Safe Withdrawal Rates: Is 60 the New 95?

Safe Withdrawal Rates (SWR) strategies, spawned by the so-called Trinity Study¹ in 1998, are based on a dangerous assumption — that the future will look like the past.

Now, most everyone knows that is a ludicrous assumption. Nonetheless, in finance we sometimes pretend that is it not, and in our closets we Baby Boomers hang on to our plaid bellbottoms, just in case.

The widely-publicized interpretation of those studies is that retirees can withdraw 4½% of their nest egg the first year of retirement and continue to withdraw that constant dollar amount, increased for inflation, every year and have a 95% probability of funding at least thirty years of retirement. (That's the widely-publicized interpretation, not mine.²)

More and more, researchers are raising serious doubts about that "history repeats itself" assumption. Dr. Wade Pfau studied withdrawal rates in other countries and found that the U.S. was an exception. The widely-advertised 4% to 4½% withdrawal rates weren't safe globally. In subsequent studies, Dr. Pfau concluded that more frugal withdrawals would probably be needed for today’s retirees to achieve a 95% chance of their portfolio lasting 30 years or more in this country. Maybe closer to 3%.

A recent study by Pfeiffer, et. al., entitled The Benefits of a Cash Reserve Strategy in Retirement Distribution Planning, investigated the benefits of maintaining a one-year cash reserve account, but I found the results of the Reverse Dollar Cost Averaging (RDCA) scenarios most interesting. RDCA is another name for constant-dollar withdrawals, or Safe Withdrawal Rates (SWR).

The study (excellent video explanation by Dr. Pfau here) compared monte carlo simulations of RDCA and a similar strategy that held one year’s expenses in a cash account to minimize having to sell stocks when prices were low. A major difference between the Pfeiffer study and the Trinity and William Bengen studies earlier is that Pfeiffer considers transaction costs and taxes and “a future of lower investment returns than seen in the historical data” based on recent capital market projections (that's current predictions of future stock market returns for those of you who speak English).

The results? In a tax-deferred environment (401(k), IRA, etc.), with a 4% withdrawal rate the cash reserve strategy improved 30-year portfolio survivability by nearly 5% from . . . wait for it . . . 55% to 59.4%. 

Not 95% to 99%.

55% to just under 60%.

In a taxable environment, cash reserves increased 30-year survivability with 4% withdrawals, but from a very risky 60% to a still risky 66%.

The following chart is a summary from the Pfeiffer study. The first pair of columns represents an unrealistic environment with no taxes or transaction costs. The second pair represents a ROTH IRA scenario with only transaction costs. The third pair represents a tax-deferred (IRA, etc.) environment and the fourth pair a taxable environment.

95% isn't even on the y-axis.

What happened to 95% survival rates and 4½% withdrawals? If Pfau and Pfeiffer are correct, history won’t repeat itselPf. . . sorry, itself . . . and 4½% won’t work. If history does repeat itself and the U.S. stock market continues to outperform the rest of the world, Bengen was correct and 4½% will work.

Who’s right?

It’s unknown. And unknowable. Check back with me in thirty years. But, the newer research nowadays seems to point to significantly lower sustainable withdrawal rates.

Maybe they’ll all be wrong. In his early writing at EfficientFrontier.com, William Bernstein wrote that retirees shouldn't expect any rate of success greater than 80%.

That "everyone being wrong" thing happens a lot with financial projections. A quite successful money manager used to predict the coming year’s market returns by waiting for other money managers' predictions and then picking the range that no one else picked. It worked amazingly well until the others caught on and they all started waiting.

If you’re basing your retirement funding primarily on portfolio withdrawal strategies, you should heed the words of the authors of the Trinity study that started it all:

"The word planning is emphasized because of the great uncertainties in the stock and bond markets. Mid-course corrections likely will be required, with the actual dollar amounts withdrawn adjusted downward or upward relative to the plan. The investor needs to keep in mind that selection of a withdrawal rate is not a matter of contract but rather a matter of planning."

95% survivability of your investment portfolio with 4½% annual withdrawals isn’t carved in stone somewhere.

In fact, 60 may be the new 95.




----------------------------------------
¹Retirement Savings: Choosing a Withdrawal Rate That is Sustainable

²I think the studies show that your probability of success is a function of the value of your portfolio at any point in time (not its initial value when you retire) and the number of years remaining in retirement. In other words, you have to reassess the safe withdrawal amount periodically, and the safe withdrawal rate increases as retirement progresses.

A Retirement Plan Begins at the End

A lot of retirement planning revolves around your expectations for the end of retirement.

You need to begin with the end in mind, as they say.

There are two basic schools of thought regarding retirement financing. The first, explained by Zvi Bodie in The Theory of Life-Cycle Saving and Investing, is often referred to as the life-cycle approach, or sometimes the "safety first" approach. It is based on the principle that you should first secure your minimum acceptable lifestyle by investing in safe bonds, life annuities and the like, and only then risk what's left of your savings in the stock market in hopes of improving your lot.

The other school is represented by Safe Withdrawal Rates (SWR) and refinements of that strategy and is predicated on making a stock portfolio "safe enough" to minimize the chances that you will go broke late in life. No one, including SWR advocates, will tell you that this strategy will work 100% of the time. In fact, they shoot for about 95%.

So, the bulk of retirement planning revolves around how important it is to you and your spouse to be financially secure if one or both of you live long lives.

For retirees like me who want as close to a zero percent probability of going broke in their nineties as they can possibly arrange, betting on how long we will live or counting on a wonderful next thirty years of market returns isn't good enough. We know that we might live to 95 or 100 and that the market might not bail us out.

But not everyone feels that way. Some feel that a 5% chance of running out of money is an acceptable risk for the opportunity to improve their standard of living. Or maybe they're convinced that longevity isn't their fate.

Neither of us is right or wrong. We safety-first people are simply less willing to take that risk than are the SWR crowd.

The group that worries me are retirees who believe they can have both a perfectly safe retirement and invest the bulk of their savings in the stock market. They hope to find a magic withdrawal rate, buy equity-indexed annuities that promise stock market returns with no downside, or some other such "spending strategy".

You can't have both. If you choose the stock market route, understand that you risk suffering a permanent reduction in your standard of living. If you opt for the safety-first route and the market goes straight up for the next 30 years, understand that you risk missing out on a huge, long-term bull market.

With either choice, in the worst case outcome you'll need to feel good about saying, "I knew the risk. It was a wise decision. I'd do it again." If you don't think you would be able to say that, you're probably making the wrong choice.

My personal feeling is that I would be happier with my current standard of living and missing out on a grand bull market than going broke late in life. Thinking that probably won't happen doesn't work for me. But, that's a personal decision.

Knowing which school of thought suits you can be a huge help when you begin planning retirement. If you're a safety-first kind of person, your plan will include strategies like saving a lot for retirement, spending less after you retire, claiming Social Security benefits as late as possible, buying TIPS bond ladders and maybe even fixed annuities.

A safety-first retiree ignores life expectancy and plans for the worst-case financial outcome — living a long time and going broke.

If you're willing to risk financial safety in your later years, your available strategies will include stock and bond portfolios, perhaps saving less and spending more, maybe claiming Social Security benefits sooner. Perhaps you consider the probability of living a very long time an acceptable risk. You may do better or worse than the safety-first strategies and you might go broke. That's the risk.

Most of the clients I work with spend the bulk of our time together struggling with the risks and rewards of these two approaches, generally trying to convince themselves that there is some way to have both maximum financial security in old age and the maximum opportunities possible with stock investments.

There isn't a way to have both, but I'm not sure I have ever completely convinced a client of that.

Need Help with Your Social Security Claiming Decision?

In my last post, I'm Not Ready for Social Security, I promised to provide an actual case study that I ran through the MaximizeMySocialSecurity.com (MMSS) website. That post listed several good free and paid websites to help you decide when to claim Social Security benefits. MMSS is the one I chose, in large part because I also use E$Planner.

Joe and Sally (real people, fake names) are approaching their minimum age of 63 to receive (also minimum) Social Security retirement benefits. They are both relatively high earners in their current careers, though Joe earns quite a bit more, so his benefits will be higher.

For various reasons, some wise though most unwise in my opinion, many people choose to claim Social Security retirement benefits at the earliest possible date, even though these benefits would increase about 8% a year for every year they waited.

I asked Joe and Sally to send me earnings histories copied from SocialSecurity.org and I plugged them into MMSS. I then ran the software with the assumption that both would live to age 70.

This is the worst case for claiming late, because if Joe waited until age 70 to claim and died sooner, he’d receive no retirement benefits at all. (Sally would, however, receive larger survivors benefits because Joe had postponed his own retirement benefits[1].)

If both Sally and Joe had claimed their own retirement benefits at age 63 and died at age 70, their lifetime benefits would have totaled $282,712.

(MMSS found 42,209 possible claiming options to consider. Want to work that out by hand?)

Now, let’s look at the other extreme and assume that both live to age 100. MMSS shows that claiming at the earliest possible age would have generated $981,232 in lifetime benefits, but claiming optimally would provide $1,246,962 in benefits, or $265,694 more. It recommends the following claiming strategy:

• Joe should take retirement benefits in Jan 2023, the year Joe turns 71.
• Joe should take spousal benefits in Jan 2019, the year Joe turns 67.
• Sally should file and suspend[ii] in Dec 2018, the year Sally turns 68.
• Sally should take retirement benefits in Dec 2020, the year Sally turns 70.

Complicated, right?

A million two is a pretty impressive number, but according to Michael Kitces, "the probability of a joint life expectancy of 30 years for a 65-year-old couple (to age 95) is already as low as 18%. A 35-year life expectancy for that same couple (to age 100) has a mere 3.7% likelihood.”

So, what happens if Sally and Joe live to 95 instead of 100? MMSS recommends the same claiming strategy and forecasts lifetime benefits of  $1,101,411. Still a nice number and $205,657 more than they would get from claiming early.

I ran several scenarios for different longevities for Joe, but always assuming Sally would live to 95, which in my experience is not an unusual outcome. MMSS recommends in every scenario that Joe claim spousal benefits based on Sally’s earnings history when he reaches age 67 and delay receiving his own benefits until he reaches age 71. Sally’s recommendation is to always claim her own benefit (not her spousal benefit), but the best age for her to claim those benefits varies depending on how long she expects Joe to live.

The rightmost column shows the additional benefits the two would receive compared to claiming at the earliest opportunity. (Click table to enlarge.)

Now, I would never recommend that you base claiming benefits on how long you guess you will live, unless you have firm medical reasons to expect a less-than-average life span. If you guess wrong, you can be really screwed.

Absent that kind of poor medical prognosis, I would suggest that Sally wait to at least age 68 to claim if she can afford to.

The free AARP site provided similar advice, but not as detailed. That’s because the site uses life expectancy rather than allowing you to choose a planning horizon. It also uses income averages instead of actual lifetime earnings records from Social Security.

There are several points to take away from this analysis:

1.     Social Security benefits claiming can be very complex (42,209 possible choices in this analysis), especially if you are married or divorced or one of you can claim a public pension. You need to consult a professional financial planner or use a reliable web-based tool. There are many possible strategies and the best websites, including SocialSecuritySolutions.com and MaximizeMySocialSecurity.com, will consider them all. Forty bucks seems a small price to pay with a hundred grand at risk. A qualified financial advisor would be a good investment, too.

2.     The specific scenario in my example cannot be generalized. You might receive different advice if you were single, divorced, eligible for a public pension, a different age, or if your earnings during your career were significantly different than these. Don’t trust magazine articles that provide general Social Security advice. No single strategy fits all. That includes "always claim as soon as you can" and "always wait as long as you can." Tailor your strategies to your households’ specifics.

3.    Your benefits claim can have a dramatic effect on lifetime benefits and your benefits may be the most important component of your retirement income if you weren’t able to save enough for retirement.

There are two additional recommendations that I would make.

First and foremost, think of Social Security benefits as longevity insurance to make sure you have income when you are very old, or that your surviving spouse does. If you were the higher earner, your spouse's survivors benefits will depend on when you claim retirement benefits. If you claim early, you not only lower your retirement benefit, you lower benefits for your surviving spouse for the rest of his or her life.

Second, consider your claiming strategy within your overall retirement financing plan. It is difficult to identify the best claiming strategy without understanding when you will need that income the most. If you have a lot of savings or can work part time to cover your spending requirements for the first few years after you retire, claim later to receive greater benefits. Consumption smoothing software like E$Planner, or a financial advisor, can help you integrate Social Security benefits with the rest of your retirement plan.

Claiming Social Security retirement benefits is very complicated and it is extremely important that you get it right. A lot of money is at stake. Unless you're an expert, get help.

Claiming early might ensure that you squeeze every penny out of Social Security should you die early, but that’s like buying home or car insurance that only pays the small claims that you could afford to pay out of pocket. 

A short retirement won't cost much.

It’s the big claims that can destroy your finances, and living to age 90 or older is a very, very big claim.

---

[1] Your spouse’s survivors benefits equal your retirement benefits, if you have begun receiving them. Limiting your own retirement benefit consequently limits your spouse’s survivors benefit.

[2] “File and Suspend” is a strategy for claiming your retirement benefits and immediately suspending them so you spouse can claim spousal benefits and you can keep the meter running on your own retirement benefit. You can read more here.

I'm Not Ready for Social Security

My high school classmates will be eligible for Social Security benefits in a year or two. I need to write the rest of this post quickly before that sinks in and I feel old.

Aw, crap. Too late.

The age when you claim Social Security benefits might have a huge impact on your standard of living after you retire.

For some people, it's an easy decision. If you're no longer working and can't get by without the benefits, you should claim them as soon as you can. Since about 95% of American workers haven't been able to save much for retirement, a lot of households won't have to think long about when to claim benefits.

They'll take them as soon as they can get them.

Some people believe that Social Security won't be around for them because conservative politicians will eventually shut it down. But, 2015 will mark the 80th anniversary of the Social Security program and the 79th anniversary of conservatives' efforts to eliminate the program.

Yet, it survives.

Others believe that the “breakeven age” is so high that they're better off claiming early than expecting to live past about age 78. That seems a bizarre argument to me.

Social Security retirement benefits, formally Old Age and Survivors Insurance, are longevity insurance intended to mitigate the risk that you will run out of money when you are very old.

Breakeven is an argument that you don't believe you will live to age 80. Unless you have received bad news from your doctor, I would suggest that you have no idea when you will die and that you need to protect against the cost of living to a ripe old age.

If you don't plan to live a long time and you do, the cost of your lost bet is quite high.

Here's the argument. I know that if I claim early I will be significantly worse off should I live a long time. In fact, I know that my spouse's survivors benefits will be significantly limited if I claim early. But I don't want to die young and leave benefits on the table, so I'm betting I won't live to 80 or beyond.

This is probably the same guy who, at a younger age said, "Buying life insurance is just bettin' against yourself", or in other words, "I'm betting I live a long time." It shows a fundamental lack of understanding of insurance.

I don't imagine many people forgo homeowners insurance because their house probably won't burn down or auto insurance because they're pretty sure they won't have a major accident, yet they're willing to bet old age in the poorhouse that they won't live past 80.

Social Security retirement benefits and the intertwined survivors benefits for married couples can amazingly complex. If you can afford to delay those benefits even a year or so, you have strong financial incentive to do so and you will probably need help with your decision.

You can discuss this with a professional financial advisor, of course, but there are also some excellent websites that can help. One website, MaximizeMySocialSecurity.com (MMSS) is available from the same company that provides E$Planner software. There are other websites, free and not, that I have not tried for the most part. Several are listed in this Wall Street Journal article.

I did try the AARP site. It provided recommendations similar to MMSS, but the inputs are fairly limited. It assumes you will live to your life expectancy, but there is a 50% chance that you will live longer than that. It doesn't let you see what would happen if you live to say, 85 or 90. Nonetheless, it recommends claiming as late as you can.

MMSS, unlike E$Planner, is a website so there is no software to download. You can run it from any web browser on any most hardware platform. It costs $40 the first year with an annual upgrade for $20, but unless your life changes dramatically, a few weeks is probably all you will need.

Next time, I'll show you the results of an actual scenario and what MMSS suggests in my post, "Need Help With Your Social Security Claiming Decision?" You may be amazed at the difference a good decision can make.

Moving the Red Line

In a previous blog, Your Own Personal Fiscal Cliff, I showed that retirement planning is about finding the maximum standard of living you can enjoy during your working years that you can maintain after retiring. That is the green “smoothed-consumption” line from the graph in my previous post that I will reproduce here.

I’ll remove the blue “over-saved” line from this chart to avoid the visual clutter, since I don't think over-saving for retirement is exactly epidemic or that it soon will be. 

I'm defining standard of living as the amount of discretionary spending you can have at a given age. Sometimes I refer to that as your “spending”, or “expenses” or “consumption”, but I mean basically the same thing — how much money you have to spend as you please.

Ideally, we'd like to find the highest (green) line that doesn't move up or down substantially after we retire like the red and blue lines above do. So, how do we move the rightmost portion of the red line up after we retire?

There are several ways. Some move the right half of the red line up by moving the left half down (decreasing our pre-retirement standard of living), but a few don't.

After you retire, you will no longer pay FICA taxes. That money can now increase your standard of living after retirement, moving the right half of the line upward (Spending money on FICA taxes did nothing for your standard of living before you retired.) 

Same goes for amounts you saved for retirement, into your 401(k) for example, on the left side. That ends when you retire. Maybe your taxes will be lower, maybe not. There may be other expenses that go away and that money can now increase your standard of living after retirement.

Social Security benefits and pensions move the right half of the red line upward. The problem with Social Security benefits, though, is that they replace at most 30% of you pre-retirement income. For most households, that will still leave quite a gap to fill.

Delaying your Social Security retirement benefits will increase them about 8% a year. If you can afford to do that, it's the best insurance against a long, expensive retirement.

You may be able to move the right half of the line upward for a while with part-time employment. Be aware, though, that your Social Security benefits will be impacted if you claim before full retirement age (66 for most people nowadays).

The obvious way to move the red line on the right upward is to increase your retirement savings while you're working, but that also lowers the red line on the left — you're saving more so you spend less.

Yet another way to nudge the line upward on the right is to cut your discretionary spending after you retire. Your pre-retirement standard of living might be cheaper somewhere else. And you don't have to move to Ecuador. Property taxes in my hometown of Chapel Hill, NC are far higher than those in Orange County just a couple of miles away, for example.

Of course, if you can't generate enough income after you retire, you will have no choice but to cut expenses and reduce your standard of living. Since Social Security benefits constitute 90% or more of retirement income for many families, that’s going to happen a lot.

Paying off your mortgage might increase your standard of living in retirement, though I would be concerned that you might be tying up a lot of your savings in a way that's difficult to undo. It's harder than you might think to convert home equity into cash after you retire. Banks, for instance, want to see a steady income before they loan money against your home and most retirees don’t have that.

Nonetheless, Professor Laurence Kotlikoff at www.ESPlanner.com says his experience is that paying off the mortgage nearly always increases retirement spending.

It is also worthwhile considering lowering your pre-retirement standard of living, the left half of the red line, so you don't have to move the right half of the line so far. By that I mean buy a reasonably affordable home. Maybe trade cars less often. A lofty standard of living while you're working sets a high hurdle for retirement. Living a little below your means before you retire is probably a great idea.

Before we move on, here is a summary of ways you might increase your standard of living after you retire:

·       Increase retirement savings while you're earning
·       Maintain a reasonable standard of living before you retire
·       Maximize your Social Security retirement benefits
·       Relocate to a place where your standard of living will be cheaper
·       Consider paying off your mortgage
·       Work part time

What is the bigger picture? I'll cover that in my next post.

Please stick with me.

Are There Other Ways to Fund Retirement?

I need your help with something.

I’ve pointed out many times that our retirement funding system simply doesn’t work for most people, and by “most” I mean around 95% of American workers approaching retirement.

On the other hand, I have spoken with many people, some of them clients, who seem to feel fairly secure in their retirement, despite not having been able to save several hundred thousand dollars over their career.

Some of those people inherited money, a home or a farm. Some had a sweet pension deal with their public or private employer. My optometrist loves his job and is still working as he approaches 80.

Others found a home in an area with a very low cost of living. (One retired to Ecuador.)

I’m curious about what other circumstances may have secured retirement for households that weren’t able to accumulate a lot of retirement savings. If you don’t believe that you will have retirement savings exceeding $200,000 by the time you retire, but you feel pretty good about your retirement prospects nonetheless, please add an anonymous (if you wish) comment to this post below.

Please describe in a few sentences why you expect to enjoy a satisfactory retirement despite limited savings.

If you prefer, e-mail your thoughts to me at JDCPlanning@gmail.com.

Maybe your thoughts will inspire someone else in a similar situation.

Thanks!

P.S. Same goes for retirement finance questions you may have. Post a comment to any blog or email me at the address above and I'll get back to you.