WASHINGTON - NBC News
America's first "baby boomer" filed for
Social Security benefits Monday, becoming among the first of nearly 80 million
Americans
born after World War II who are expected to apply for such benefits over
the next two decades. Kathleen Casey-Kirschling, 61, was born one second
after midnight on Jan. 1, 1946. She becomes eligible for Social Security
in two and a half months.
With fewer and fewer employers offering defined-benefit plans, retirees living longer more active lives, and, as signaled by the news item above, with the largest population group in our nations history now approaching retirement, it does not come as a great surprise that the question we hear more and more frequently is what is the maximum (safe) annual withdrawal rate for someone's retirement portfolio.
In fact, many of the same clients who originally came to us asking, "How much do you think I can earn on my portfolio each year?" are now asking, "How much do you think I can take from my portfolio each year?" For the same reasons stated before, this topic has become an area of intense interest and study for financial practitioners as well as retirees.
If you are tempted to jump to the end of this article to find THE correct withdrawal rate, I should point out that, unfortunately, no such number exists. The fact that there is no specific figure is not for lack of trying. There has been a great deal of academic research done to determine this number using stochastic present values, gamma distributions, and Monte Carlo simulations. Got all that? Well, in short, these are all just very sophisticated sounding ways of guessing. All of the variables that go into their various equations are guesses, so by definition, the results are also guesses.
In the absence of the ability to predict the future, selecting an appropriate withdrawal rate is a function of the estimates you must make on rates of return, mortality, inflation, and spending patterns. That all said, I will admit that much of the research done on this topic concludes that a range of 3% to 5% is reasonable. At KIM, although we believe this range is appropriate for many of our clients, it's simply not a good fit for everyone.
To be clear, I would like to define a "withdrawal rate" as it is commonly used when discussing portfolio distribution strategies. Despite what it may sound like, the withdrawal rate is not the percentage of your portfolio that you would withdraw each year, but rather the percentage of your portfolio that you would take out in the first year. After that, the dollar amount of your annual withdrawal is typically increased by the rate of inflation.
For example, a 5% withdrawal rate means that someone with a $1,000,000 portfolio will take $50,000 in year 1. Assuming inflation of 2.5% throughout the year, the calculation for year 2 would be: $50,000 x (1.025) = $51,250, which could be more or less than 5% of your portfolio value depending on how it has performed over that year.
Rather than diving too deeply into the mathematics behind this type of research, I will highlight some of the more important variables to consider in determining a reasonable amount to withdraw from retirement assets. That said, I thought a brief summary of Monte Carlo analysis would he helpful given its popularity.
Basically, in a Monte Carlo simulation, thousands of scenarios are run using random values for multiple variables (i.e. mortality, rate of return, inflation, etc.) based upon the probability distributions for each variable. The results of all the scenarios represent a range of possible outcomes. For example, if we run 1000 different scenarios on a particular withdrawal rate and 950 of the scenarios indicate the investor will not deplete their assets, we can say our confidence level that that particular withdrawal rate is "safe" is 95%. As you can see, this type of analysis is insightful, but not a guarantee.
Given the inherent uncertainty in selecting the "right" withdrawal rate for your portfolio, it is important to understand the key variables that affect the outcome - mortality, inflation, risk/return, spending patterns, and distribution of returns - and specifically, which of these can be controlled and which cannot.
Mortality
Aside from following your doctor's orders, there is not a lot that
can be done to control this variable. The simple reality is that the longer
you live, the more probable it is that you will deplete your nest egg. Below
is data relating to the life expectancy of men and women at age 65. Although
the Society of Actuaries and the Department of Social Security actually break
this up into sub-categories (white collar, blue collar, smoker, non- smoker,
etc), the chart below is a good summary of the overall data.
However, be cautious of financial planners and journalists who assume these
percentages are absolutes.
They are probabilities based on history and the expectations of actuaries.
That said, even if this data proves remarkably accurate, you still may live
longer than these figures suggest. Again, this is information that is helpful
and should be considered in a financial plan. However, it must be taken with
a grain of salt.
Inflation
Unless you find yourself taking over the responsibilities of Ben
Bernanke as the Chairman of the Federal Reserve, there isn't a great deal you
can do
to control inflation. Moreover, how do you measure inflation? Many political
and economic pundits argue that CPI (Consumer Price Index) is a poor measure
of "real inflation". They claim the reason for continued use of this
yardstick is because it systematically understates real inflation and thus
saves the government money as social security payments are linked to increases
to the CPI.
While that may or may not be true, I do know many retirees on a fixed budget
who see a big disconnect between the official data and their monthly bills.
Whatever gauge you use to estimate future prices, we believe it is wise to
select a withdrawal rate that allows for a portion of your investments to be
dedicated to assets that may fight the negative effects of inflation. The chart
below shows the yearly CPI from 1958 to present. As you can see, the historical
average has been slightly above 4%. Many believe it is reasonable to
expect lower rates of inflation going forward because of their confidence in
our central bank and the emergence of a more competitive global marketplace.
Although we believe this is a reasonable argument, it's far from a guarantee.
As with most factors, we continually reassess this data and act accordingly
as it relates to our clients' portfolios, withdrawal rates, and retirement
plans.
Risk/Return
No discussion of withdrawal rates could
be complete without analyzing investment performance. As I mentioned earlier,
we are often asked about our expectations
for yearly returns. Unfortunately, far less frequently we are asked about the
risk (volatility) associated with those returns, which can be even more important.
In fact, once an investor reaches the stage at which they start to take money
from a portfolio, high volatility can hurt the sustainability of withdrawals
more than high returns can help. As Dr. Moshe Milovsky wrote, "It is often
stated that spending money in retirement is akin to creating your own pseudo
bear market since each year the withdrawal process reduces the portfolio growth
by the spending rate." Add in a "real" bear market to a high
risk portfolio and the combination can be devastating. The good news is that the level of portfolio risk can be managed. In fact,
at KIM, much of our efforts are directed at targeting risk. Most of our portfolios
have actual target volatilities relative to a benchmark (often the S&P
500). Although we may increase or decrease the amount of risk we incur in an
effort to achieve higher returns based upon our market outlook, we still try
to remain within a relatively tight range.
Spending Patterns
Spending patterns simply refers to how much you spend as
time progresses. While this may seem like it's a variable that is both easy
to predict and easy
to control, that is not always the case. Aside from unexpected health care
or family emergency costs, we find that rarely is a recent retiree accurate
in
predicting how much they will spend. In fact, when discussing strategy with
a client who is entering retirement, I mentally use their spending expectations
as a starting point, not an absolute. I'm sure many reading this will say to
themselves, "I'm different, I've got it all figured out." Well, that
may be true, but most people we work with discover they are wrong. We generally
find that over the first year or so people are spot on with their predictions.
However, once they get a little deeper into retirement we start to get calls
for unplanned withdrawals for extra travel, a new hobby, etc. For this reason,
we find it very important to have regular communication with our clients to
stay on top of any changes in their financial situation that may affect the
way we are managing their portfolio.
Distribution of Returns
Our final variable is the sequence, or order, of the
yearly returns. This is best explained by example. The chart below shows two
portfolios with identical
average annual returns, standard deviations, and compound growth rates. However,
the order in which the overall returns were constructed is different. In fact,
in this example, the data stream is simply inverted. What's most interesting,
and concerning, is the difference in the withdrawal sustainability. Portfolio
A, with three negative years after the withdrawals began, depleted its assets
after the first 12 years. At the same time, Portfolio B is distributing assets
at year 21 and appears to be growing beyond the scope of the chart.
This definitely falls into the category of a variable that you cannot control.
Fortunately, there are strategies that can mitigate the negative effects of
poor market performance at the beginning of retirement. One simple example
is to have enough money in cash equivalents in advance to pay expenses. Other
more complex strategies would be to employ decision rules based upon yearly
real returns (returns after inflation). Some experts even argue that annuitizing
a portion of your portfolio can decrease the odds of out-living your nest egg.
Again, these are strategies we continually discuss with our clients in an effort
to make their retirement nest egg last throughout retirement.
Conclusion
If you add it all up, it becomes obvious why there is no "one-size-fits-all" magic
withdrawal number. The good news is that there are variables you can control.
The bad new is that there are variables you can't control. When we council
clients on this topic, we try to uncover any factors that may influence what
we believe to be a reasonable withdrawal strategy. For example, some retirees
have a stronger desire to leave an estate than others. We often find that our
clients with children who earn significant incomes are more comfortable with
the prospect spending all of their savings compared to clients who have children
with less earning power. Some other common discussions we have focus on long-term-care
insurance, annuities, taxed vs. tax-deferred accounts, how many months of expenses
should be in money market accounts, etc. Although we find many similarities
with the people we help, we also recognize there are unique circumstances that
have to be taken into consideration when developing a plan for retirement.
-- John Cogswell, CFA
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