Tag: retirement capital

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Retirement Asset Planning

Safe Withdrawal Rate – A Nice Rule of Thumb

Retirement Income Center

Last week’s post, The Sequence of Returns – The Roulette Wheel of Retirement, showed how “luck of the rate-of-return draw” can have a dramatic affect on a retirement asset plan in determining whether you will outlive your investment portfolio. In two scenarios where the retirement age (65), portfolio beginning value ($500,000), average rate of return (7%), withdrawal rate (5%), and inflation factor applied to the withdrawal rate (3%) were identical, and the only variable was good vs. bad early years, there were quite different results. With the “Good Early Years” scenario, after 25 years, at age 90, distributions totaled $964,000, the portfolio earned $1.385 million, and the portfolio value was $921,000. Under the “Bad Early Years” scenario, the portfolio was depleted after 16 years at age 81 after taking distributions totaling $541,000 and the portfolio earning $41,000.

Many people would argue that 5% seems like a reasonable withdrawal rate, however, as we saw, under the “Bad Early Years” scenario, this proved to be too aggressive. The financial planning industry, after many years of debate, has settled on a rule of thumb of 4% as a “safe withdrawal rate.” That is to say, you can withdraw 4% of the value of your portfolio in your first year of retirement and then increase your withdrawal amount by an inflation factor in subsequent years without depleting your portfolio during your lifetime. As an example, assuming a portfolio value of $500,000 at retirement and a 3% inflation factor, you could withdraw $20,000 ($500,000 x 4%) in Year 1, $20,600 ($20,000 x 1.03) in Year 2, $21,218 ($20,600 x 1.03) in Year 3, etc.

Is a “safe withdrawal rate” something we should live by or is it simply a rule of thumb? While a 4% withdrawal rate during retirement can potentially enable you to sustain your retirement capital for the duration of your retirement, this is not always the case, particularly in “Bad Early Years” scenarios. In addition to the withdrawal rate, the interplay of the following ten variables will determine whether or not you will outlive your portfolio:

  1. Type of portfolio, i.e., nonretirement vs. retirement
  2. Income tax rates
  3. Source of income tax payments, e.g., checking account, nonretirement sales proceeds, IRA withdrawal, etc.
  4. Retirement duration
  5. Average rate of return
  6. Sequence of returns
  7. Timing of earning of income
  8. Inflation rate
  9. Frequency of withdrawals
  10. Timing of withdrawals

As an example of the interplay of several of these variables, let’s make the following assumptions:

  1. Retirement age: 65
  2. Beginning portfolio value: $500,000
  3. Average rate of return: 6%
  4. Sequence of returns: Bad early years
  5. Withdrawal rate: 4%
  6. Inflation rate: 3%
  7. Frequency of withdrawals: Annual
  8. Timing of withdrawals: Beginning of year

In this scenario, despite the fact that the withdrawal rate has been reduced from 5% per the “Bad Early Years” scenario in the last post to 4%, which is generally considered to be a “safe” withdrawal rate, by simply changing one other variable, i.e., reducing the average rate of return from 7% to 6%, per Bad Early Years Assuming 6% Average Rate of Return, the portfolio is depleted at age 85. While the frequency and timing of withdrawals in this example may not be typical, the “safe withdrawal rate” of 4% isn’t conservative enough.

There are other scenarios where the interplay of the various variables is such that a withdrawal rate of 4% can prove to be problematic. As is typically illustrated, the previous example assumed an inflation rate of 3% each and every year. What happens if inflation averages 3%, however, the sequence of inflation rates is such that it is much higher in the first five years, say 7%. This would result in larger withdrawals in years 2 through 6, and, depending upon the rate of return, sequence of returns, and duration of retirement, this could result in premature depletion of the portfolio.

Mathematics aside, there are several other issues to consider when planning to use a safe withdrawal rate. For starters, why should you base your withdrawals for the duration of your retirement on the value of your retirement portfolio on a single day, i.e., the day before you retire? Also, it does not consider the fact that a sizeable portion of your expenses may be for mortgage and/or other fixed payments that don’t increase each year, and, as such, don’t require an inflation factor to be applied to them. In addition, the safe withdrawal rate methodology doesn’t take into consideration the fact that we typically incur nonrecurring expenses, planned and unplanned, e.g., new car, home improvements, wedding, etc., in addition to our ongoing expenses.

Another factor not incorporated in safe rate withdrawal calculations is the affect of differences in sources and amounts of non-portfolio income, e.g., Social Security, pensions, part-time income, etc. on portfolio values. What about the impact of inheritances on the amount of subsequent withdrawals? Finally, who is going to be responsible for doing the accounting to ensure that the amount of withdrawals doesn’t exceed the targeted amount in a particular year?

While the amount of withdrawals calculated using safe withdrawal rate methodology may match your income needs in some years, this probably won’t be the case in most years. This is arguably its single biggest weakness. I don’t know about you, but I don’t want to live my life based on a simple calculation that doesn’t consider my changing financial needs. While a safe withdrawal rate is a nice starting point, or rule of thumb, for calculating retirement withdrawal amounts, its limitations need to be considered when applying it to one’s retirement plan.

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Retirement Asset Planning Retirement Income Planning

Retirement Asset Planning – The Foundation

Retirement Income Center

Last week, in Retirement Planning Risks, I discussed six risks associated with retirement planning in general. In order to understand and appreciate the value and importance of retirement income planning and its associated strategies, let’s take a closer look at retirement asset planning.

As was presented in The Retirement Planning Paradigm Shift – Part 2, the focus of retirement asset planning is on the accumulation and “spending down” of one’s assets. The accumulation phase is common to various financial planning areas, not just retirement, including house purchase planning and education planning, to name a couple. With most types of planning, you’re typically designing a plan for the purpose of accumulating funds for either (1) a single expenditure at some specified, or target, date, in the future, e.g., a down payment on a house, or (2) a series of expenditures for a limited and specified series of target dates, e.g., a four-year college education.

With all types of financial planning, there are two major stages:  (1) design, and (2) funding, or plan implementation. Similar to an architect, a financial planner, after consultation with his/her client(s), designs a financial blueprint, or plan, for achieving a particular goal, or series of goals. Assuming that the client approves the recommendations, the plan is generally funded with a single lump sum or a series of payments over a specified period of time, depending on the plan’s goals, the client’s current and projected resources, and various other factors.

With most types of financial planning, when you reach the plan’s target date, you immediately, or over a limited number of years, e.g., four in the case of college education, see the results of your plan. What distinguishes retirement asset planning from other types of planning and adds to the complexity of the plan design and funding strategy is the “spend-down” phase.

Unique to retirement asset planning, the timeframe of the “spend-down” phase is undefined. It can last for less than a year and, although it is unlikely, it can go on for as many as 60 years, depending upon when it starts and a host of many variables.

Unlike most types of financial planning where you get to see the results of your plan after reaching a specified target date, this is not the case with retirement asset planning. As a result of all of the risks discussed in last week’s post, there’s an inherent uncertainty associated with retirement asset planning. Even if you’ve done an excellent job of accumulating what appear to be sufficient assets for retirement, you generally won’t know if this is true for many years.

While retirement asset planning can provide a solid foundation for a successful retirement plan, unless it is accompanied by a customized retirement income plan at the appropriate stage in your life, there is a higher likelihood that your retirement income will fall short of your needs and that the plan, itself, may not succeed.

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Financial Planning Retirement Asset Planning Retirement Income Planning

Is Your Retirement Plan At Risk?

Retirement Income Center

Before I write about the specific risks associated with retirement asset planning and the strategies that retirement income planners use to address, and, in many cases, mitigate, these risks, let’s take a look at risks that are common to all retirement planning. While many of these are uncertain and/or uncontrollable, each of them needs to be addressed in a retirement plan.

The risks that will be discussed are as follows, with the first three common to all types of financial planning, and each one intended to be a brief introduction vs. a comprehensive discussion:

  1. Inflation
  2. Investment
  3. Income tax
  4. Longevity
  5. Health
  6. Social Security benefits reduction

Inflation

Although it is unpredictable as to amount and fluctuation as it pertains to individual and overall variable expenses, a key risk that must be considered in the design and funding stages of all retirement plans is inflation. Unlike most types of financial planning where it is a factor only in the accumulation phase, inflation is equally, if not more important, during the withdrawal stage of retirement planning. The longer the time period, the more magnified are the differences between projected vs. actual inflation rates insofar as their potential influence on the ultimate success of a particular retirement plan.

Investment

Unless you are living solely off of Social Security or some other government benefit program, you are directly or indirectly exposed to investment risk. Even if you are receiving a fixed monthly benefit from a former employer, although it isn’t likely, your benefit could potentially be reduced depending upon the investment performance of your former employer’s retirement plan assets and underlying plan guarantees. Whenever possible, investment risk should be maintained at a level in your portfolio that is projected to sustain your assets over your lifetime while achieving your retirement planning goals, assuming that your goals are realistic.

Income Tax

Even if income tax rates don’t change significantly as has been the case in recent years, income tax can consume a sizeable portion of one’s income without proper planning. With the exception of seven states (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming) that have no personal income tax and two states (New Hampshire and Tennessee) that tax only interest and dividend income), the rest of us need to be concerned about, and plan for, state, as well as, federal income tax. In addition, if you have a sizeable income, it is likely that income tax legislation will be enacted that will adversely affect your retirement plan on at least one occasion during your retirement years.

Longevity

Unlike other types of financial planning, the time period of retirement planning is uncertain. Although life expectancies are often used as a guide to project the duration of a retirement plan, no one knows how long someone will live. The risk associated with the possibility of outliving one’s assets is referred to as longevity risk. In addition, life expectancies, themselves, are changing from time to time. The August 19, 2009 edition of National Vital Statistic Reports http://bit.ly/pAgRk announced a new high of nearly 78 years for Americans. Planning is further complicated for married individuals since you are planning for multiple lives.

Health

An extremely important risk that is sometimes overlooked or not given enough consideration in the design of retirement plans is health. Under-, or uninsured, long-term care events as well as premature death in the case of a married couple, can deal a devastating blow to an otherwise well-designed retirement plan. It is not unusual for a prolonged long-term care situation, such as Alzheimer’s, if not properly planned for, to consume all of one’s retirement capital and other assets. Inadequate life insurance to cover the needs of a surviving spouse can result in dramatic lifestyle changes upon the first spouse’s death.

Social Security Benefits Reduction

Once considered to be unshakable, the security of the Social Security system, including the potential amount of one’s benefits, is questionable. In addition, it was announced in May that for the first time in more than three decades Social Security recipients will not receive a cost of living adjustment, or COLA, increase in their benefits next year. While beneficiaries have received an automatic increase every year since 1975, including an increase of 5.8% in 2009 and a 14.3% increase in 1980, this will not be the case in 2010.

Each of the foregoing six risks needs to be considered, and appropriate strategies developed, in the design and implementation of every retirement plan to improve the chances of success of the plan.

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Retirement Asset Planning Retirement Income Planning

The Retirement Planning Paradigm Shift – Part 2

Retirement Income Center

I hope that you’ve had a chance to read The Retirement Planning Paradigm Shift – Part 1. If not, please take the time to do so. This is a continuation, promoted at the end of Part 1 as “Return of the Blog.” Have no fear. While it’s definitely more technical than Part 1, it’s not scary. Break out the popcorn and read on.

Similar to the scientific breakthroughs that Thomas Kuhn discussed in his 1962 landmark book, The Structure of Scientific Revolutions mentioned in Part 1, retirement planning is undergoing a paradigm shift. This is quite natural given the fact that financial planning as a profession is still in its infancy. Its origins trace back just 40 years when Loren Dunton, the father of financial planning who is credited with coining the term “certified financial planner,” set up the Society for Financial Counseling Ethics with a meeting of 13 individuals at Chicago’s O’Hare Airport in 1969.

In order to understand the retirement planning paradigm shift, let’s start by taking a look at two basic financial statements:  the Statement of Financial Condition, or Net Worth Statement, and Cash Flow Projection.  Both reports are frequently prepared by financial planners at the outset of a planning engagement and are  typically updated throughout the course of a relationship with a client. A Net Worth Statement and Cash Flow Projection are used to plan for, and to monitor progress toward, the pursuit of one’s financial goals, including retirement.

The results of cash flow projections that professional financial planners have been preparing for years have only begun to be experienced and scrutinized by retirees during the last couple of decades. As with all new mthodologies, some prove to be successful and others need to be modified based on experience. Retirement planning is no exception.

Traditional retirement planning as it has been, and continues to be, practiced by most financial planners, focuses on the accumulation and “spending down” of one’s assets. This is, in essence, retirement asset planning.  While this type of planning works well in the accumulation stage, ideally resulting in projections of sufficient retirement capital when conservative assumptions are used, unfortunately, it often proves to be inadequate for meeting one’s needs when the plan plays out in retirement years. The reasons why this occurs are important and will be the subject of a future blog post.

As a result of the uncertainty of traditional retirement asset planning as a solution for providing a predictable income stream to match one’s financial needs in retirement, retirement income planning was born.  Cash flow projections incorporating the latter approach typically result in a better matching of projected income to projected needs, reducing the likelihood of outliving one’s retirement capital.

While this alternative approach is still evolving, it’s logically and emotionally more appealing than traditional retirement asset planning for someone who is within 10 years or so of, and throughout, retirement. When properly employed by professional retirement income planners, retirement income planning should ultimately prove to be a more effective strategy for meeting many indviduals’ retirement needs for the vast majority, if not the entire duration, of retirement.

Retirement income planning should supplement, and should not replace, traditional retirement asset planning at the appropriate stage in one’s life in order to provide a total solution. Understanding this phenomenon requires a paradigm shift that will become apparent in future blog posts and will hopefully be an “Aha!” experience, common to all paradigm shifts, that you can use to create a more rewarding retirement planning experience.