Friday, April 15, 2016

A Model of Retirement Planning, Part 1

The details of retirement financial planning are easier to understand once you imagine the big picture and can see what the pieces are and how they fit together. It's easy to get stuck in the weeds.

Most retirement literature, unfortunately, doesn’t start with the big picture. It often jumps right into asset allocations or sustainable withdrawal rates. So, let’s take a step back and build a basic model of retirement finance, starting with how much the bills will be and how we will pay them.

Funding retirement begins with the simple observation that after one retires, the bills keep coming but the paychecks stop.

We then need to find the “best” way to pay the bills, with “best” being defined from an individual household's perspective. The plan one household considers best might be completely unacceptable to a different, even quite similar household. Given two households with identical finances, for example, one might find a life annuity to be "the best" solution while the other might not trust insurance companies and refuse to even consider annuities.

Paying for the expenses of retirement is the basic problem, so let's start with the cost. Expenses are also sometimes referred to in a retirement planning context as spending or consumption. I'll use them synonymously here.

One way to estimate retirement expenses is to assume that we will maintain our pre-retirement standard of living after we retire. We can subtract FICA taxes and retirement savings amounts from our pre-retirement paychecks because those are two items we will certainly not need to pay after retirement. The result is an estimate of the amount of retirement income needed assuming no changes to our standard of living. But, it isn’t a very good estimate for two reasons. First, our spending will change as we age (it typically declines). Second, living expenses aren’t entirely predictable.

Some living expenses are fairly predictable but some are random. I can predict that I will have a grocery bill, a housing bill and a Netflix bill next month and I can predict the amounts fairly accurately.

When my son needed $500 a while back to repair his car's ignition switch, we didn't see that coming. When my daughter needed an emergency appendectomy, that wasn’t in the plan. Living expenses have both unpredictable and predictable components, which means that your total annual living expenses are unpredictable.

The predictable part is simply the minimum. I can be pretty sure that my living expenses will be $50,000 next year, but I might also have a large unpredictable expense or two next year. So, my total expenses next year will actually be somewhere between $50,000 and some amount that could be much larger but is unpredictable.

This “expense risk” is the fallacy in looking at retirement planning simply as an income problem, such as a sustainable withdrawal amount from a portfolio of volatile investments.

Retiring for an unpredictable number of years with unpredictable expenses and somewhat-predictable income.
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Let’s say a planner (or an online calculator) tells you that you can spend 4% of your savings each year and your savings will likely last at least 30 years. That 4% provides you with a nice standard of living when added to your Social Security benefits until one day someone in your family becomes quite ill and you have $100,000 of uninsured medical bills or your adult child becomes unemployed and moves back home. Your retirement plan – and perhaps your retirement – is destroyed.

What went wrong? Your planner (or that online calculator) promised that you could spend 4% of your portfolio balance annually and your savings probably wouldn’t be depleted for at least 30 years. He (it) didn’t say what would happen if you should need to spend more than the 4% you planned. You thought 4% spending was safe, but how can you know that your retirement finances are “safe” without knowing how much you might have to spend? The income side of the equation alone doesn't show all the risk.

How long you will live in retirement is more critical than spending. If your desired standard of living costs $60,000 a year, you retire at 65 and die at 66, your entire retirement will cost about $60,000. If you live to 100, retirement will cost about $2.1M. (Those totals don’t include the aforementioned unpredictable expenses and the longer you live, the more likely you are to be hit with them.) A healthy person can't predict how long he or she will live and that means the total cost of retirement is highly unpredictable even without large, unexpected costs.

Life expectancy and spending are the two largest determinants of retirement cost and, as I have pointed out, both are unpredictable. So, when someone asks how much money they will need to retire or how much retirement will cost, the correct answer is, “We can't say with any certainty, at all. We can tell you what typically happens, but your retirement may not be typical.” That rules out waiting until you're certain you can afford it to retire. Certainty is absurd.

This doesn't imply that because retirement is largely unpredictable retirement planning has no value. We can't say with certainty that it won't rain June 2nd of next year but we can plan an outdoor wedding that has a better chance of success than simply hoping for nice weather.

Where will we find the income to pay our bills after we retire? It typically comes from Social Security benefits, pensions, part-time employment, and personal savings invested in income-producing assets like stocks, bonds, and real estate.

Income is more predictable than expenses or it can be if retirement is funded appropriately. Spending from pensions, life annuities, TIPS bond ladders and Social Security benefits is pretty predictable. Investments are less predictable, but the most you can lose from your investment portfolio is its total balance. Unexpected expenses can cost much more than your savings.

Imagine, for example, that you have saved $100,000 and have it invested in stocks and bonds. The most you can possibly lose in the market is $100,000 and it is extremely unlikely that you will lose all of it. On the other hand, it’s easy to imagine a medical bill exceeding $100,000.

This large amount of risk inherent in retirement finance is an unavoidable reality. Even if you fund retirement entirely with Social Security benefits and life annuities, making your expected income more predictable, retirement will still be very uncertain because some expenses are highly unpredictable. If you are very wealthy relative to your spending, of course, this matters much less.

Here, then is the first part of a retirement finance model:
The challenge of retirement income planning is to best position our available resources to maintain our desired standard of living throughout an unpredictable length of retirement with somewhat-predictable future income but largely unpredictable future expenses.
Note that the primary goal is to maintain a desired standard of living throughout retirement and not to maximize wealth, income or an inheritance. Once the standard of living goal is achieved– itself alone a massive challenge for most households – any uncommitted resources can be applied to the other goals.

Standard of living, by the way, is also a moving target. We naturally become less active and spend less as we age. As David Blanchett showed, however, spending typically declines as retirees age when they spend appropriately for their savings level. Retirees who under-save tend to spend less over time and retirees who over-save tend to spend more as they age. The latter two tend to "correct" spending as they recognize that they are depleting savings too quickly or have more money to spend.

This is the beginning of the “big picture” and one of the reasons questions like “how much money do I need to retire” and “when can I retire?” are so difficult to answer and why retirement planning is so challenging. It also points out that most retirement planning focuses too narrowly on investment results.

Lastly, it points out just how risky retirement is. As financial planner, Larry Frank, frequently reminds me, “everything is stochastic.” By stochastic he means random or unpredictable. And, by everything he means the market, interest rates, inflation, expenses, taxes, Social Security benefits, how long we will live and most other significant factors of retirement financial success.

But, unpredictable life spans, income, and expenses aren’t the entire “big picture” of the retirement finance model. I'll expand the model in future posts, starting with Adding Risk to the Model, Part 2.


  1. This is a great beginning to describe the "big picture" Dirk! The reality is that nothing during our working years was predictable (and we manage(d) to survive). Think your income while working was predictable? Take a look at your Social Security statement's earnings history (yes - it's all there ... online via ). Most will see income changes in some form or fashion over time.

    Then, our brains expect something different when we retire. All of a sudden we want certainty. The irony is the harder one tries to lock in the income (think fixed guaranteed income), the more risk one inadvertently takes (think loss of purchasing power).

    What the profession should really do is educate people to living within their means during all stages of life and to expect the unexpected by keeping something reserved for those. Economists teach us to maximize utility (read spending) at all moments in time. Rather, I think keeping some in reserve for the unexpected is more prudent. How do you do this with a portfolio in retirement? Underspend what you could rather than spend to the max (

    I look forward to your future posts on this Dirk as you flesh this out more.

    PS. I'm working with a research colleague in Canada on retirement "model" vs fixed period simulations or calculations. So far interesting stuff - I'll send you an advance of the working paper soon Dirk.

    PPS. IE11 still has posting problems too.

  2. Great post Dirk. You touch on a lot of subjects. I might add that some of us plan on retiring on the early side (say around 55 ish) and with travel plans expenses might actually increase before they decline. Also 4% assumption might be dated in a low interest rate environment. Looking forward to Part II.

    1. Thanks, Andy.

      The 4% reference was simply an illustration (I should be more careful about that). If someone were going to implement an SWR strategy currently, I'd recommend 3%. But, I think SWR strategies are – what's the technical term? – hooey, so I don't really recommend either.

      Your point about your own personal spending is a good one. Research shows typical behavior for groups of retirees based on past spending patterns. It isn't useful for predicting the spending of an individual household. You're much better off doing the best job you can to predict your own spending, taking travel into consideration, for example, and revising your forecast annually. Ditto for a withdrawal rate.

      Great comments. Thanks!

  3. "We can subtract FICA taxes and retirement savings amounts from our pre-retirement paychecks ..."

    There is an additional "adjustment" that needs be made to your gross income to find the retirement income needed - taxes. You don't need your pre-tax retirement income to match your pre-tax pre-retirement income but rather you want your post-tax retirement income to match your post-tax pre-retirement income. And those taxes can be significantly different.

    Before retirement much if not all of your income will be taxed: by the Feds, State, and even cities/counties. After retirement many localities don't tax unearned income. Many states don't tax SS benefits and even the feds may tax only a portion of SS bennies. And finally as you pass 65 your standard deduction increases.

    Just quickly, a working couple making 65K might experience a tax bill of $9000 (5K to the Feds, 2.5K to the state and 1.5K to the city) above and beyond FICA withholding (nearly 5K). After retirement savings (6K) they might be living on 45K/yr. In retirement, with 32K of SS income and 12K of taxable retirement income their total tax bill could be 0 as in NADA. While still having essentially the same disposable income.

    Then, as you point out, you have to recognize that this first order guess is just that - a first order guess.

    1. I omitted taxes from the first-order estimate for two reasons. First because, as you mention, it's a first-order estimate. But, secondly, FICA taxes and retirement savings go away permanently (unless you return to work). While taxes might decrease significantly after you retire, they can also come back to bite you on the butt later in retirement in the form of the "tax torpedo" or simply RMDs that don't push you into a higher Social Security tax bracket. It depends on the retiree's individual situation.

      You will also notice that I said the first-order estimate isn't a very good one.

      Unlike FICA and retirement savings, taxes don't necessarily go away permanently. Future tax obligations are uncertain.

      Thanks for the comment!

  4. Great post on the need to look at the bigger picture for retirement planning, Dirk. I couldn't agree more with your comment regarding the fact that most retirement literature jumps right into assets allocations or sustainable withdrawal rates. Your post inspired me to write about my actuarial vision of the Big Picture, including at least thinking about reserving for long-term care costs and unexpected expenses before jumping into this year's spending budget.

    1. Thanks, Ken. I read your post and I think our perspectives are quite similar, though we use different tools for planning. I tend to use simulation because that's what I'm comfortable with and you use actuarial techniques because, well, you're an actuary!

      I think it works well to have multiple perspectives and, again, our basic models are the same. I have at t least two more posts on the model, so keep me honest.

      My readers can check out your post at this link.

      Thanks for sharing!

  5. Too often the 4% rule (and its variations) are used interchangeably with "withdrawal rate" and "spending rate". That significantly damages its usability. I liken the 4% rule to a longevity table or actuarial table for the account. Based on investment and withdrawal parameters, it estimates the probability of the investment life. It does not define a spending rate.

    Its application for most living off the investment is, combined with other income streams, to define a "normal" neutral cash flow (incomes = expenses). If you spend above that rate, you need to look at where the probabilities move to given your remaining longevity plan. If the probabilities go from 99% to 98% you may not care. But if it goes from 99% to 75% then it is time to adjust. Or if you spend below the 4% rate the probabilities may go well above 100%. As I recall, the 4% rule is based of near 100% success analysed against some of the worst markets experienced prior to 1985 (today minus 30 years)

    Now I'm off to read the next installments...which I look forward to seeing what you have to say.

    1. Nick, thanks for writing!

      Actually, I wouldn’t explain it that way.

      The 4% rule is based on work by William Bengen, who created the term “Safe Withdrawal Rate”, so I believe “safe withdrawal rate” and “4% Rule” are, in fact, interchangeable and that is how they are commonly used. When retirement researchers and writers use the term “spending rate”, you are correct that they are not referring to the total amount of money a retiree spends, but rather to the amount that they spend that is funded by their savings portfolio.

      The 4% Rule has nothing to do with expenses, only with income.

      William Bengen’s work was first published at Bengen, William P. (October 1994). Determining Withdrawal Rates Using Historical Data" (PDF). Journal of Financial Planning: 14–24. The 4% “safe withdrawal rate” was calculated by determining that, if a retiree had spent a fixed dollar amount annually, adjusted for inflation, equal to 4.4% of his initial portfolio balance, his portfolio would have lasted at least 30 years in 95% of the rolling 30-year periods of market returns known in 1994. He concluded that spending that fixed-dollar amount was safe 95% of the time.

      Bengen also showed that the SWR increased as life expectancy decreased and found an SWR of 8.9% with 10 years remaining. So, 4.4% only estimates 95%-safe spending at 30 years. Some people believe the 4% rule means that they can spend 4% of their initial portfolio balance every year, but that is a misinterpretation. The retiree maintains 95% safety by increasing the SWR over time and multiplying it by the current portfolio balance. To quote Bengen from Conserving Client Portfolios During Retirement, “the adviser should examine the projected current withdrawal rate through the entire time horizon of the clients, not just the first year of retirement.”

      Capital markets have changed significantly since 1994 and Wade Pfau now suggests that the safe withdrawal rate is probably closer to 3%. I highly recommend Bengen’s book and Wade’s paper.

      I’m not sure how the probability of portfolio survival could “go well above 100%”, or any amount over 100%, for that matter. Maybe you can get back to me on what you mean by that.

    2. Saying that the "the probabilities may go well above 100%" is not mathematically correct (you can't beat 100% is this usage). But metaphorically it may have use. First off I have not studied his paper yet and thanks for the link.

      As I understand, he ran the analysis using varying percentages for as many years as he had 30 year data each year starting in January. Success was defined as the account being greater than zero at the 30 year mark. Let's say, for conversation purposes, that he did 100 runs at 4% and 95 were greater than zero at 30 years. That would be 95% probability of success. Let's also say that at 3.9% that 96 were greater than zero at 30 years (96%). Continue that mind game until you are at 3.5% with 100% success rate. Now let's extend the "rule" downwards to 3%. It is still 100% using the greater than zero evaluation yet one could argue that 3% is better than 3.5% just like 1% is better still.

      The unknown is what the amount was at 30 years and when the amount would go to zero. You don't know if the balance goes to zero in 10 days, 10 years or never. Let's again say for conversation purposes that the balances all collapse to zero with a couple years after 30 years. That is a much different problem than if they normally distributed around 46 years.

      By lowering the withdrawal rate, you effectively lengthen the life expectancy of the portfolio. You can also increase the withdrawal rate by shortening the event horizon (30 years).

      When viewed in the context of how long the balance will stay above zero, one can see why I liken it to a longevity or actuarial table. for example, at 30 years, 95% of the portfolios are "still alive".

      You can approximately recreate his analysis using Then look at the charted results. It is better than just looking at the 30 year probability threshold. Note also that T Rowe Price and Fidelity compute a similar result but as I understand it these are Monte Carlo simulations.

  6. Hi Dirk, Thanks so much for your blog and the thoughtful comments. My question relates to your cited example of $100,000 in unexpected medical bills as a potential unexpected expense event. Shouldn't we rightfully expect such events to be covered by medical insurance?
    Thanks, Mitch

    1. Excellent question, Mitch!

      The answer is a resounding "no, you should not expect health insurance to cover all your expenses." Most households that declare bankruptcy due to medical expenses had health insurance coverage when their crisis began.

      Medicare doesn't cover all medical expenses – more like half. (This AARP piece explains in more detail.)

      Of course, neither does private insurance.

      A retiree who generates huge medical bills will often do so because he or she needs long term care. Medicare does not cover LTC. There are plenty of other examples of health insurance costs that you may need to pay that will not be reimbursed by health care insurance.

      Unfortunately, a lot of retirees believe Medicare will cover all their health care expenses. This gives a false sense of security.

      Thanks for writing!

    2. Thanks, Dirk. Do you then generally recommend LTC Insurance? I've not read every topic you've posted, but the mentions of LTC I've seen have not been strong endorsements. Could you point me to a post in your blog or other source that discusses LTC, whether and when to buy it, etc.? Thanks again, Mitch

    3. I did write about Long-Term Care Insurance
      here a few years back and I have written about it in several comments along the way.

      I’m not sure there is a great answer to your question. LTC insurance is flawed, in my opinion. Here are a few of the reasons:

      - You have to medically qualify for LTC Insurance and many retirees won’t. As I understand, disqualifying issues are not always obvious. A young woman in otherwise good health, I am told, had a knee replacement and was turned away because joint problems apparently correlate strongly with LTC costs later in life.
      - Insurers can raise premiums for large classes of people and your rates might become so high that you can no longer afford them. Some argue that the big premium increases are behind us but I had a client just last year whose premium increase pushed the point of affordability. If you let the policy lapse, all the payments you previously made went for naught.
      - The insurance is expensive. Most households won’t be able to afford the premiums.
      - A couple who saved a few million dollars for retirement might be better off self-insuring the risk.
      - Many carriers have gotten out of the business and more likely will, in my opinion.

      If you are in between these two levels of wealth, you might be able to tailor a smaller package that is affordable. I recently had an LTC insurer work with a client to find a package that was both affordable and provided a meaningful level of coverage.

      My go-to guy for all issues insurance is Joe Tomlinson. The last time he and I discussed this issue his position was that despite the known flaws households that can afford LTC insurance should buy it. He’s quite conservative when it comes to retirement risk and so am I.

      My advice would be to find a good LTC insurance agent, see what coverage he can suggest. If it’s affordable then apply for the policy and see if you qualify medically.

      Hope that helps a little.