Don't follow the 4% rule

A Morningstar article
"Unpacking the 4% Rule for Retirement-Portfolio Withdrawals" by Christine Benz http://news.morningstar.com/articlenet/article.aspx?idS4335
discusses the 4% rule (initially spend 4% of portfolio value, and increase withdrawals with inflation thereafter), which I think is risky, because it ignores changes in portfolio value. At the least, I think this rule should be supplemented with a rule that caps current annual withdrawals as a portion of portfolio value, say 6%. If the spending dictated by the 4% rule exceeds 6% of CURRENT portfolio value, the retiree spends only the 6%. Following the 4% rule blindly can lead to a retiree running out of money if his portfolio does badly.
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On 1/28/12 7:58 AM, Beliavsky wrote:

Nice article. The Trinity study is getting old, and I'd like to see more analysis, say, how this plan fared through the '00s.
I'd suggest there are a number of variations, one you show, the 6% cap. Other is that in down years, the withdrawal doesn't get an inflation factor.
My own plan is the budget for retirement not include social security at all. So, while we're spending 4%, we're not yet taking SS benefits and when they kick in, our spending doesn't change, but our true 'withdrawals' would be about 2.8-3%.
Last - I am not a fan of annuities, except for the immediate kind. A $200,000 payment will get us $12,000/yr. This would otherwise be the withdrawal off of $300K. An intelligent look at one's wealth, and desire to leave an inheritance, compared to the straight 4% rule might point to a mix where, on $1.5M which would offer a $60K/ yr return, one might buy $500K in the immediate annuity, returning $30K. This leaves the remaining $1M with a safer 3% withdrawal. Just thinking out loud here. (The annuity does not inflate, by the way, but one is also less active at 75 than 65, in general)
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It helps to look at an actuarial table http://www.ssa.gov/oact/STATS/table4c6.html to see what lifetime risks are. With interest rates low, immediate annuities don't have much of a payout until age 80. If a person has severe or chronic health problems it doesn't make sense to buy an immediate annuity because death might come earlier than average.
-- Ron
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On 1/28/12 12:00 PM, Ron Peterson wrote:

Agree, 100%. The purchase is a shift of risk, at a cost. The 4% withdrawal carries risk both from the market and longevity, the IA, that you'll die, although I quoted a 6% that was a joint number, obviously, I'd not want to take "our" money and buy an IA on just my life.
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tnx for the info to consider....
We are just now starting to think about the whole retirement planning, and mostly how to draw down from various sources. It's not so much having to create the wealth, but on the flip side - how and where to draw the funds.
We have a pretty healthy portfolio of stocks.. and some bonds. But haven't thought about how to sell those for cash. The main support will come from wife's teacher pension, and I have a little SS - but not counting on it.
BTW - teachers that get a state funded pension in most cases LOSE their SS benefits from any payments prior to becoming a teacher. Actually it's like a threshold thing, but if you had some SS prior to teaching, and then taught for a long time - the teacher retirement will overshadow the SS payments and you get nothing from SS...
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Such a person should consider getting a Medically Underwritten (Rated Age) Immediate Annuity. Someone with such problems might actually have a *greater* need for the income stream than a healthy person would.
A person with a serious medical condition may qualify for an annuity which pays them a greater than normal income. This occurs when an insurance company determines that the persons actuarial age is older than their chronological age. The level of income calculated based on a so-called rated age is usually greater because the insurance company expects the duration of the income stream to be shorter, i.e., the company expects to make fewer payments.
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That sounds good, but who writes those policies? I think that it is difficult to get lifetime annuities for those over 90 and they also have a pressing need.
-- Ron
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The same insurance companies that write normal annuity policies. As an example picked at random, Mutual of Omaha/United of Omaha Life Insurance Company. See http://cpsinsurance.com/annuity/hrspia/uooClientHandout.pdf
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I cooked up a quick spreadsheet modeling the drawdown from a $1M portfolio invested entirely in VFINX. It survives a 7% annual withdrawal, adjusted for inflation, with no loss of real value over the past 21 years (21 years being the life expectancy of a 65-year- old). Here's a link to the Google spreadsheet:
https://docs.google.com/spreadsheet/ccc?key oZ1EM6IBna-dHhoNWhUdjktOW9hSFRXTXZFZDZSb0E
The CPI values are from Robert Shiller and the VFINX data is from Yahoo (adjusted for dividends, of course). I suppose I could have used Prof. Shiller's S&P 500 data and adjusted for dividends, myself, but I was lazy. Plus it's nice to have the fund expenses baked in to the NAV.
If anyone would like to see variations on this, just let me know.
--Bill
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On 1/31/12 11:58 AM, Bill Woessner wrote:

https://docs.google.com/spreadsheet/ccc?key oZ1EM6IBna-dHhoNWhUdjktOW9hSFRXTXZFZDZSb0E
Nice. Note, however, the 90's S&P returned a CAGR of 17.59%. So I'm not too surprised that it survived the '00s, since it grew enough so the withdrawals in the '00s start at near 3%. A deeper analysis would offer start dates moving forward, year by year, right to the 'lost decade.' Start 2000 at even a 4% withdrawal and where would we be now?
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On 1/28/2012 4:58 AM, Beliavsky wrote:

I wish Morningstar or someone would do a survey to see if they can find any 1990s-early 2000s era retiree who actually followed one of these rules as a withdrawal strategy. Meaning, in year one multiplied their account value by 4%, 4.2367%, whatever, and took that out, and increased the amount by CPI every year. I seriously doubt that person exists!
I've always thought of it as a construct for discussing the risk of running down savings during retirement. A precisely defined percentage may be of interest to an institution (e.g. insurance company, pension) that makes contractual promises regarding lifetime income. But those institutions aren't necessarily motivated to maximize the benefit, there may be padding for risk insurance and profit. And they have alternatives like offloading the risk of drops (via derivatives - like the ones sold to Berkshire Hathaway), or for pensions, increasing contributions when investments don't go well.
In practice, for individuals, I think it's the rare area where behavioral issues work in your favor...the tendency seems to be cutting back on spending when investments drop in value, exactly the opposite of the assumption in the 4% simulations - that have you blindly increasing spending for CPI every year.
Cheap "withdrawal strategy": follow one of the IRA minimum distribution tables - which is a steadily-increasing percentage of last year's account value. At age 65, the single life table says 21.0 is your divisor, 1/21 = 4.8%. All roads lead to Rome?
-Tad
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Of course, there's a huge difference between the single-life table and the uniform (which basically assumes joint life for a couple where they are both of similar age) table.
At age 70, the single-life table gives a life expectancy of 17 years, meaning about 5.9%, while the uniform table gives 27.4 years, meaning 3.65%.
And, of course, the biggest wrinkle of all, if you use the single-life table and are 111 years old or older, the life expectancy is defined to be 1 year, so as soon as you are 111, you spend the entire thing down in that one year and will be broke for all the years which follow...
In reality, like Tad, I use these kinds of tools as starting points for discussions, not etched-in-stone plans. Planning and managing distributions in retirement is a process, not a one-shot deal. These guidelines are probably more useful long before retirement for helping to estimate targeted savings goals. If I have, say, a couple who are in their 30s or 40s, with retirement 20-30 years out, it's impossible to know exactly how much they are going to need to save, but the 4% rule is a great starting point - it implies that your savings needs to be 25x the amount you plan on spending annually out of that savings.
For a 65 year old couple, perhaps one or both of whom are already retired, the 4% rule isn't enough - it's still just a starting point. More realistically, we need to assess their resources, their spending patterns (especially things like if/when their house will be paid off leading to huge drops in monthly cash-flow needs), and especially importantly - ideas for plan B and plan C - what do you do if your spending is higher (or investment returns are lower) than you expected. When a couple is 60 or 65, I really look at their retirement more like endowment investing rather than a spending-down plan. Their time horizon needs to be 30 years - the odds are substantial that a couple who are both in that age range will have at least one of them live 30+ years. That "endowment" idea, of course, like a real endowment, needs to be carefully reviewed regularly. Real endowments don't use the 4% rule (which doesn't adjust payouts when investments underperform).
One widely used endowment rule was to tie spending to 5% of the three-year rolling average of total endowment market value. The three-year average smoothed it out so that spending wouldn't drop quite so much after a bad market year, and tying it to asset value rather than fixing a dollar value and adjusting with inflation (4% rule) meant that if the assets did underperform, spending would have to be throttled. Perhaps I'll run some historical numbers for the 5%/3yr rule against some traditional portfolios (ie. 60/40 SP500/LehAgg). Note that in an ongoing down/flat market, this 5%/3yr rule does, in fact, lead to asset depletion and lowered spending.
There are a lot of other endowment rules out there and in use, with varying degrees of complexity in the formulae, and varying degrees of adherence to stability in spending versus linking spending to market returns. And I think anyone doing this kind of planning can learn a lot from them - knowing full well that retirement is *not* the same thing as an endowment and that you do have to have plan B and plan C available. Endowments (ie. Universities) may have a lot more leeway to either cut spending or ask for more donations than retirees have...
--
David S. Meyers, CFP(R)
http://www.MeyersMoney.com
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A follow-up article by Benz http://news.morningstar.com/articlenet/article.aspx?idS6284 (see the "Percentage of Portfolio With Ceiling and Floor" section) discusses imposing a cap and floor of the proportion of the portfolio spent, as I suggested above. I agree with Tad's comment that these percentage caps and floors should increase with age, to account for decreased life expectancy.
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