How Retirees Can Spend Enough, but Not Too Much (NYT article)

The article below explains why the "X% of initial wealth, increased annually for inflation" rule is bad. An academic working paper that also criticizes the rule is "The 4% Rule - At What Price?", by Scott,
Sharpe, and Watson (available online).
How Retirees Can Spend Enough, but Not Too Much By RON LIEBER Published: August 28, 2009 http://www.nytimes.com/2009/08/29/your-money/individual-retirement-account-iras/29money.html
When you retire, youll probably want to visit your grandchildren more than once each year. Perhaps youll aim to give money each month to charity or your religious congregation.
The amount you have saved will clearly matter a great deal in whether you can do these things. But so will your portfolio withdrawal rate the percentage of your assets that you take out each year to pay your expenses. You want it to be high enough to afford fun and generosity but low enough that you have little risk of running out of money.
Until a few years ago, the standard advice was that 4 percent or 4.5 percent was about the best you could do. So if you had $500,000 in savings, 4 percent would give you about $20,000 in your first year of retirement to augment Social Security and any other income. Then, you could give yourself a raise each year based on inflation. At 3 percent inflation, youd end up with $20,600 in the second year of retirement and so on from there.
More recently, however, several studies have suggested that withdrawing 5 percent or even 6 percent was possible and still prudent.
...
Heres one big reason to be suspicious about applying that same 4.5 percent withdrawal rate to all people, no matter when they retire: Should a person who had the bad luck to retire in March 2009, at the stock markets recent bottom, spend 4.5 percent of, say, $350,000, or could they spend a bit more? After all, people who retired a year or two earlier with the same portfolio, before the bulk of the stock markets decline, might have started with 4.5 percent of $550,000 (and taken inflation-adjusted raises each year from that initial amount until they died).
It didnt seem right to Michael E. Kitces, a financial planner and director of research at Pinnacle Advisory Group in Columbia, Md. He said he was uncomfortable with all the decisions made based on the day you happen to come into my office and the balance on that day.
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I thought the following two points from the article were interesting:
1. [Michael Kitces, a financial planner and research director at his company] tried to figure out whether one could estimate how much better or worse stock market returns might be in the years after big declines and whether the answer might allow for a more generous initial withdrawal rate. What he concluded was that the overall markets price-earnings ratio taking the current price for the Standard & Poors 500-stock index divided by the average inflation- adjusted earnings for the past 10 years before the date of withdrawal was predictive enough to produce guidelines. Then he came up with the following suggestions for a portfolio of 60 percent stocks and 40 percent bonds meant to last through 30 years of retirement.
If the ratio was above 20, indicating that stocks were overvalued, than a 4.5 percent withdrawal rate was prudent given that the stock market was likely to fall. But if it was between 12 and 20 (the historical median is roughly 15.5), a 5 percent rate was safe, tested against every historical period for which data was available. And if it was under 12 a level it almost got to earlier this year a rate of 5.5 percent would work.
The most recent figure was 17.67, which suggests a 5 percent withdrawal rate for current retirees. It had been above 20 until October 2008.
2. Jonathan Guyton, a financial planner with Cornerstone Wealth Advisors in Edina, Minn., looked at the 4.5 percent baseline and asked a different question: Couldnt it be a whole lot higher if a client was willing to forgo the annual inflation raise when conditions called for a bit of thrift? [The article responds to this. My rough impression is absolutely. ISTM that one positive of this recession or incipient depression is that food prices are stable or even cheaper than a few years ago. If a retiree owns his/her house, then the bulk of their actual inflation costs in times like these may arise from an increase in the cost of luxuries like vacations. If the annual inflation raise for scenarios like those in this article was previously based on say the CPI, then this perhaps should be revised, on the proverbial case- by-case business. OTOH health costs are such an unknown. Even people on Medicare have to plan for meaningful out-of-pocket expenses. These expenses are not going down, both because of currently out-of-control inflation in health care and because one's medical needs tend to rise as one gets older.]
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I heard Ed Easterling of Crestmont Research speak a couple of years ago. One of his handouts was a matrix showing the annual returns from the stock market starting at any year and ending at any year. So you can look up 1940 in one column and read across to 1950 and see the annualized returns over that period. But it also includes the P/E for the starting year. There is a vivid inverse correlation. The higher the P/E in the starting year, the lower the returns in the following years. The chart is available online at:
http://www.crestmontresearch.com/content/Matrix%20Options.htm
So there is considerable support for the approach of varying your withdrawals based on P/E in any given year.
Elle: It's good to hear from you. You haven't been posting much.
-- Doug
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Cam what would you suggest instead?
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On Aug 30, 8:38am, "HW \"Skip\" Weldon"

Forget generic advice and rules of thumb. Model your own specific situation.
The model I gave above had 5 original equations in the spreadsheet that I pulled down (spreadsheet users know what this means). It gave yearly detail on savings, spend down rate, savings interest before taxes, annual Social Security payment, Income Spent. I retired a landlord and my best spreadsheet had 15 original equations. I could sell off rentals as I ran out of cash. Someone planning to sell their free and clear home when their savings run out might need 7 or 8 equations. There is no correct generic real estate advice. I live in Southern California and sold a couple rentals by 2006 that kept some 20% appreciation years. Land is valuable, buildings depreciate, but the cost to replace increases. Its complicated. Some places land is cheap, supply is plentiful and building depreciation lowers actual sales price.
I would shoot for my money lasting till 95. That way I can pay an uncovered $100,000 medical bill, send a grandchild to college, buy a boat or RV or take that vacation to Paris and die at 83 without being terrified of going broke. I have safety margin and sleep at night. Leaving your heirs a couple hundred grand dont hurt. Here goes:
RENTER (no house to sell) Year 0 you turn 65 and collect Social Security and only other income is Savings (CDs, bonds, stocks) Interest. Savings $500,000 Savings rate 4% Savings tax rate 20% Inflation 3% Social Security $14,400 (annual) (assume SS income alone is near 0 tax, so we will just say 0 tax) Social Security Cost Of Living Adjustment 2% First year savings spend down -0.1% (you INCREASE your savings by one tenth of one percent) First year income spent $30,000
At age 89 half your savings are gone. Your same standard of living costs $61,000. At age 95 all your savings are gone. Your last year same standard of living costs $72,000 Age 95, you are now living on $26,000 Social Security.
RENTER (no house to sell) Only change: Savings rate 10%
First year savings spend down -1.68% (you INCREASE your savings by 1.68 percent) First year income spent $46,000
At age 84 you still have all your original savings, but are now spending down 3.5% this year. At age 91 half your savings are gone. Your same standard of living costs $99,000. At age 95 all your savings are gone. Your last year same standard of living costs $108,000 Age 95, you are now living on $26,000 Social Security.
I wont give a sell your house scenario as real estate is all over the place.
Dont plan your retirement on a single metric (4% starting spend down). Do write out your strategy. Then plot Age vs Savings and Income Spent. Dont live the last couple years of your life in terror because you are approaching your estimated death age (80).
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How would you reply to those who would prefer drinking cold beer, watching good football games on TV or taking nice trips rather than getting this detailed with their investments?
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Drinking beer and watching Football is good!
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On Aug 31, 11:03am, "HW \"Skip\" Weldon"

Why would you think it is either-or. I do both. It seems to me that doing the latter is the best way to make sure I can keep doing the former.
If someone fails to do adequate planning with their investments, then they shouldn't look to the rest of us for a bailout if their savings run out before their life does.
Dave
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On 2009-08-31 09:03:15 -0700, "HW \"Skip\" Weldon"

You can think of "freedom from paper work" as one of the advantages of worry-free retirement that is the ultimate goal of all the investing and planning in the earlier years. However, that goal is not shared equally by everybody. Some people may have no trouble with spreadsheets and calculating, and would gladly do it before retirement and during retirement if it means a little more income. So it is true that generic advice and rules of thumb do not hold for everybody.
If you drink too much beer and spend too much time at the TV with football games early in your career, you will certainly not have to worry about spreadsheets and equations later, but then again you may not have enough income to take nice trips after retirement. And the beer could run out. Actually the paperwork may not end, because applying for welfare and getting assistance takes time and paperwork.
But there are some kinds of "generic advice" that do hold for everybody. Examples: Take advantage of employer-matching pension plans. Pay off all credit card debt before investing. Save part of all you earn. Take all tax deductions to which you are entirled. Become informed. Avoid scams, and so on. But when it gets to specific decisions about how to plan investments, what type of investments to hold, or what money to withdraw in retirement, it is not the same for everybody.
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For the beer drinkers who are less concerned about accuracy:
I looked at about 10 retirement calculators and yahoo has the closest to what I like.
Its not perfect. It assumes about a 3% Social Security COLA. It has too few parameters (SS COLA, Starting SS Income, Tax Rate) and the defaults are not realistic (8% return) but I realize they did this to make it really easy. Carefully select the parameters. I pay more in CA state taxes than they used overall. Garbage In Garbage Out.
http://finance.yahoo.com/calculator/retirement/ret02
This calculator figures out your required savings as a percentage of income.
Carefully read the paragraph that looks something like this:
"To provide the inflation-adjusted retirement income you desire, you will need to save 50.1% of your yearly income (less any employer match, if applicable). This year, for example, the amount would be $20,042 or $1,670 a month.If you wait just one year to start saving for retirement you will need to save 55.9% of your annual income, which amounts to $22,341 in the first year. Save Now and Save Less!!!"
Note that that this specific calculation depends on your saving half your income until retirement.
The graph is nice and clearly shows there is a save up period and a spend down period.
You can print out this information (their print this page didnt print right on my computer) and take it to your accountant as a basis for discussion.
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On Aug 30, 11:38am, "HW \"Skip\" Weldon"

The annual withdrawal MUST have some dependence on how the portfolio value changes, especially when it falls. If withdrawing a constant fraction of portfolio value is not feasible because the retiree needs more stability, maybe withdraw a fraction of the average portfolio value over the last N years. If the portfolio value goes down a lot and stays down, spending at the rate initially planned is reckless.
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Cam wrote:

I'm having a little difficulty following your math. If I spend down 4% of my half-mil savings and add SS, then my first year income is $34,400, not $50,000. So are you saying that if I over-spend my budget in my first year then my money won't last? That seems like a no-brainer. In addition, these withdrawal rules assume a larger return (though not 10%) than you've assumed here.
-Will
william dot trice at ngc dot com
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Fair enough, I didn't show the math because it's tough to do in text. I think you are forgetting that your $500,000 will earn $20,000 in interest (4% rate) before taxes and $16,000 after taxes. Your "4% first year spend down rate" income is $20,000 spend down plus $16,000 after tax interest income plus $14,400 Social Security. You spend down $20,000 of savings and have $50,000 total to spend on your lifestyle. I might point out that once you start spending down, spend down increases every year. You get less investment income and your same standard of living costs more.
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A 65 year old can get over 6% payment on an immediate annuity. To handle 3% inflation, half of the annuity would have to be saved leaving 3% to be spent.
-- Ron
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A 65 year-old male can get an single life, inflation adjusted immediate annuity from Vanguard that pays 6.1%. For women, the rate is about 5.5%. For non-inflation-adjusted immediate annuities, the rates are 8.2% and 7.5% respectively.
Dave
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I was being sloppy on my posting. I was looking at a joint immediate annuity which would be 6.7% for a 65 year old couple.
Does an inflation adjusted immediate annuity get the same tax treatment as a non-adjusted annuity?
-- Ron
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