As discussed in our posts of July 12, 2013 and October 11, 2013, and in the Journal of Personal Finance paper (originally written in February, 2014), we have been recommending the following assumptions for annual budget determinations under the Actuarial Approach:
- Expected annual rate of return on savings: 5% (a nominal interest rate)
- Annual desired increase in payments/inflation: 3%,
- Expected payout period (in years): Until age 95 or life expectancy if longer.
In the absence of significant changes in interest rates, we recommend continued use of these assumptions for 2015 retiree budget determinations.
The remainder of this post will discuss the rationale for continuing these recommended assumptions.
Investment Return and Inflation Assumptions
In prior discussions, I have tied the expected future nominal expected rate of investment return on accumulated assets to the approximate interest rate "baked into" immediate annuity purchases. For this purpose, I have used the immediate annuity purchase rates made available on the Income Solutions website.
According to this website, as of November 26, 2014, a premium of $100,000 could purchase a monthly immediate annuity of $571 for a 65 year old male and $544 for a 65 year old female. Assuming a life expectancy at age 65 of 22.9 years for a 65-year old male and 24.9 years for a 65-year old female (based on the Society of Actuaries 2012 Individual Annuity Mortality Table with 1% per year mortality improvement, a link to which is available in the "Other Calculators/Tools" section of this website), I have determined that the interest rate inherent in these annuity purchase rates is about 4.3%. This rate is slightly lower than the 4.6% rate I approximated last February using the same approach. This change may be due to the use of more conservative mortality assumptions, declining interest rates or some combination of the two.
While I have no problem if a retiree wants to use an investment return assumption lower than 5% (particularly if the retiree is heavily invested in fixed income securities), I continue to believe that an annual 5% nominal return can be reasonably justified by retirees with relatively diversified investment portfolios. I would caution, however, against assuming higher nominal (or real) investment returns based on increased investment in equities as those strategies carry more risk that should be reflected in the assumption.
Consistent with Wade Pfau's research, I believe budgeting should assume a real rate of return of about 2% per annum, so I am retaining the 3% per annum inflation assumption combined with the 5% investment return assumption as my recommended economic assumptions for 2015 budgeting.
Mortality
As discussed above, the Society of Actuaries has released several new mortality tables which show significant mortality improvement has taken place in recent years. For example, life expectancy for a 65-year old male has increased by about a year under the new Individual Annuity Mortality Table (with 1% annual improvement). Under this revised table, a 65-year old male has about a 24% probability of surviving until age 95, while this probability is about 33% for a 65-year old female. Note, however, that this new table is based on mortality experience for individuals who buy immediate annuities from insurance companies and presumably have better than average health. By comparison, life expectancies under the 2010 Social Security tables (with 1% mortality improvement), with experience based on essentially the U.S. population are 17.6 years for 65-year old males and 20.4 years for 65-year old females, respectively. While some argument can be made for increasing the "live to 95" assumption by a year (at least for females), I continue to believe that this assumption is reasonable. Of course, if you are already in your late 80s, you need to look at longer possible payment periods.
If you are the rare retiree who has a good idea when you are going to die, feel free to use your knowledge in your budgeting. If you are like most of us, you should plan to live longer than your life expectancy, at least relatively early in your retirement. The problem with doing this is that this increases the probability that you will die with more (unspent) assets than you desired. To some extent, this is simply the cost of not buying an annuity.
The chart below shows projected budget amounts (in inflation-adjusted dollars) for a 65-year old retiree with $600,000 in accumulated assets under the Actuarial Approach (and recommended smoothing) using two different approaches for determining the remaining payout period. The first approach uses the retiree's life expectancy (based on the SoA 2012 Individual Annuity Table) while the second approach uses the "live until 95" approach recommended in this website. Investments are assumed to earn 5% per annum, inflation is assumed to be 3% per annum and the retiree is assumed to spend exactly the budget amount each year. This chart illustrates the problem with using one's life expectancy each year and having the misfortune? of surviving.
(click to enlarge)
In his November 26 article, "Why Retirees Now Have to Question the 4% Withdrawal Rule," Jeff Brown suggests modifying the 4% Rule to make it more flexible rather than maintaining its "set-and-forget" characteristic and employing a lower safe withdrawal rate as some advisers have suggested in light of current low yields on fixed income investments. Mr. Brown says,
"So how do you get from here to the living-large lifestyle [The 4% withdrawal at initial retirement increased by inflation] described above? With flexibility. You don't need to skimp every year to prepare for a disaster that might never happen so long as you can cut spending if it does. That way, if the $1 million portfolio [at initial retirement] were to fall to $700,000, you could hit reset and withdraw only 4 percent of the new amount -- $28,000 instead of $40,000 plus inflation. If the fund were to recover, you could hit reset again and take 4 percent of the new amount, then go back to annual increases to offset inflation."
There is nothing magical about 4%. It happens to be a reasonable withdrawal rate if you are a currently age 65 planning for a thirty-year retirement, you are using the assumptions we recommend for the spreadsheet tools on this website and you have no other annuity income or plans to leave money to heirs. If you go to the runout page of the Excluding Social Security V 2.0 spreadsheet on this site, you will see that the budget withdrawal from savings under the circumstances described above is 4.34% at age 65, 4.99% at age 70, 5.97% at age 75, 7.60% at age 80 and 10.89% at age 85. This is just mathematics based on a declining expected payout period as one ages. Thus, any approach that hits the 4% restart button at an age after 65, is going to miss the mark.
If you are going to utilize a flexible approach that increases or decreases spending budget amounts based on actual experience (be it from investment experience more or less than assumed or spending variations), you are better off using the Actuarial Approach and hitting the reset button on that approach each year to stay on track. If you want to have some smoothing in your spending budget from year to year, use the smoothing approach we recommend.
Its coming up to the end of the year. This year again, we will revisit some of the example people we have looked at over the past couple of years to determine 2015 spending budgets for them in light of 2014 experience. Once again, we will illustrate how effective and how easy the Actuarial Approach budgeting process can be.
I'm pleased to see that several retirement pundits are extolling the virtues of measuring personal retirement plan liabilities and comparing those liabilities with accumulated assets to help individuals plan for retirement. This approach is comparable to what actuaries do for pension plans and is the basis for the Actuarial Approach advocated in this website.
In his November 22 article, "Is Your Retirement Fully Funded," Robert Powell says:
"If you want to get a sense how best to generate income in retirement, consider doing what corporate pension plans do. Determine the “funded status” of your personal retirement plan."
In his guest article in The Retirement Café, Michael Lonier says:
"The household balance sheet, not portfolio theory, is the foundation of personal financial management, anywhere in the lifecycle. A solid understanding of the household balance sheet provides the basis for a reasonable and practical way to solve the puzzle of how to best use household resources to fund retirement or reach other goals."
Finally, as discussed in our post of November 16, a recent survey by Russell Investments concluded that not enough Financial Advisors were using "math and science" to develop spending budgets for their clients and should be periodically comparing the client's assets with the client's liability (the present value of the future withdrawals from the accumulated assets) similar to how actuaries measure the funded status of pension plans (which coincidentally is the basis for the approach recommended in this website).
The Actuarial Approach for determining a spending budget in retirement matches current personal assets with the retiree's liabilities, where such liabilities are defined as the present value of level real dollar spending over the retiree's expected lifetime. The spreadsheet tools included in this website not only determine liabilities based on these constraints, but can be used to determine liabilities under other constraints. For example, if a retiree determined that she could spend $75,000 per year, but wanted to know the liability associated with her "essential" level of spending of $50,000 per year, she could use a trial and error process to determine what level of accumulated savings produced a spending budget of $50,000 per annum. That amount would be her liability for essential expenses. Similarly, as discussed in our previous post, individuals close to retirement can use the spreadsheet tools (and the trial and error process) to determine what level of accumulated savings (or liability) will produce their desired level of retirement income.
Generally the focus of this website is to help individuals who are already retired establish an annual spending budget. From time to time, however, I will venture into the "how much do I need to retire" side of the retirement challenge. This post is aimed at individuals who are close to retirement but are unsure of whether they have sufficient financial assets to meet their needs throughout retirement.
This exercise is very similar to what I wrote about in my August 31 post--Managing Your Spending in Retirement--It's Not Rocket Science, except the first step in testing to see whether you are financially prepared to retire is to determine your spending needs in retirement. Generally this is done by looking at your normal expenses for a year, subtracting expenses that you don't expect to have in retirement (such as Social Security taxes and work-related expenses) and adding expenses you do expect to incur in retirement (such as increased travel and leisure expenses). Don't forget to factor in taxes that you will need to pay in retirement.
The second step in the process is to determine your total expected income for a year from all sources, such as Social Security, accumulated savings, pensions, annuities, earnings from part-time work and other sources of income. This is where the spreadsheet tools available on this website come into play. If you are not going to defer commencement of your Social Security benefit, use the "Excluding Social Security V 2.0" spreadsheet and add in your estimated Social Security benefit (and any other fully inflation indexed annuity benefit and expected earnings from employment) to the total spendable amount. If you do plan on deferring your Social Security benefit, use the "Social Security Bridge" spreadsheet. Note that for this step you may wish to exclude some of your accumulated assets, such as home equity or other assets, on the theory that such assets will be available for unexpected (or lumpy) expenses in retirement. I suggest that you input the assumptions we recommend in addition to your specific data.
The third step in the process is to compare the results of the second step with the first step to see if the two numbers line up. If the result of the second step is significantly lower than the result of step one, you may not be financially ready to retire. If you are not as conservative as I am, you can input higher investment return assumptions and/or lower inflation assumptions to see how these changes can affect your expected annual income. But remember that there are no guarantees when it comes to expected income from accumulated savings and the more liberal (or wishful) you make the assumptions, the more likelihood that future real spending will have to be reduced.
Normally at this point in my posts I provide an example of how this test might work. I'm not going to do that this time. Having recently read the quote attributed to Benjamin Franklin, "Tell me and I forget. Teach me and I remember. Involve me and I learn", I'm going to encourage you to kick the tires on these spreadsheets. Take a few minutes to crunch your own numbers. You'll find it a worthwhile exercise.
Lets assume that you and your Financial Advisor meet approximately annually to determine your spending budget for the year. If you don't actually have a Financial Advisor, then you and/or your spouse are acting as your own Financial Advisor. In a recent survey of Financial Advisors by Russell Investments, 234 Financial Advisors were asked how they develop spending budgets for their clients near or in retirement. 25% responded that they based their approach on levels of pre-retirement spending, 22% indicated that they used a rule of thumb like the 4% Rule, 19% indicated that they used some variation of the Bucket Strategy, 16% indicated that they compared assets with future liabilities and 18% indicated some other approach.
The Russell Investments survey concluded that not enough Financial Advisors were using "math and science" to develop spending budgets for their clients and should be periodically comparing the client's assets with the client's liability (the present value of the future withdrawals from the accumulated assets) similar to how actuaries measure the funded status of pension plans (which coincidentally is the basis for the approach recommended in this website).
Along the same line, in an interview for Advisor Perspectives, Nobel Laureate Bill Sharpe provided his views on developing spending budgets and the 4% Rule (and other Safe Withdrawal Rate Rules):
"What you spend should depend upon (1) how much you’ve got and (2) how long you think you might live, or the range of possible lengths of life. The 4% rule is fine on both fronts on day one. For example – you’ve got $1 million and you’re 65. Spend $40,000. This may be just fine.
After the initial year, however, what you spend with this rule has nothing to do with how much you have, or for that matter, how long you expect to live. Most importantly, it doesn’t depend how much you have at the moment. Any rational person would say, “What you spend ought to depend upon how much money you have.” Isn’t that self evident? A rule that doesn’t do that after year one doesn’t make any sense. And this should be the end of the discussion. But we see such an approach advocated in many places."
Finally, Dirk Cotton provided similar views in his entertaining blog of October 27,2014 entitled "Spherical Cows." Commenting on the use of Safe Withdrawal Rate approaches, Dirk said,
"One of my favorite Spherical Cows is the one used to calculate sustainable withdrawal rates. SWR models assume that a mythical investor will continue to spend the same amount of money each year from savings, even after it becomes obvious that he or she is about to deplete their retirement savings. The models take a percentage, say 4%, of initial portfolio value and subtract that fixed dollar amount ($4,000 from a $100,000 portfolio in this case) from the portfolio balance every year, counting the number of years before the portfolio is depleted.
Many financial writers argue that no one really "does it that way", meaning everyone adjusts spending based on their remaining portfolio balance instead of spending a flat amount, but I have two responses to that. If no one does it that way, then everyone in the financial press should stop saying that you can do it that way. And second, the SWR models predict outcomes for you only if you do "do it that way". (Operations Research guys say that a model is predictive only to the extent that its policies are followed.) The SWR results aren't predictive if you do something else, like adjust spending to portfolio value changes – which apparently is what everyone is actually doing."
Bottom Line: If you act as your own Financial Advisor, you should spend the time to learn the pros and cons of alternative withdrawal strategies. The Actuarial Approach recommended in this website uses established actuarial principles that consider how much assets you have each year and the expected payout period. If you do work with a Financial Advisor, you should compare the budget recommended by your Financial Advisor with the budget developed using the Actuarial Approach and discuss any significant differences with your Financial Advisor. If you are a Financial Advisor for others, you may wish to consider employing the math in the Actuarial Approach for your clients to see how it compares with whatever method you are currently using.
Time for a brief celebration! This is our 100th post in our ongoing effort to help retirees develop a spend-down strategy for their self-managed assets as part of an overall process of developing an annual spending budget in retirement. As we approach the end of 2014, I remain just as convinced as I was in 2010 with post #1 that the Actuarial Approach recommended in this website represents a better systematic withdrawal strategy than most approaches that are commonly used.
And what better way to celebrate than to have a reporter say some nice things about what we are doing. Read Ian McGugan's recent article in the Globe and Mail.
Mr. McGugan took such an interest in the spreadsheet tool recommended in this website for determining a spending budget in retirement (Excluding Social Security V 2.0) that he kindly offered to write a "less actuarial" explanation of it. Click here to see Mr. McGugan's nice write-up. Thanks Ian.
Our 100th Post celebration must also include special thanks to my buddy, Kin Chan, for his assistance with managing the website and pointing out all the sentences that don't make any sense.
I first proposed a recommended smoothing algorithm for The Actuarial Approach in my post of October 11, 2013. The purpose of the recommended smoothing algorithm was to balance the desire to have relatively constant real dollar budgets from year to year with the need to keep spending budgets reasonably on track with the "actuarial value" determined using the applicable spreadsheet from this website (generally Excluding Social Security V 2.0), recommended assumptions and the retiree's actual data as of the beginning of each year.
In general terms the recommended smoothing algorithm involves taking the budget amount from the previous year, increasing that amount by inflation (the increase in CPI) for the previous year and making sure that the resulting value is not more than 110% of and not less than 90% of that year's actuarial value. If the resulting value falls within the corridor, the inflation adjusted value is used to develop the budget for the year. If the value falls above or below the corridor limit, the applicable corridor value is used in the budget calculation.
Recently, in a conversation with Ian McGugan, reporter for the Globe and Mail in Toronto, Mr. McGugan pointed out that I wasn't terribly specific about what budget amount was being used in this smoothing calculation. Mr. McGugan (a bright guy) correctly pointed out that in the various examples contained in my website, I had inconsistently used several different amounts for the previous year's budget amount for this calculation.
I will readily admit that there was more art than science involved in developing this smoothing algorithm. For example, I don't know whether some or all retirees who may use the Actuarial Approach would be better served with a 12% or 8% corridor. Perhaps someone like Wade Pfau or some other retirement academician can utilize Monte Carlo modeling to develop an optimal corridor. Similar arguments can be made with respect to the budget (or portion of the budget) that should be subject to the corridor.
If the retiree has an immediate defined benefit pension benefit or life insurance annuity as a retirement income source, she has at least three choices with respect to how the recommended algorithm can be applied:
- to the portion of the budget attributable to accumulated savings only
- to the portion of the budget attributable to accumulated savings plus the pension/annuity, or
- to the total budget, including income from Social Security
If the retiree has no immediate pension or annuity income sources, then items 1 and 2 above will be the same.
Personally, I would prefer that the spending budget stay reasonably close to the actuarial value, so I will recommend that the 90% to 100% corridor be determined using the portion of the budget attributable to accumulated savings plus the pension/annuity rather than using the entire budget including Social Security, as it will produce a somewhat smaller corridor range, all other things being equal.
As a result of Mr. McGuggan's excellent suggestion to try not to confuse readers when possible, I have revised the examples in the June, 2014 article "Using the Actuarial Approach to Determine Your Annual Spending Budget in Retirement" to reflect the more specific recommended smoothing algorithm above.
I thank Mr. McGuggan for his feedback and encourage other readers to submit their suggestions for improvements to this website.
The title of this post is a re-working of the saying used by the mechanic in the old Fram Oil Filter TV commercials. His famous line was, "You can pay me now, or you can pay me later." A similar principle applies to spending your accumulated savings--assets you spend today will reduce the amounts available to you (or your heirs) tomorrow and visa versa. The trick, of course, is to figure out the best way to meet your spending objectives, including making your money last your lifetime. This difficult "balancing act" is what this website is all about.
It is also important to remember that most systematic withdrawal strategies produce a spending budget. As with any other budget, you are free to deviate from the budget and spend what you feel is an appropriate amount. Some systematic withdrawal strategies (like the Actuarial Approach recommended in this website) automatically adjust for such deviations. Other approaches may not.
As promised in my post of October 9, this post will discuss the systematic withdrawal approach suggested by David Zolt in his recent Journal of Financial Planning article. Readers can also find more details about his approach in his website.
In summary, Mr. Zolt uses a Hybrid safe withdrawal/actuarial approach. He incorporates Monte Carlo modeling using historical returns from 1926-2013 and then uses a deterministic approach similar to the Excluding Social Security V 2.0 spreadsheet in this website (which he calls the Target Percentage Test) to monitor whether spending remains on track during retirement. In general, if the proposed withdrawal in any year, measured as a percentage of remaining accumulated assets, falls below the Target Percentage, Mr. Zolt's approach would require the retiree forgo that year's cost of living increase. His most recent article proposes another alternative to forgoing the entire cost of living increase if the test is failed.
The first case study in Mr. Zolt's recent article describes how his approach could work for a couple, both age 63 with $650,000 in accumulated retirement assets, total Social Security benefits of $3,000 per month and a fixed dollar $1,000 per month benefit from a pension plan. Based on his Monte Carlo analysis, Mr. Zolt determines that this couple has a "superb" chance of making the money last with an initial withdrawal rate of 5.7% if they are willing to forgo cost-of-living increases whenever the proposed withdrawal for the year measured as a percentage of accumulated assets exceeds the Target Percentage for this couple. By comparison, if we input this couple's data in our Excluding Social Security V 2.0 spreadsheet and use our recommended assumptions , we would get an initial withdrawal rate of 3.57%. There are two reasons why Mr. Zolt's initial withdrawal rate is much higher than ours for the same couple: 1) We use different assumptions for future experience and 2) The Actuarial Approach attempts to keep total retirement income (including income from the fixed dollar pension) constant from year to year in real dollars.
Using Mr. Zolt's Target Percentage spreadsheet, we can determine that if payments are to last 32 years and increase by 3% per annum, the couple's assets must earn a minimum of 7.7% per annum. Tables 1 and 2 below compare spending budgets every five years produced by Mr. Zolt's approach (assuming the target percentage is determined using 7.7% investment return, 3% cost of living increases and payment for 32 years) vs. the Actuarial Approach (using recommended assumptions) assuming future experience is either 5% investment and 3% inflation (Table 1) or 7.7% investment return and 3% inflation (Table 2). Table 3 compares spending budgets assuming future experience of 7.7% per annum and 3% inflation, but changes the assumptions used under the Actuarial Approach to 7.7% investment return and 3% inflation while Table 4 assumes future experience of 5% per annum and 3% inflation, but the assumptions used under the Actuarial Approach are changed to 5% investment return and 0% inflation. Under all four tables, the retired couple is assumed to spend exactly the spending budget under either approach each year.
Under the assumptions for future experience in Table 1, spending budgets decline significantly in real terms under the Target Percentage Approach. The couple's money does, however, last the entire 32 years. Under the Actuarial Approach and recommended assumptions, spending budgets remain constant from year to year in real dollar terms. Under the assumptions for future experience in Table 2, spending budgets decline somewhat under the Target Percentage Approach as the approach does not adjust spending from accumulated savings to make up for inflation erosion of the fixed dollar pension benefit. Under the Actuarial Approach (using recommended assumptions), the more favorable investment experience produces significant increases in the spending budget in later years.
The purpose of Tables 3 and 4 is to illustrate that similar results can be achieved under the Actuarial Approach by varying assumptions used to determine the annual spending budgets from the recommended assumptions.
Which approach is right for you? There is no easy answer to this question. Both approaches are dynamic in that spending budgets may need to be increased or decreased during retirement since both approaches involve annual checking to see how last year's spending budget increased with inflation compares with an actuarially determined target. The Actuarial Approach using recommended assumptions assumes future investment returns will be 2% real, while Mr. Zolt's approach uses a real rate of return closer to 4.7%. His approach also does not consider the effects of inflation on other fixed dollar income (such as pensions or annuity contracts) or amounts desired to be left to heirs. There is nothing mathematically superior about either approach. While Mr. Zolt's approach can be made more conservative by using more conservative target percentages, his reliance on historical rates of return makes his approach less conservative (more likely to involve decreasing real dollar spending budgets in future years) than the Actuarial Approach (which tends to tie investment return assumptions more closely to interest rates inherent in current immediate annuity contracts). This may be ok for some retirees, as long as they understand that higher amounts spent early in retirement mean smaller spending budgets later, all things being equal. Other retirees, however, may be less concerned if the spending budget increases in later years as a result of more favorable than assumed experience. Being a retired actuary, I tend to favor the more conservative approach. But, in the end, the bottom line of this post is the same as its title, and it is up to you to determine how conservative you want to be in determining your spending budget (and your actual spending) from year to year.
In his October 22 blog post, Michael Kitces points out several of the problems associated with Monte Carlo modeling and determination of "safe withdrawal rates" based on assumptions about future experience that will not be realized. Mr. Kitces suggests that the solution lies in "reframing" the model outcomes. He says, "consider what happens if we actually call it a probability of adjustment, instead of a probability of failure. When we frame the outcomes as failures, the nature [sic] response from clients is to think up terrible images of what failure might look like, and then seek to avoid it at all costs. But when we frame the outcomes as “adjustments” it leads to very different – and much more productive – conversations instead, such as “How big would the adjustment be? When would I have to make the adjustment? How will I know when it’s time to adjust?”
He also expresses concerns about surpluses that are ignored in the safe withdrawal rate determination, saying, "it’s not just the probability of failure that’s misnamed. It’s also the probability of success, which is more like a probability of Excess. It’s the likelihood of having excess money left over, and sadly makes no distinction about how much will be left over! A Monte Carlo analysis in traditional retirement planning software treats having $1 left over the same as $1M and the same as $10M – they’re all “successes” – yet clients would react to this very differently. When you call it a probability of “excess” it again raises the question “how much of an excess are we talking about?” and a more productive conversation."
While I agree with Mr. Kitces' assessment of the problems, in my opinion, reframing the outcome is not the answer. The actuarial approach suggested in this website automatically provides valuable input for Mr. Kitces "productive conversations." As indicated in my previous post, retirees need to wean themselves off the safe withdrawal rate Kool-Aid and live with the fact that that sometimes their spending budget may increase or decrease in real terms from year to year, depending on actual investment experience and spending.
This month's Journal of Financial Planning celebrates the twentieth anniversary of publication of the article, "Determining Withdrawal Rates Using Historical Data", by William P. Bengen. This article formed the basis for what is now known as the "4% Rule" or "4% Withdrawal Rule."
In this month's Journal article, Jonathan Guyton, CFP, offers his thoughts on the original research performed by Mr. Bengen, and Mr. Guyton's article contains glowing praise from many others for Mr. Bengen's research. According to Mr. Guyton, "Bill Bengen framed a deceptively complex question and crafted and elegant simple answer that remains relevant two decades later for hundreds of thousands of financial advisers and easily 100 million retirees."
As someone who doesn't understand the appeal of the 4% Rule, or it's many safe withdrawal rate progeny, please forgive me if I don't enthusiastically join in this celebration.
Based on historical returns provided by Ibbotson Associates' Stocks, Bonds, Bills and Inflation 1992 Yearbook, Mr. Bengen noted that hypothetical individuals who retired in each year from 1926 to 1976 who invested at least 50% of their assets in equities and who withdrew 4% of accumulated assets in the first year of retirement and increased that amount by inflation each year would be expected to have their assets last at least 30 years (Figure 1b of Mr. Bengen's article). As a result of this analysis of these historical returns, Mr. Bengen concluded that it was "safe" going forward for almost all retirees to withdraw 4% of accumulated assets in the first year of retirement and increase that first year amount by inflation for subsequent years if they invested at least 50% of their assets in equities and rebalance their portfolio each year. In fact, Mr. Bengen said, "It is appropriate to advise the client to accept a stock allocation as close to 75 percent as possible and in no cases less than 50 percent."
I agree with the concerns expressed about the 4% Rule expressed by researcher Nobel Laureate, William Sharpe in his article, "Staying Flexible on Retirement Spending" (highlighted in my second post in 2010) where he points out the problems inherent in combining a fixed spending strategy with investment of a portfolio with variable returns.
I list what I believe to be the many shortfalls of the 4% Rule in this website and in my recently published article in the Journal of Personal Finance. For brevity sake, I will not be re listing them here. Suffice to say that the 4% Rule requires the retiree to have faith that historical performance is a good indicator of future experience and the retiree should "stay the course" irrespective of actual investment returns or spending. By comparison, the Actuarial Approach advocated in this website suggests looking to see whether the retiree is "on track" on an annual basis and making appropriate adjustments.
In the twenty years following release of Mr. Bengen's original research, many researchers have suggested modifications to the 4% Rule to deal with its significant shortcomings and to refine the assumptions and methodology (Monte Carlo modeling) used to forecast future experience. In fact, an example of such refinement is also featured in this month's Journal of Financial Planning entitled, Retirement Planning by Targeting Safe Withdrawal Rates, by David Zolt, CFP, EA, ASA, MAAA. This is an update of Mr. Zolt's original article which I discussed in my post of May 23rd of last year. Like many suggested modifications to Mr. Bengen's original work, Mr. Zolt has dealt with some of the problems, but his approach and various tables are much more complicated than Mr. Bengen's "elegant simple answer." I will be discussing Mr. Zolt's approach in a subsequent post.
Bottom line: Retirees who invest in risky assets should not expect those assets to produce a fixed level of real income in retirement as implied by the 4% Rule or other safe withdrawal rate approaches. They need to use a dynamic withdrawal approach (like the Actuarial Approach advocated in this website) and live with the fact that that sometimes their spending budget may increase or decrease in real terms from year to year, depending on actual investment experience and spending.
