RETIREMENT ADVICE FOR A SAFE FINANCIAL FUTURE
3d blog in a retirement spending series
RETIREMENT SPENDING PLAN FOR INVESTORS WILLING TO ASSUME REASONABLE RISK FOR POTENTIALLY GREATER FUTURE INCOME
The retirement planning process during the distribution phase following retirement is considerably more complex than investing for growth during the accumulation years prior to retirement. Merely investing for growth without any need for current income or distributions is relatively straightforward. When the paychecks stop, the retirees must rely upon their investments, pensions and social security to replace their prior salary, with annual increases for inflation, and their nest egg must last for both spouse’s lives. How does the retiree know if he saved enough money for this purpose if he doesn’t know how long he will live, how much his investments will earn, or how the family’s expenses will change in the future? Also, is the financial advisor who helped during the growth phase qualified to advise during the more complex distribution phase?
Special expertise is required to balance competing goals and risks, with the least stress, in an uncertain world. Health, lifespan and the capital markets are all uncertain – but you must determine a sustainable spending rate, adjusted for inflation, and a proper asset allocation. The risk of running out of money increases if the retiree spends at too high of a rate, invests too aggressively, encounters declining markets during the early years or lives longer than expected.
This section is for retirees who seek a higher standard of living and are willing to take more investment risk to achieve it. There are many factors to consider before a retiree decides to increase his risk tolerance for potentially greater future returns. It requires both a willingness and ability to tolerate greater fluctuations in value that may result in either greater gains or losses. If the added risk results in losses that will interfere with the ability to pay for the necessities of life, the decision is foolish. If it would only prevent the ability to fund another vacation, it may be justified.
Conversely, retirees who didn’t accumulate an adequate investment account, or those who involuntarily retired sooner than desired because of unexpected health reversals or an unplanned termination from employment, must either reduce their cost of living or increase their investment risk to potentially increase returns and generate more income.
Unlike the safety-first approach to meet needs-based goals, the focus of the market-based approach is on lifestyle goals, including needs, wants, likes, and wishes. A diversified portfolio, with 60% stocks for both growth and income and 40% bonds for income, will potentially generate a total return that will support increasing annual distributions. Relying on a simplistic rule of thumb like a 4% withdrawal rate for everyone is dangerous in view of the many variables and uncertainties. With proper analysis, financial planning, and investment management, we believe that a starting rate of 4% or less is prudent for younger retirees, with increasing future withdrawals. Older retirees, with shorter life expectancies, can increase distributions to 5% or more.
Rules of thumb are usually over simplified. Even if they apply in most situations, the complexity and uncertainty of forecasting future capital markets, life expectancies, interest rates, and spending needs precludes using rules of thumb in all situations. A recent analysis by Sam Pittman, Ph.D., at Russell Investments involves the creation of several models for various economic scenarios. He uses Monte Carlo simulations to determine if the assumed spending rate will be sustainable, or if there will be a shortfall with lower than expected investment returns or higher spending rates. It is complex because it simulates future interest rates as well as investment returns. If future interest rates and investment returns rise, the growing investment account will fund the assumed spending needs more easily. Conversely, if interest rates decrease, the cost of funding the spending plan will increase.
In addition, instead of initially forecasting success for the next 30 years, his forecasts are for multiple 10 year periods. I like this more conservative approach because it assumes that the retirees will live for the next 30 years but performs the calculations over more manageable periods. Projections over three decades are subject to magnified errors. Looking back over the past 30 years, try to imagine how unlikely it would have been to project the extreme fluctuations in inflation, the stock market, and gold prices? The long-held belief that you can’t lose money in real estate was disproved over the past few years.
Whether the projection is for 10 or 30 years, more frequent monitoring is preferable so that we can recommend small adjustments to keep the plan on track. The reality of real world events usually differs from projections. As a comparison, every airline prepares a detailed flight plan but a storm over Chicago on routine flights from Los Angeles to New York requires a deviation to avoid the storm. Likewise, stock market corrections, high inflation, and increased spending require adjustments. These events are all foreseeable but unpredictable.
Knowing that you will not run out of money during your lifetime is the dominant concern to every retiree. The wealthy with lavish lifestyles and the middle class with more modest spending plans share this concern. Large public and corporate pension plans hire expensive consultants to perform complex mathematical calculations that project if the assets, earnings and future contributions will be sufficient to pay future monthly pensions for the lives of all current employees, retirees and their beneficiaries for their entire lives. Every retiree shares the same concern, but can’t benefit from the principle of large numbers where some employees die younger and others outlive the average life expectancy. Good health, family genes and luck could unduly stress their assets to last an additional 20 years or more. Additionally, retirees must be self-reliant because they can’t count on the government or corporate employer to add money if there is a future short-fall. Applying the analytical process used by large institutional pension plans might help the retirees plan their own futures.
The funded ratio is the metric used by defined benefit pension plan actuaries to calculate the safety of the plan. It answers the important question: Are the assets sufficient to guarantee the payment of pensions for the lifetime of all retirees, active employees, and their beneficiaries? 100% or higher provides a margin of safety. Lower funded ratios of 80%-60% or less increase the cause for worry. If the employer is financially unable to increase the funded ratio by additional contributions, the plan may become insolvent and fail.
The calculation of the funded ratio is complicated but the concept is simple. It compares the portfolio value with the cost of the future spending plan. The plan is fully funded if the lifetime withdrawals are less than the portfolio value. If the funded ratio is less than 100%, the plan will become more risky and may potentially fail. This outcome may occur if investment returns are consistently below expected returns or if spending exceeds projections.
By monitoring investment results and spending regularly, modest adjustments may keep the plan on track. Planning for 10-year increments is better than blindly trusting a 30-year lifetime projection. However, regular updates and calculations take time and many advisors lack the knowledge or skill for retirement spending calculations so advise clients to rely on rules of thumb. This makes some clients happy because they prefer not to pay the planning fees. The devil is in the details so a detailed analysis of all current and projected spending needs is essential. Without proper planning, there can be no comfort in the plan’s success. Even with proper planning, retirees who deviate from their budgeted spending plan may cause the plan to fail.
Have you noticed that over the past several years, most major corporate pension plans have terminated their defined benefit pension plans and replaced them with 401(k) plans to reduce their liability? Today, defined benefit plans are mostly limited to government entities, but many are actively seeking to terminate them for newly hired employees. Individual retirees do not have the option to pass on the liability to others, therefore, meticulous planning with an experienced Certified Financial Planner® designee is recommended. We strongly recommend that our clients adopt a spending plan that is more than 100% funded so that a market drop or decline in interest rates will not cause their plan to fail.
For those fortunate employees covered by defined benefit pension plans who enjoy a guaranteed monthly income for life, your concern with this section is limited, as follows: 1. If your retirement spending needs are greater than your pension. 2. If inflation is higher than the annual increases guaranteed in your plan. 3. To make up the shortfall between the lower benefits guaranteed to your beneficiary and the actual spending needs. 4. For other succession desires to leave assets to children, family or charities. The reason is that all pension benefits terminate at death.
The time horizon, or life expectancy, and asset allocation are also important considerations in the plan design. Where the spending needs represent a small percent of the retiree’s investments, there is no need to take unnecessary risk. Where the spending represents a much higher percent of assets, the option may be the uncomfortable choice to either spend less or increase the portfolio risk with the hope to achieve greater returns.
It is difficult to assign a fixed withdrawal percent for retirement spending that is appropriate for every investor. Considerations vary greatly based on the risk profile, age, health, life expectancy, size of the investment portfolio compared to the spending need, and desire to provide for successors or for charitable bequests. As stated earlier, the starting withdrawal rate should ideally be lower than 4% to minimize funding problems and gradually increased if investment earnings exceed projections. This strategy will also provide a cushion for error if adverse circumstances require higher withdrawals.
We are great believers in the potential of equities for growth portfolios, but during the distribution phase, retirees should be more concerned about declines than growth. With less ability to recover from market reversals, a more conservative asset allocation is appropriate. An asset allocation model of 60% equities and 40% fixed income, reviewed and rebalanced annually, is a prudent initial strategy More conservative models are better for fully funded plans or at older ages. Taking more risk than necessary for financial and emotional success is foolish.
How to choose the best retirement income Strategy, July 22, 2014, by Joe Tomlinson, Tomlinson Financial Planning, LLC. published in Advisor Perspectives.
Understanding the sequence of return risk – Safe withdrawal rates, bear market crashes, and bad decades. By Michael Kitces, MSFS, MTAX, CFP, CLU, ChFC, director of research for Pinnacle Advisory Group. October, 2014, Retirement Planning magazine.
Various blogs by Jonathan Guyton and Michael Kitces, financial planners and Wade Pfau, professor at The American College.
Bill Bengen is credited with the development of the 4% rule in the early 1990s, postulating that the investment account would last at least 30 years if one initially withdrew 4%, and increased it annually at the rate of inflation.
2014 Retirement spending guide, by Sam Pittman, Ph.D. August, 2014 (revised October, 2014), Russell Investments.
Views from beyond the Barron’s staff by Mathew Greenwald, president of Greenwald & Associates, as published in Barron’s, November 10, 2014.