End of Year Reminder--Time to Determine Spending Budget for Next Year

It's that time of the year for many of us retirees to determine our spending budget for next year.  You may also wish to take this opportunity to revisit your investment strategy.  I will illustrate how easy this process is with an example retiree, Richard.

Richard retired last year at this time at age 65.  At that time, he used about 20% of his accumulated savings to buy an immediate life annuity that pays him $15,000 per year.  At the beginning of 2013, he had $800,000 left after his annuity purchase.  He inputted the assumptions recommended in our October 11, 2013 post (5% interest, 3% inflation, 30 years expected payout period (95-65) and $10,000 as the desired amount of assets at death) into the spreadsheet in this website, to determine a total spendable amount (excluding Social Security) for 2013 of $45,179 ($30,179 from accumulated savings and $15,000 from the annuity).  He deposited $30,179 in his non-interest bearing spending account and decided to invest half of the remaining assets ($769,821) in equities and the other half in a variety of fixed income investments.  During 2013, Richard spent exactly the amount in his spendable account plus the $15,000 from the annuity. 

Easy Steps to Determine Richard's Spending Budget for 2014

The first step in the process is gather asset data as of the end of 2013.  Richard's equity investments yielded almost 29% during 2013 and his fixed income investments yielded about 1%, so his end-of-year assets are $884,909 (compared with expected end-of-year assets from the previous year's calculation of $808,312, or an asset gain for 2013 of $76,597). 

The second step in the process is to determine a preliminary spending value for 2014 by inputting new amounts into the spreadsheet on this website.  If the same assumptions and amounts are used as last year except using $884,909 for accumulated savings and 29 years for expected payout period, Richard's preliminary 2014 spendable amount is $49,947 ($34,947 + $15,000).

The third step in the process is to apply the smoothing algorithm discussed in our October 11, 2013 post to the preliminary spending value.  Richard determines that the Consumer Price Index has increased by about 1.3% during 2013.  Therefore, he determines his 2014 spendable amount as last year's total spendable amount ($45,179) increased by 1.3% ($45,766), but not less than 90% of the preliminary 2014 total spendable amount of $49,947 (.9 X $49,947 = $44,952).  Since the corridor value is lower than last year's value increased with inflation for the year, it does not apply and Richard's total spendable amount for 2014 is $45,766 ($30,766 from accumulated savings and $15,000 from the annuity).

Richard plans to transfer $30,766 of his accumulated savings in his spending account and rebalance the remainder ($854,143) so that he has 50% in equities and 50% in fixed income investments.  He recognizes that because he has the annuity and Social Security, his actual investment mix is weighted more heavily in fixed income than equities, but he is comfortable with that result. 

New Research On Variable Spending Strategies (Like the One Recommended in This Blog)

In this December 10 article, Dr. Pfau compares the spending paths created by two variable withdrawal strategies: The Guyton Decision Rules and the Blanchett actuarial approach discussed in our November 20 post.  Unfortunately, Dr. Pfau's compares what is essentially a spending smoothing algorithm (Guyton) with year-by-year application of Blanchett's spreadsheet calculator without application of any smoothing of the results. However, as Dr. Pfau revealed in his article, Mr. Blanchett, "would almost certainly incorporate a moving average approach to smooth out the cash flows."
 
As I said in my original 2010 article (available in the articles section), the most important step in the five step general actuarial process to developing an estimate of how much you can spend each year involves periodic calculation of the theoretically correct spendable amount (using the simple spreadsheets found in this website, or Mr. Blanchett's spreadsheet or some other more "robust" calculator) and application of an algorithm to smooth actual experience as it occurs. See our post of October 11, 2003 for our recommended smoothing algorithm.
 
Dr. Pfau concludes that, "More research about variable withdrawal rates should look to build in a smoother spending path with changes only made when thresholds are crossed, and to more carefully calibrate the relationship between withdrawal rates and age." I agree and encourage Dr. Pfau to look at the approach recommended in this website.

Follow Up To July 23, 2013 Post--Delaying Commencement of Social Security

The consulting firm October Three has written a nice article about the potential financial advantages of delaying commencement of Social Security benefits until age 70. Readers of this blog will remember that we discussed this strategy and pointed readers to a spreadsheet on our site that would enable retirees to use their accumulated savings to "bridge" the period from age of retirement until age 70 (or some other age) in our post of July 23rd of this year. 
 
Using that spreadsheet, information for the example retiree in the October Three article, accumulated savings of $500,000 and the recommended assumptions described in this website (5% investment return, 3% inflation and survival until age 95), readers can confirm that if the example retiree retires at age 62 uses his accumulated savings as a Social Security bridge and defers commencement of his Social Security benefit until age 70, he can expect (under the recommended assumptions) to have total lifetime real retirement income of $39,130 per year starting at age 62 using the delay strategy vs. $35,655 per year if he commences Social Security at age 62. As can be seen in the spreadsheet runout tab, at age 70 he will be expected to have $305,906 of accumulated assets at age 70 under the delay strategy as compared with $514,533 under the non-delay strategy (commencing Social Security and level withdrawals from accumulated savings at age 62). The example retiree has essentially used a total of $240,804 of his accumulated savings to purchase a higher Social Security benefit commencing at age 70. To see the calculations using the delay strategy follow this link. Note that the estimated Social Security benefit commencing at age 70 has been increased by 3% per year for eight years of assumed CPI increases.
  
October Three argues that, "Rather than annuitizing retirement wealth, participants can get a much better deal by spending down retirement assets and deferring Social Security." While I like the article, I will have to reserve the right to pick a small bone with October Three over their use of "much better" here, as our post of September 22, 2013 shows comparable increases in total retirement income through combinations of self-insuring and purchase of deferred annuities (immediate, delayed or deferred). 
   
When considering the delay strategy, readers will also want to factor in other considerations, such as comfort in spending a significant amount of accumulated savings in the early years of retirement, taxation of Social Security benefits, possible future changes in Social Security law and possible changes in general interest rates/investment returns.

David Blanchett Develops Simple Formulas and Spreadsheet to Approximate Dynamic Prudent Withdrawal Rate Approach

In Mr. Blanchett's recent article in the Journal of Financial Planning, SimpleFormulas to Implement Complex Withdrawal Strategies, Mr. Blanchett develops "simple" formulas that approximate the results achieved by the more complicated Monte Carlo modeling anticipated in developing Prudent Withdrawal Rates discussed in my post of September 10, 2013.  In addition, Mr. Blanchett further simplifies the process by providing an Excel spreadsheet that enables users to input a few items and develop their own simplified Prudent Withdrawal Rates.  Here is the link to his spreadsheet.

http://www.davidmblanchett.com/tools 

I compared withdrawal rate percentages produced by Mr. Blanchett's spreadsheet assuming 50% equities, total portfolio fees of 0.20% and a 75% Target Probability of Success with the withdrawal rates produced by the Excluding Social Security 2.0 spreadsheet on this site for payment periods of 10, 15, 20, 25 and 30 years (using the recommended assumptons for investment return and inflation), and the results were very close (within .03 percentage points) for payment periods of 30, 25 and 20 and relatively close for payment periods of 15 years and 10 years. 

As mentioned in my September 10 post, I support the dynamic "actuarial" approach proposed by Messrs. Frank Sr., Mitchell and Blanchett, and I believe that Mr. Blanchett's simplification is a very useful addition to make their approach more accessible to financial planners and other users.  

I will point out that Mr. Blanchett's spreadsheet is most useful to a retiree who has no other sources of retirement income or bequest motives as it does not coordinate with other sources of retirement income, such as annuities, and it does not provide for leaving a specific amount to heirs.  To reflect such items, you may have to use their more complicated model, or the simple spreadsheet set forth in this website. 

Vanguard Introduces Its Modification of the 4% Withdrawal Rule

Readers of this blog will note that I devote a fair amount of energy ranting against the 4% Withdrawal Rule (and other "Safe" withdrawal rates) as retirement decumulation strategies.  In addition, I'm generally not all that impressed with proposed modifications to the 4% Rule designed to somehow make it more workable.  Vanguard recently announced its proposed modifications in a paper entitled, "A More Dynamic Approach toSpending for Investors in Retirement."  They suggest a two-step process for determining an annual spendable amount payable from accumulated savings:  Step 1:  Take X% of end-of-the-previous-year accumulated savings.  Step 2:  Subject the result of Step 1 to a corridor, the ceiling of which is (1+Y%) of the spendable amount from the previous year and the floor of which is (1-Z%) of the spendable amount from the previous year, where "X" depends on the "planning horizon" and investment philosophy and "Y" and "Z" are arbitrarily chosen upper and lower limits (they suggest a value of 5 for Y and 2.5 for Z).  Readers of the paper who get as far as Appendix 3 will note that the example set forth in this appendix describes a slightly different approach than the approach described in the body of the paper, which I am assuming is an error).

While the Vanguard modification of the 4% Rule does make the approach more dynamic (i.e., it reflects actual investment experience to some degree), I believe this approach to be inferior to the actuarial approach suggested in this website for the following reasons:

As is the case for most "safe" withdrawal rate strategies, it defines success as not outliving accumulated assets.  It does not adequately address the risk of under spending.

It doesn't attempt to provide constant real dollar spendable income in retirement.

It doesn't coordinate with other forms of retirement income such as immediate or deferred annuities and it doesn't reflect bequest motives. 

With all the adjustments required for different planning horizons and investment philosophies, it is not appreciably simpler than the actuarial approach set forth in this website (particularly if you use the assumptions and algorithm I recommended several posts ago).

Enough Already With the 4% Rule

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.

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.

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.

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.

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.