the average annual rate of return, but also on the sequence of returns. If investment returns begin relatively poorly and subsequently rebound (Scenario #2), end of period assets will be lower under this approach than if investment returns begin more favorably and subsequently perform less favorably (Scenario #3).
By contrast, because it employs the market value of an individual’s assets each year, the ABB withdrawal amounts shown in the Table 3 will fluctuate up and down each year depending on how scenario investment returns compare with the 4% assumption used to develop the ABB (which, for the purpose of this table, is assumed to remain unchanged for the entire five-year measurement period). However, ending asset values under all three investment scenarios are approximately the same, and the calculated ABB withdrawal for year 6 is identical. Therefore, as with the “zero withdrawal” scenario discussed above, the value of the assets remaining after a period of time under the ABB is a function only of the average annual return for that period, not the sequence of the returns during the period, and there is no SORR.
A Few Comments About the 4% Rule vs. ABB
One of the positive features of the 4% Rule is that there is not a lot of variability in amounts withdrawn from year to year. Financial advisors who advocate this approach and use a similar “fixed” approaches for the spending algorithms in their Monte Carlo models argue that it is this stability feature that is of paramount importance to their clients; a feature for which they believe many clients are willing to sacrifice other attributes (such as maximizing total spending) to achieve. Having no clients, we can neither confirm nor refute this impression.
Spending exactly the ABB each year can involve spending volatility if significant amounts of investments supporting the retiree’s spending fluctuate in market value from year to year. There are many ways to deal with this potential volatility, including:
- Smoothing the spending budget as discussed in our post of January 2, 2017
- Establishing a Rainy-Day Fund to “bank” some of the asset gains to be used at a later time when returns are poorer
- Minimizing investments in risky assets
We take some comfort from the fact that about half of the people we talk with tell us that our approach is too conservative and the other half tell us that it is too aggressive. Occasionally we will actually run across someone who will look us in the eye and tell us that the ABB is both too conservative and too aggressive. Most of the time, however, these individuals have never really tried out our workbooks. See our post of November 6, 2017 for further discussion of the five most common misperceptions about the Actuarial Approach.
In this website, we don’t tell you how to invest and we don’t tell you how much you should spend each year. We do recommend, however, that you calculate your ABB “data point” each year so that you can see how the spending budget approach you are using compares with this benchmark. It is our hope that this comparison will help you in developing a reasonable spending budget that is consistent with your retirement financial goals.
Conclusion
In our humble opinion and based on our own personal preferences, we believe the dynamic Actuarial Approach is a better withdrawal strategy than the fixed 4% Rule. When it comes to helping you develop a reasonable spending budget, however, we have no doubts--we believe the Actuarial Approach blows the socks off the 4% Rule and is a better spending algorithm than fixed (or constant dollar) approaches used in Monte Carlo models. If you want a more robust alternative to the 4% Rule (or other fixed spending approaches) where you won’t have to worry about SORR, you have found it here with the Actuarial Approach.
