In David Ning's October 23, 2003 blog titled, The 4 Percent Safe Withdrawal Rule Declines to 3 Percent,Mr. Ning says that most investors will "do fine by sticking with a flexible
version of the original 4 percent retirement rule." His proposed
modification to the 4 percent rule to make it "flexible" is to "pause the
inflation adjustment when markets decline." Of course, he doesn't say how
long the pause will be required. It is now about 5 years since the
stock market crash of 2008. Is it now ok, under Mr. Ning's proposed
modification to recommence inflation adjustments?
As I have said many times in this blog, the 4% Rule is far from an optimal
decumulation strategy. And making unspecified modifications to it to
address some of its flaws does not make it appreciably better. Rather than
rely on set and forget strategy that is supposed to be "safe" with respect
to the risk of outliving one's assets (but may result in
significant underspending), you need to periodically crunch your numbers
based on your situation. The spreadsheets and actuarial process set
forth in this website make this task relatively easy.
Let's look at three different retirees, each with $500,000 of accumulated
retirement assets. Based on the spending spreadsheet in this website and
the recommended assumptions discussed in my previous posts, I will show you
that if you desire constant inflation adjusted spending in retirement, there
is no x% withdrawal rate that will work for all situations.
Robert retires at age 65, has no bequest motive and no other sources of
retirement income (other than Social Security). Using the Excluding Social
Security 2.0 spreadsheet and the recommended assumptions discussed in my
previous post, Robert can withdraw $21,725, or 4.3% of his accumulated
savings in his first year of retirement.
Ray retires at age 75. He has a deferred annuity starting at age 85 of
$35,000 per year and no bequest motive. Inputting his information into the
spreadsheet and the recommended assumptions shows that Ray can withdraw
$40,220, or 8.04% of his accumulated savings in his first year of
retirement.
Richie retires at age 60. He has an immediate life annuity from his
company's pension plan of $20,000 per year and he wishes to leave $250,000
(in nominal dollars) to his heirs when he dies. The spreadsheet says that
he can withdraw $11,049, or 2.21% of his accumulated savings in his first
year of retirement.
So, while Robert might be ok using the 4% rule, Ray may be
significantly underspending and Richie may be
significantly overspending if they use it.
Thursday, October 24, 2013
Friday, October 11, 2013
Reasonable Assumptions and Algorithm for Simple Actuarial Process
Several individuals have suggested that I provide some guidance with respect
to assumptions and the algorithm to be used with the spreadsheets and
process described in this website. The following are my
brief thoughts on possible inflation and investment return assumptions to
use, reflecting the current economic environment, as well as a possible
algorithm to use to adjust future withdrawals for actual experience as it
emerges. Earlier this year (see post of July 12), I recommended that you
plan to live until 95 (unless you are already over 85).
Inflation: In light of an estimated investment return assumption on bonds imbedded in current immediate annuity purchase rates of a little bit more than 4% per annum (as discussed in our post of September 22, 2013) and the long-term relationship between bond returns and inflation, I would assume inflation of something in the neighborhood of 3% per annum.
Investment return: Given expectations of inflation of 3% and expected bond returns of 4+%, I probably wouldn't use an investment return assumption much higher than 5% per annum (and would use a lower rate if most of my investments were in bonds or other fixed income or I just wanted to be more conservative in my retirement budgeting). I know that some will argue that equities have historically yielded higher real rates of return, but they also carry higher risk of loss that I would reflect by using a more conservative assumption.
Algorithm for adjusting future withdrawals for actual experience: I like the approach of increasing last year's withdrawal with actual inflation and then testing the result against a corridor around this year's calculated value. The example that follows uses a 10% corridor.
In year 1, Joe determined his withdrawal to be $10,000. Inflation during year 1 was 3%, so his preliminary year 2 withdrawal is $10,300. Let's assume actual experience was favorable and his calculated value (using the spreadsheet and revised input items) at the beginning of year 2 is $11,000. Since the preliminary withdrawal of $10,300 is 94% of the calculated value, Joe would budget a withdrawal of $10,300 in year 2.
Let's assume inflation of 2% in year 2, so Joe's preliminary withdrawal for year 3 would be $10,506 ($10,300 x 1.02). Let's assume that Joe's calculated value for year 3 is $12,000. Since the preliminary value of $10,300 is less than 90% of the calculated value, Joe would budget a withdrawal for year 3 of $10,800 (90% of the calculated value of $12,000). Joe's preliminary withdrawal for year 4 would be $10,800 plus inflation during year 3.
Inflation: In light of an estimated investment return assumption on bonds imbedded in current immediate annuity purchase rates of a little bit more than 4% per annum (as discussed in our post of September 22, 2013) and the long-term relationship between bond returns and inflation, I would assume inflation of something in the neighborhood of 3% per annum.
Investment return: Given expectations of inflation of 3% and expected bond returns of 4+%, I probably wouldn't use an investment return assumption much higher than 5% per annum (and would use a lower rate if most of my investments were in bonds or other fixed income or I just wanted to be more conservative in my retirement budgeting). I know that some will argue that equities have historically yielded higher real rates of return, but they also carry higher risk of loss that I would reflect by using a more conservative assumption.
Algorithm for adjusting future withdrawals for actual experience: I like the approach of increasing last year's withdrawal with actual inflation and then testing the result against a corridor around this year's calculated value. The example that follows uses a 10% corridor.
In year 1, Joe determined his withdrawal to be $10,000. Inflation during year 1 was 3%, so his preliminary year 2 withdrawal is $10,300. Let's assume actual experience was favorable and his calculated value (using the spreadsheet and revised input items) at the beginning of year 2 is $11,000. Since the preliminary withdrawal of $10,300 is 94% of the calculated value, Joe would budget a withdrawal of $10,300 in year 2.
Let's assume inflation of 2% in year 2, so Joe's preliminary withdrawal for year 3 would be $10,506 ($10,300 x 1.02). Let's assume that Joe's calculated value for year 3 is $12,000. Since the preliminary value of $10,300 is less than 90% of the calculated value, Joe would budget a withdrawal for year 3 of $10,800 (90% of the calculated value of $12,000). Joe's preliminary withdrawal for year 4 would be $10,800 plus inflation during year 3.
Wednesday, October 2, 2013
Use Our Spreadsheet to Estimate How Much Deferred Annuity to Purchase
In his September 24, 2013 article, "Why Retirees Should Choose DIAs over SPIAs", Dr. Wade Pfau reaches the conclusion that "Deferred-income annuities
(DIA's) work even better than SPIA's, by providing more liquidity and better
longevity protection at a lower cost." Previously, combinations of single
premium income annuities (SPIAs) and equity investments had been Wade's
Efficient Frontier champions.
Wade mentions two risks using DIAs: 1) Over or underestimating future inflation and the associated impact on a fixed annuity amount payable many years in the future and 2) running out of accumulated savings prior to commencement of the deferred annuity.
If you decide to purchase a deferred annuity with some of your accumulated savings and self-manage the remainder, you can use the "Excluding Social Security V 2.0" spreadsheet on this website to help you model future experience and coordinate the withdrawal of your self-managed assets with the fixed amounts payable from the annuity to try to achieve constant real dollar total withdrawal/annuity payments. The Runout tabs show total combined withdrawal/payments each year under the input assumptions. The risk of buying too little or too much deferred annuity can also be mitigated to some degree by spreading the purchases over a number of years.
Wade mentions two risks using DIAs: 1) Over or underestimating future inflation and the associated impact on a fixed annuity amount payable many years in the future and 2) running out of accumulated savings prior to commencement of the deferred annuity.
If you decide to purchase a deferred annuity with some of your accumulated savings and self-manage the remainder, you can use the "Excluding Social Security V 2.0" spreadsheet on this website to help you model future experience and coordinate the withdrawal of your self-managed assets with the fixed amounts payable from the annuity to try to achieve constant real dollar total withdrawal/annuity payments. The Runout tabs show total combined withdrawal/payments each year under the input assumptions. The risk of buying too little or too much deferred annuity can also be mitigated to some degree by spreading the purchases over a number of years.
Sunday, September 22, 2013
Retirement Income Source Diversification
http://howmuchcaniaffordtospendinretirement.webs.com/Retirement_Income_Source_Diversification_09222013.pdf
As indicated in previous posts, It is not unreasonable to manage risks in retirement by diversifying sources of retirement income. This could involve maximizing Social Security benefits (by deferring commencement), utilizing some life insurance company annuity products (or defined benefit plan annuity income) and utilizing a rationale spend-down strategy for managed assets. This article compares three diversified options with the 100% Annuity option and the 100% Self-Managed option.
Thursday, September 12, 2013
Gotbaum Tells Council Lump-Sum Cash-Outs Are Like Cigarettes: Legal but Bad for You
Pension Rights Center
http://www.pensionrights.org/sites/default/files/docs/news/130903_bna_pension_benefits_reporter_-_gotbaum_tells_council_lump_cashouts_are_like_cigarettes_legal_but_bad_for_you_-_k2_nstein_quoted_banner_version.pdf
In this article, the head of a federal government agency implies that most people aren't very smart when given a choice between an annuity and a lump sum in a defined benefit plan. He indicates that since 1997, more than two out of three people have taken the lump-sum option instead of an annuity when given a choice.
Therefore he concludes that more government regulation is needed to prevent you from making the "bad" lump sum choice.
This thinking appears to be shared by representatives of the Department of Labor who continue their push to make it more difficult for people to take "bad" lump sums from defined contribution plans.
Never mind that recent research from Felix Reichling and Kent Smetters questions the supposed superiority of the annuity choice. And never mind that recent research from Frank Sr., Mitchell and Pfau (see previous post) suggests that it may make financial sense to rollover the lump sum to an IRA and purchase an annuity at a later date. And never mind that rolling over the lump sum to an IRA, buying a longevity annuity with a portion of the proceeds and self-managing the remainder of the assets may help you better manage risks in retirement by diversifying your sources of retirement income.
Bottom line--Don't worry. When it comes to your retirement, your federal government knows what is best for you.
Tuesday, September 10, 2013
Life Expected Income Breakeven Comparison Between SPIAs and Managed Portfolios
by Larry Frank Sr., John B. Mitchell and Wade Pfau
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2317857
A tip of my hat to Messrs. Frank Sr., Mitchell and Pfau for publishing this fine (and very thorough) paper. The authors use a sophisticated Monte Carlo simulation approach to conclude that many retirees may find it financially beneficial to delay purchase of a single premium life annuity until a later age and self-manage their retirement assets until such age.
"The paper provides insight and guidance for the retiree decision making between whether to annuitize or manage their retirement savings." While the authors' analysis examined this decision on an "either or" basis, it would be interesting to see their analysis for partial SPIA annuitization/partial self-management strategies (which could affect investment allocation decisions) or strategies that involve purchase of single premium deferred annuities (sometimes referred to as longevity annuities).
If you have read even a few of my prior blog posts, you will know that I am not a big fan of "set and forget" Safe Withdrawal Rates determined using Monte Carlo simulations. As indicated in the authors' paper, the authors advocate a dynamic approach, described as follows:
"The newer camp is more dynamic with annually recalculated, serially connected, simulations to arrive at a Prudent Withdrawal Rate (PWR) that is sustainable given current conditions. Client annual reviews include annual updates to the simulation data to reflect 1) period life table changes and changes in personal health, 2) current portfolio value, 3) latest market data series, and 4) current year feasible spending needs. The dynamic school provides an ongoing method to address how often and by what method "revisiting" the PWR and making corrections to it recognizing that markets affect the safety of withdrawals and that time allows the PWR to increase."
Thus, while the authors use Monte Carlo simulations, they are using an approach that is similar to the actuarial approach advocated in this website. In discussions with Mr. Frank Sr., he even refers to his approach as an "actuarial" approach. Since it is so similar, he makes it very difficult for me to find fault with it.
This paper is a practical application of the previous work done by Messrs. Frank Sr., Mitchell and Blanchett in three papers that describe in more detail their dynamic approach. Links to these excellent papers may be found in Mr. Frank Sr.'s website and blog "Better Financial Education.com"
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2317857
A tip of my hat to Messrs. Frank Sr., Mitchell and Pfau for publishing this fine (and very thorough) paper. The authors use a sophisticated Monte Carlo simulation approach to conclude that many retirees may find it financially beneficial to delay purchase of a single premium life annuity until a later age and self-manage their retirement assets until such age.
"The paper provides insight and guidance for the retiree decision making between whether to annuitize or manage their retirement savings." While the authors' analysis examined this decision on an "either or" basis, it would be interesting to see their analysis for partial SPIA annuitization/partial self-management strategies (which could affect investment allocation decisions) or strategies that involve purchase of single premium deferred annuities (sometimes referred to as longevity annuities).
If you have read even a few of my prior blog posts, you will know that I am not a big fan of "set and forget" Safe Withdrawal Rates determined using Monte Carlo simulations. As indicated in the authors' paper, the authors advocate a dynamic approach, described as follows:
"The newer camp is more dynamic with annually recalculated, serially connected, simulations to arrive at a Prudent Withdrawal Rate (PWR) that is sustainable given current conditions. Client annual reviews include annual updates to the simulation data to reflect 1) period life table changes and changes in personal health, 2) current portfolio value, 3) latest market data series, and 4) current year feasible spending needs. The dynamic school provides an ongoing method to address how often and by what method "revisiting" the PWR and making corrections to it recognizing that markets affect the safety of withdrawals and that time allows the PWR to increase."
Thus, while the authors use Monte Carlo simulations, they are using an approach that is similar to the actuarial approach advocated in this website. In discussions with Mr. Frank Sr., he even refers to his approach as an "actuarial" approach. Since it is so similar, he makes it very difficult for me to find fault with it.
This paper is a practical application of the previous work done by Messrs. Frank Sr., Mitchell and Blanchett in three papers that describe in more detail their dynamic approach. Links to these excellent papers may be found in Mr. Frank Sr.'s website and blog "Better Financial Education.com"
Wednesday, August 14, 2013
Renaming The Outcomes Of A Monte Carlo Retirement Projection
(Nerd's Eye View, August 14, 2013)
http://www.kitces.com/blog/archives/537-Renaming-The-Outcomes-Of-A-Monte-Carlo-Retirement-Projection.html#extended
When explaining outcomes of a Monte Carlo retirement projection for a safe withdrawal rate strategy, Mr. Kitces suggests replacing the phrase "probability of failure" with "probability of a mid-course correction" and replacing "probability of success" with "probability of accumulating excess assets." He implies that this "framing" will help facilitate good decisions.
Does renaming the outcomes of such a projection, as advocated by Mr. Kitces, improve the safe withdrawal rate strategy or is he just putting lipstick on a pig? In his article, Mr. Kitces implies that the safe withdrawal rate approaches he anticipates aren't really the "set-it and forget-it" approaches anticipated by Bill Bengen, the inventor of the 4% Rule. He implies that a safe withdrawal rate strategy needs to be revisited periodically to make sure that the client's spending plan remains on track (assets don't shrink too rapidly nor grow too large). If this is true, however, there seems to be little gained by doing all those calculations that comprise a Monte Carlo projection over doing a simple deterministic projection (except perhaps the impression of more precision). In both instances incorrect projections of future experience need to be adjusted for actual experience.
Even though it employs a deterministic projection, I continue to believe that the actuarial approach outline in this website is superior to the "set-it and forget-it" safe withdrawal rate strategies. Once Mr. Kitces describes how the approach he anticipates actually determines how and when mid-course adjustments are made, I might be more open to endorsing it.
http://www.kitces.com/blog/archives/537-Renaming-The-Outcomes-Of-A-Monte-Carlo-Retirement-Projection.html#extended
When explaining outcomes of a Monte Carlo retirement projection for a safe withdrawal rate strategy, Mr. Kitces suggests replacing the phrase "probability of failure" with "probability of a mid-course correction" and replacing "probability of success" with "probability of accumulating excess assets." He implies that this "framing" will help facilitate good decisions.
Does renaming the outcomes of such a projection, as advocated by Mr. Kitces, improve the safe withdrawal rate strategy or is he just putting lipstick on a pig? In his article, Mr. Kitces implies that the safe withdrawal rate approaches he anticipates aren't really the "set-it and forget-it" approaches anticipated by Bill Bengen, the inventor of the 4% Rule. He implies that a safe withdrawal rate strategy needs to be revisited periodically to make sure that the client's spending plan remains on track (assets don't shrink too rapidly nor grow too large). If this is true, however, there seems to be little gained by doing all those calculations that comprise a Monte Carlo projection over doing a simple deterministic projection (except perhaps the impression of more precision). In both instances incorrect projections of future experience need to be adjusted for actual experience.
Even though it employs a deterministic projection, I continue to believe that the actuarial approach outline in this website is superior to the "set-it and forget-it" safe withdrawal rate strategies. Once Mr. Kitces describes how the approach he anticipates actually determines how and when mid-course adjustments are made, I might be more open to endorsing it.
Sunday, August 11, 2013
Retirement Planning in an uncertain world
Steve Vernon (CBS Moneywatch, August 7, 2013)
http://www.cbsnews.com/8301-505146_162-57597036/retirement-planning-in-an-uncertain-world/
Another excellent post from my friend and fellow Fellow of the Society of Actuaries. Steve succinctly outlines the risks involved in planning for retirement in today's world and suggests the following two-step strategy:
The actuarial approach outlined in my website enables you to coordinate the spend-down of your self-managed assets with your guaranteed lifetime income and allows you to make the periodic adjustments Steve refers to "in the event that your forecasts are wrong."
http://www.cbsnews.com/8301-505146_162-57597036/retirement-planning-in-an-uncertain-world/
Another excellent post from my friend and fellow Fellow of the Society of Actuaries. Steve succinctly outlines the risks involved in planning for retirement in today's world and suggests the following two-step strategy:
- "Step 1: Plan to support the life you want, using your best estimate of the future regarding the economy, capital markets, your life expectancy and so on.
- Step 2: Be prepared in the event that your forecasts are wrong."
The actuarial approach outlined in my website enables you to coordinate the spend-down of your self-managed assets with your guaranteed lifetime income and allows you to make the periodic adjustments Steve refers to "in the event that your forecasts are wrong."
Thursday, August 1, 2013
The Power of Diversification and Safe Withdrawal Rates
Geoff Considine (Advisorperspectives.com, July 30,2013)
http://advisorperspectives.com/newsletters13/The_Power_of_Diversification.php
Mr. Considine argues that the 4% Rule is still a valid decumulation strategy provided the retiree's assets are invested in a more diversified portfolio than originally anticipated by Bill Bengen, the rule's inventor.
The 4% Rule. In the first year of retirement, withdraw 4% of your accumulated savings. In each year thereafter, withdraw no more and no less than the first year amount increased by measured inflation since the first year. Make no adjustments for actual investment performance and hope that the assumptions underlying the Monte Carlo analysis performed to determine the "safeness" of the rule pan out and that you die prior to exhaustion of accumulated savings (without leaving too much behind).
Weaknesses of the 4% Rule.
http://advisorperspectives.com/newsletters13/The_Power_of_Diversification.php
Mr. Considine argues that the 4% Rule is still a valid decumulation strategy provided the retiree's assets are invested in a more diversified portfolio than originally anticipated by Bill Bengen, the rule's inventor.
The 4% Rule keeps resurfacing like a vampire in a bad horror movie. As I have said many times in this blog, the 4% Rule (and most other Safe
Withdrawal Rate approaches) have just too many weaknesses to be considered an
optimal decumulation strategy. I will briefly summarize the 4% Rule and what I
believe to be its major weaknesses below.
The 4% Rule. In the first year of retirement, withdraw 4% of your accumulated savings. In each year thereafter, withdraw no more and no less than the first year amount increased by measured inflation since the first year. Make no adjustments for actual investment performance and hope that the assumptions underlying the Monte Carlo analysis performed to determine the "safeness" of the rule pan out and that you die prior to exhaustion of accumulated savings (without leaving too much behind).
Weaknesses of the 4% Rule.
- It doesn't accommodate a payout period other than 30 years without adjustment.
- It doesn't accommodate a different investment approach without adjustment.
- It doesn't accommodate a desire to leave a specific bequest at death
- It doesn't accommodate a flexible spending schedule (for example if needed for unanticipated medical expenses or to use more assets early as a means to delay Social Security benefits as discussed in the previous post)
- It doesn't coordinate with other fixed income payments such as immediate or deferred life annuities or payments from defined benefit plans
- It doesn't adjust for actual emerging experience.
Tuesday, July 23, 2013
Efficient Retirement Design--Combining Private Assets and Social Security to Maximize Retirement Resources
John B. Shoven and Sita N. Slavov
Stanford Institute for Economic Policy Research (SIEPR)
http://siepr.stanford.edu/system/files/shared/documents/Efficient_Retirement_Design-March_2013b.pdf
The authors conclude "with today's life expectancies and today's extremely low interest rates, it is almost to everyone's interest to delay the commencement of Social Security. For many people, it is the value maximizing strategy." The authors also discuss value-maximizing strategies for when to claim benefits for two-earner couples, and suggest that individuals consider delaying commencement of Social Security benefits either by spending other accumulated assets after retirement and before Social Security commencement, by continuing to work, or through a combination of the two. An excellent read for anyone who has not yet commenced Social Security benefits (or who is still able to defer their Social Security benefit commencement date).
Readers are reminded that this website contains a simple spreadsheet that enables retirees to model using their accumulated savings to "bridge" the period between retirement and commencement of Social Security benefits while attempting to maintain constant total spendable income in real dollars.
Stanford Institute for Economic Policy Research (SIEPR)
http://siepr.stanford.edu/system/files/shared/documents/Efficient_Retirement_Design-March_2013b.pdf
The authors conclude "with today's life expectancies and today's extremely low interest rates, it is almost to everyone's interest to delay the commencement of Social Security. For many people, it is the value maximizing strategy." The authors also discuss value-maximizing strategies for when to claim benefits for two-earner couples, and suggest that individuals consider delaying commencement of Social Security benefits either by spending other accumulated assets after retirement and before Social Security commencement, by continuing to work, or through a combination of the two. An excellent read for anyone who has not yet commenced Social Security benefits (or who is still able to defer their Social Security benefit commencement date).
Readers are reminded that this website contains a simple spreadsheet that enables retirees to model using their accumulated savings to "bridge" the period between retirement and commencement of Social Security benefits while attempting to maintain constant total spendable income in real dollars.
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