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.

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"

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.

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:

1. "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.
2. Step 2: Be prepared in the event that your forecasts are wrong."

It would not be unreasonable to address the risks Steve outlines by employing some combination of (i) guaranteed lifetime income (immediate or deferred annuities, annuities from defined benefit pension plans and Social Security, including deferring commencement of Social Security to effectively buy increased lifetime income protection as discussed in my previous posts) and (ii) periodic withdrawals from self-managed assets.

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."