The impact of realistic spending on your retirement

May 28, 2014

In a post last week I showed that for the majority of retirees the standard recommended spending model in retirement does not match reality. Spending  in retirement actually grows by less than inflation over time. In this post I want to show you how using a more realistic sending model impacts how much you can withdraw from your portfolio in retirement.

If we go back and use the same model we used to calculate SWRs, we can adjust annual spending to see the impact of using a more realistic spending model on SWRs. For this post I simply changed the annual spending adjustment in retirement to grow by 1% less than inflation during the 30 year retirement periods (-1% per year real spending). This is actually pretty conservative compared to the actual retiree data.

Second, I took at look at combining a realistic spending model with a flexible spending model I’ve discussed in the past. The Floor Ceiling method basically allows spending adjustments in retirement based on the performance of the portfolio. For this post I used a floor ceiling model with unlimited upside and a max floor of -10% to inflation adjusted spending.

The results are shown in the table below for 30 year retirement periods, a 70-30 SP500 10yr UST bond stock portfolio with data going back to 1929.

SWRs for base vs realistic vs fcm model may 2014

The standard retirement model says your SWR is 4.39% for this portfolio. By simply using a more realistic spending model the SWR for the portfolio goes up to 4.90% an increase of almost 12%. The FCM model with its flexible spending says your SWR is 4.84% for this portfolio. By combining both approaches the SWR for the portfolio goes up to 5.39%, an increase of over 22%! That’s a raise of 22% per year in retirement simply by being more realistic and flexible. Very powerful stuff.

For those still building for retirement the implications are perhaps even more impactful. The percentage increases in SWR are equivalent to a reduction in the amount you need to fund your retirement. If you can spend 22% more with these models in retirement it also means you would need 22% less to retire. That could translate into several years of work or no work in this case.


Spending Realities in Retirement

May 20, 2014

It’s usually worthwhile to question conventional wisdom. At the minimum you usually learn where that wisdom came from. Often you learn the conventional wisdom is not the best approach. This happens to apply rather well to the topic of retirement spending. Lets take a look at the conventional wisdom regarding retirement spending and see why it may not be the best approach.

All the standard retirement models tell retirees to adjust spending every year for inflation right? This how the SWR (Safe Withdrawal Rate) model works. You pick a percentage of the portfolio to withdraw in year 1 and then adjust that spending every year for inflation. Simple enough. The theory being that at the minimum we want to maintain the same ‘standard of living’, i.e. real spending, from year to year. The biggest question to ask is this model actually how retiree spending evolves over time?

Anectodally, this model has always felt a bit off to me. For one, I meet a lot of retirees and speak to them quite a bit about finances and spending. Many I’ve met have held spending constant for years while maintaining their quality of life. In my personal situation, on average spending has either stayed the same or declined every year. What gives?

Fortunately, some recent research has shed some light on this topic. Michael Kitces has a great post covering this research which I highly recommend. I’ll just highlight a few points from the post. Lets first look at how retirees actually spend. Here is the data:

Annual Real Change in Consumption for Retirees May 20 2014

The orange line in the graph above is spending adjusted for inflation, real spending. This is the line all retirees fall on according to the recommended retirement models. The reality is somewhat different. For the majority of retirees real, inflation adjusted spending declines in retirement. Even towards the end of life. The declines are on the order of 1% a year, growing to 2% a year, then back to 1% a year in the later years but still never positive. Definitely a different reality than the models portray. An important point: this is real spending. Actual spending may still actually increase. For example, inflation is 3%, spending goes up 2%, real spending is then down 1%. Now lets look at how you can use this in your retirement.

I think the best way to use this research is to take a look at your retirement in stages. Michael also talks about this in his post but basically the idea is to divide retirement into three spending stages. Like pictured here;

three stage retirement model may 2014


Each of the three stages can be modeled with a different change in retirement spending. For first stage, say 60 to 70, -1% per year in real spending could be used (or conservatively the standard model’s o% per year), for the second stage, 70 to 85, -2% per year, and for the third stage back to -1% per year. This can be tailored to be fit your specific circumstances which is also much better than the standard retirement model.

OK, so far all we’ve done is match the retirement model to a better representation of retirees’ actual experiences. Now for the punchline. Being that realistic scenario is less spending than the model means one of several things. One, the standard SWRs are too conservative. Two, retirees need less money to retire to being with. Three, worst case, the SWRs from the standard retirement model plus a more realistic spending outlook means a much higher probability of success in retirement. I’ll take a look at some of these implications in later posts.

Standing on the edge: diversified portfolios & the modern retiree

May 16, 2014

What’s the hardest part of the retirement decision? For many its taking the leap of faith that financially what’s worked in the past will continue to work in the future. And often the start of every single year, during those early years of retirement, brings the anxiety right back again. I’m in my ninth year of withdrawals and while the anxiety has lessened by orders of magnitude, it is still there. Someday I may recount the year by year story, maybe after year 10. In today’s post I want to look back a bit in order to look forward. We’ll go back to the beginning of the year 2000 and the year 2008 and look at the decisions facing those retirees. Then we’ll look at how those portfolio decisions performed through the end of 2013.

For every retiree since 1996 the retirement decision matrix, SWR decisions vs stock allocation, has looked exactly the same. The table below shows what those choices are:

SWRs by allocation May 2014

Why have the historical SWRs not changed since 1996? Because, as I show in this post, the SWR is solely determined by the worst case retiree in history which happens to be the 1966 retiree. That 1966 was the worst case period was not know until that 30 year retirement period was over in 1996. Lets assume that the 2000 and the 2008 retiree chose an SWR of 4.39%. They then were faced with several investment portfolios offering different levels of diversification and risk management. They used data similar to what I presented in this post. I’ll use the various diversified IVY portfolios, their timing relatives, and the Permanent Portfolio. How have the 2000 and the 2008 retiree fared if they chose one of those portfolios? Here is the data.

Diviersified portfolios and the modern retiree

First, lets look at the year 2000 retiree, 14 years later. Everyone of these portfolio choices would have worked out just fine compared to the worst case 1966 retiree. In every case the more diversified portfolios did even better and the timing/trend following portfolios did even better. Only the the retiree that chose the standard 70% US stock, 30% US Bond portfolio, ended with less money than when they started with. Several of the portfolio choices would also have given the 2000 retiree the opportunity to adjust their withdrawal rates higher due to the great performance. Diversification works and it paid off in spades. All as expected.

Now, lets turn to the 2008 retiree. Hmm, notice something interesting here. For the last 6 years, diversification has basically failed to give a portfolio much benefit. The bull market in US stocks has been quite powerful. Only the two most aggressive portfolios, that combine timing and momentum (GTAA 3 and GTAA 6) beat the standard 70/30 portfolio substantially. What should we make of this? Time to abandon diversification all together? I hope you don’t think so. The last 6 years of US market out performance does not trump the long term historical data. Nor should it. If anything I think it suggests the diversified portfolios are set to outperform going forward. And so far, in 2014, that is proving itself out. But hey, that’s forecasting and who knows.

There is something more important here to take away. While it may be intellectually easy to say, stick with diversification, emotionally, while looking at your portfolio statements, it is a different story for most people. Any strategy you choose will have periods where it under performs other strategies. And those periods of under performance can be significant. This uncertainty can make taking the leap into retirement quite scary. How do you deal with this?

This is a concept called base rates which I’ve discussed in my quant strategy posts but the concept applies here as well. How best to deal with base rates less than 100%, i.e. that your portfolio choice will under perform for various periods often a lot longer than you feel comfortable with? The best way is not to go with one strategy all or nothing. A part of your retirement portfolio could be a standard 70/30 stock bond portfolio, another part could be more broadly diversified IVY B&H 13 for example, etc.. This way during any given period part of your portfolio is outperforming. This I think is the best way to deal with the emotional factors involved in retirement investing.

In summary, the 2000 and the 2008 retiree while both doing just fine with any of the various retirement portfolios discussed here have had quite a different experience. While for one diversification has been a boon, for the other it has been mostly a meh. This is quite the exhibit of the uncertainty in retirement. It is important I think to let the long term record speak for itself but at the same time choose a few of the strategies to make the emotional aspect of retirement investing easier to deal with and thereby increase the chances of success.


Revisiting the worst times to retire in history (2013 update)

May 12, 2014

Today I wanted to do another yearly update post. This time I’ll refresh the worst times to retire in history with data from 2013 which adds another year in the retirement story of the 5 ‘unluckiest’ retirees in history. See here for last year’s update.

As I said in last year’s update:

The worst time to retire since 1929 turns out not to be the Great Depression, as most people would believe. In fact, the worst time to retire in history was 1966, followed by 1965, then by the Great Depression year of 1929. The SWR (safe withdrawal rate) of 4.39% for a 70% stock 30% bond portfolio is solely determined by the retirement results of the 1966 retiree. Of course, we care about the present not the past. How are the year 2000 and the year 2008 retiree doing compared to those who retired during these worst of times? The table below (click for a larger image) shows the year by year progress for 5 retirees; the 1929 retiree, the 1965 retiree, the 1966 retiree, the 2000 retiree, and the year 2008 retiree. It uses a starting portfolio value of $1M, with a 70% stock 30% bond portfolio, which yielded a max SWR of 4.39%.

Here is the updated table with 2013 data.

Worst times to retire in history 2013 update CWR vs years

After 14 years, the year 2000 retiree is doing pretty well compared to history. It may not seem that way. The year 2000 retiree’s portfolio is down to $787K and the $61K yearly withdrawal is now 7.7% of the portfolio. CWR is defined here. But that is way better than the 1929, 1965, or 1966 retiree, all of whose portfolios survived a 30 year retirement. The year 2008 retiree is doing even better. After 6 years, despite the financial crisis, portfolio value is back to where it started and so is the current withdrawal rate. This is a much better situation than any of the other 4 example retirees.

In short, both our ‘unlucky’ modern retirees, 2000 and 2008, are doing just fine. With respect to history they are in a better position than the three worst retirement periods in history (1929, 1965, 1966). The 4% SWR rule looks to be just fine for yet another year.

P.S. I only discuss the worst retirement periods in history and the worst current periods, 2000 and 2008. This means that any other starting year in retirement has better results than that shown here. For example, the 2001 retiree would be better off than the 2000 retiree.


Higher Safe Withdrawal Rates from a 100% Bond Portfolio?

October 5, 2013

Is it possible to achieve higher safe withdrawal rates, compared to a stock/bond portfolio, from a 100% bond portfolio? With bond prices at historical highs? That’s what I wanted to find out. I started thinking in this direction after my look at bottoms up retirement planning and calculating what low real rates are actually needed to achieve retirement success. This is mainly because what really kills SWRs in risky portfolios is negative withdrawals early in retirement and inflation as I discussed in my ‘Insist on 1966′ post. So I thought it would be useful to look at what the lowest risk retirement model is and what are the SWRs (safe withdrawal rates) from such a model. Then we can compare all other models, using riskier assets, to this minimum risk model and decide on the tradeoffs. The results are rather surprising.

I’ve always been somewhat surprised just how low the recommended SWRs are. The 4% SWR rule for a 30 year retirement that has proven to work historically for even the worst retirement periods has a worst case 30 yr period return of about 7%. That’s a 4% withdrawal rate from 7% returns! Pretty low when you think about it. Basically, because of negative returns, particularly early in retirement, what they call sequence of return risk, SWRs are much lower than the worst case portfolio returns. But it gets even more interesting. Lets look at what the SWR would be for a portfolio if you could get guaranteed 0% real return. Then lets compare those  ‘ideal’ SWRs to those from risky portfolios. In the table below I show such a comparison. BTW, the 0% real return SWRs are simply 1/retirement period.

Zero risk retirement model vs sotck bonds models oct 2013

The two highlighted SWRs are the most commonly recommended asset allocations in retirement; 60/40 stock bond allocations or 70/30 stock bond allocations for a 30 year retirement period. As the table shows you don’t get much of a benefit in SWR from risky portfolios until you go beyond a 25 year retirement period. At the same time I think it would be surprising to many investors that you could have an SWR of 3.33% for a 30 yr retirement period with a 0% real return. At this point you should be asking, ‘great, but where in the world can you get a guaranteed 0% real return?”. Turns out we can get pretty darn close with a laddered bond portfolio of US Inflation Protected Bonds (TIPS). TIPS offer a guaranteed return of principal and inflation protection of that principal which takes the two biggest retirement risks off the table from the start.  And beyond zero real returns, so far over their history, US TIPS have offered positive real returns over the entire term structure. The next thing to I tool a look at is what SWRs are achievable with a portfolio of US TIPS at today’s prices?

To calculate the SWRs for a laddered portfolio of bonds, in this case US TIPS, takes a little doing. I started with prices and data on the available US TIPS from the WSJ quote page. I used prices at the end of day on Sept 23, 2013. Download those into an excel spreadsheet and build a model for various time periods with a target of having equal payouts for each year of retirement, basically keeping real standard of living the same, just like the traditional SWR models. Fortunately, you can use the solver function in excel to do the hard work for you. The results are shown in the table below and you can access my spreadsheet here and play with the model for yourself.

SWRS for 100% TIPS priced as of Sep 23 2013

So, for retirement periods of 20, 25, and 30 years, you get higher SWRs from a 100% US TIPS portfolio than from a 60/40 stock bond portfolio! Let that sink in for a minute. And that is with the  historically low real rates offered today. This again shows just how detrimental negative returns are for retirement portfolios and is what keeps SWRs for risky portfolios so low. And if you, like many others, think future returns and SWRs will be lower than the past then these numbers should be even more compelling. At the minimum these super safe SWRs should be used as a benchmark when considering riskier asset allocations.

What about the downsides? Of course there are always downsides or drawbacks to any approach. For me, the biggest one of a 100% US TIPS portfolio is that there not as much upside as there is with a risky portfolio. If you hold the bonds to maturity the indicated SWR is all you get. No adjusting SWRs higher if markets perform well. If real rates only go higher from here the bonds also need to be held to maturity in order to protect principal. On the other hand, if/when markets experience another major/correction crash, real rates will undoubtedly go much lower, the TIPS could be sold with nice capital gains, and you could then implement a risky 60/40 portfolio at much lower valuations. So there is the potential for some upside. The other downsides are that the portfolio is a bit harder to implement that just buying ETFs for stocks and bonds, and TIPS do bring up some tax complications for investors. None of these are insurmountable and if people are interested I can provide some more info in the comments to this post.

In exchange for potentially less upside in total wealth you get, most importantly, a much higher probability that your portfolio will last throughout your retirement period. No worrying about stock market fluctuations and the like. In other words, greater piece of mind. Of course, it doesn’t have to be all or nothing. A TIPS portfolio such as this can be used as a base for a retirement portfolio and combined with risk assets (mainly stocks), to provide upside for the investor. Or you could even add other bonds to the TIPS ladder for some bond upside. For the investor who wants to take even more risk off the table a TIPS portfolio can be combined with a deferred income annuity to take longevity risk complete off the table.

In short, its very possible to build a retirement portfolio out of 100% US TIPS that has higher safe withdrawal rates than those provided by riskier portfolios. This can be a great option for conservative retirees or those who do not want to take any stock market risk.

Big upside from flexible spending in retirement

September 26, 2013

Back in 2010 I posted on an alternative retirement withdrawal approach that allows for higher safe withdrawal rates (SWR). Back then I didn’t have a detailed model of this approach to provide much more insight. Now I do. Its very worthwhile revisiting this strategy and discuss the great benefits it can have to retirement plans. This alternative approach relies on having some flexibility, on the downside, in retirement spending. Lets take a look in detail on how this works, its benefits, and how you can apply it to your retirement plans.

This alternative withdrawal method is called the floor-ceiling model (FCM) and it was pioneered by William Bengen, the man behind the concept of SWR in the first place. Basically, the method calls for spending a fixed percentage of your portfolio each year subject to certain limits. Applying a fixed percentage to each year’s portfolio value can and will cause dramatic fluctuations in spending. That’s where the limits come in. This is quite different from the traditional SWR strategy where your SWR percentage is applied once at the beginning of your retirement and all subsequent withdrawals are simply adjusted for inflation. The FCM method just applies a limit to how much of a decrease you are willing to endure to real spending in any given year. As it turns out there is no need for an upper limit. Having this flexibility to adjust spending during bad years increases the SWRs. The chart below is from my original post.

FCM SWRs Sept 2013

As you can see from the table, having downside flexibility in spending allows higher SWRs while also providing upside spending possibilities in years where the portfolio does well. In Bengen’s original model in addition to the FCM method he added alternative assets classes, e.g. small cap stocks, in calculating his SWRs. I wanted to recreate his approach but isolate the impact of purely applying the FCM method to the traditional portfolio allocations of the SP500 and 10yr government bonds for various allocations to stocks and bonds. The table below shows the SWRs for various asset allocations for the traditional SWR method.

SWRs for traditional SWR method sept 2013

And here are the SWRs for the various asset allocations for the FCM method with a -10% limit to inflation adjusted spending.

SWRs for FCM SWR method sept 2013

As the tables above show the FCM method allows approximately 10% higher SWRs in retirement. The downside being that on average you end up with less wealth after the 30 year retirement period. I think most retirees would trade a guaranteed 10% per year higher spending rate for the possibility of higher end wealth. I would. But that’s not all. To see the true impact of the FCM method vs the traditional SWR model lets look at the detailed spending by year for the worst case and the best case retiree in the historical record. The table below compares the tradition versus the FCM method for the 1966 retiree (the worst case) and the 1975 retiree (the best case) for a 70% stock, 30% bond allocation. For the FCM method I highlighted years in which spending decreased from the previous year.

SWR traditional vs FCM for 1966 and 1975 retirees sept 2013

For the worst case retiree, 1966, the higher FCM SWR of 4.84% came at a small cost. In two years spending would have gone down and overall total dollars withdrawn over the 30 years would have been slightly less. $3.37M vs $3.38M. For the best case retiree, the FCM not only had a higher SWR of 4.84% but provided huge upside in spending $422K of spending in year 30 vs $163K in spending for the traditional method. In addition total lifetime spending was 2.5 times higher with the FCM method. The downside was more volatility to that spending as you can see from the highlighted cells. A worthy trade off? I think so.

In short, allowing for some flexibility in spending into your retirement model can have some huge benefits with little downside.

Safe Withdrawal Rates – insist on 1966

September 9, 2013

Today I want to touch on a little understood aspect of safe withdrawal rates (SWRs) in retirement. Using the historical method to determine SWRs (as opposed to Monte Carlo analysis) means that the maximum SWR (approx 4%) is singularly determined by one 30 year period, the 30 year retirement period for the 1966 retiree. The 1929 Great Depression retiree had it better than the 1966 retiree did. By looking at the details of the 1966 retiree’s situation we can gain some insight into implications for the more modern retirees and use it as a benchmark for more modern portfolio allocations.

What was so bad about the 30 year retirement period starting in 1966 is that it was the worst time in history to retire and solely defines the SWR for a 60/40 stock bond portfolio consisting of the SP500 and US 10 yr Government bonds (basically the benchmark retirement portfolio). At first glance the 1966 retiree did pretty well. The 30 yr return for a 60/40 portfolio starting in 1966 was 9.67% per year. Stocks returned 10.62% per year during this period and bonds returned 7.61% per year. These numbers often are used to scare modern retirees. You’ve seen the stories – future returns will not be what they were in the past due to current valuations and low yields and thus the 4% rule is dead. As I’ve written about before, maybe. But there is more insight here under the surface. What matters more in determining SWRs are real returns, inflation, and the sequence of returns. Lets look at each of these for the 1966 retiree.

The 9.67% annual return for the 60/40 portfolio starting in 1966 becomes a 4.46% real return after inflation, 5.41% for stocks and 2.39% for bonds. Now we’re starting to get a glimpse of the problem for the 1966 retiree. Low real returns due to high inflation. And inflation has a dual impact. Not only does it eat into returns but it also increases withdrawal rates to keep the standard of living constant. Inflation for the 30 year period for the the 1966 retiree was 5.21% per year, one of the highest on record. The final nail in the coffin for the 1966 retiree was the sequence of returns. It turns out that successful SWRs are more correlated with the initial 15 yr return for a retiree than for the full 30 year period return. Low or even negative returns early in retirement are the worst thing that can happen during your retirement. If we look at the first 15 years of the 1966 retiree’s returns the picture becomes much clearer. For the first 15 years, the 60/40 portfolio had a real return of 5.74% nominal but -0.18% per year after inflation. Stocks returned 0.8% per year during this period and bonds returned -2.60% per year. And to round it out inflation averaged 5.92% during this 15 year period. Brutal is all I can say. Take a look at the 1966 retiree’s portfolio value, withdrawals, and current withdrawal rates (CWR) during his/her 30 years.

1966 retiree portfolio


And yet, despite the poor real returns, high inflation, and a terrible sequence of returns, the 4% rule worked. Which I think shows the robustness of the 4% rule. In order for the 4% SWR to fail in the future the situation needs to be worse than it was for the 1966 retiree; poor real returns, high inflation, and really bad early years. At the same time we have more tools and knowledge available to the investor today to combat such a possibility. For example, broader more diverse asset classes, alternative withdrawal strategies, and/or portfolio strategies that mitigate downside risk. All can be used to increase the likelihood of the future success of the 4% SWR.

Finally, another important insight here is that when looking at some of the modern portfolio allocation strategies like the IVY portfolio we need to take the results with a grain of salt. Most of the modern portfolios only have data going back to 1973. Well, if you only look at data from 1973 onwards you’ll miss the worst case period in history for retirement. For example, if you look at the SWRs for the various portfolios I track you’ll see SWRs way higher than 4%. But since the data for those portfolios doesn’t encompass 1966 they need to be adjusted downwards as I mentioned in the post.

In short, when thinking about future SWRs or looking at alternative asset allocation models or portfolio strategies as applied to retirement make sure you insist on 1966.

P.S. All the data in this post is from my own calculations using historical returns for the SP500, the US 10 year government bond, and US Inflation using CPI.

The benefits of delaying social security

August 21, 2013

Everyone knows that delaying the starting age of social security increases your benefits. Its right there in your social security statement. But most people don’t know how big an impact delaying social security can have when looked at in terms of investment returns. If retirees knew how big an impact delaying social security can make they might make different decisions.

I’ll use my situation as an example. I’ve found that the percentage changes are approximately the same for everyone I’ve looked at, mainly family members. The table below shows the difference in my and my wife’s social security benefits at the age of 62, 67 (our full retirement age), and 70 years old. I’ve adjusted the benefits to $1 for privacy reasons – the percentage change is what matters here. These numbers we calculated from our actual social security benefit statements. Benefit statements are accessible on-line now.

Social Security Delay Benefits Aug 2013

If we take social security at the first chance we get, 62, we each get $1 in benefits. If we wait until our full retirement age of 67 the $1 in benefits increases to $1.42, and increase of 42%. If we wait an additional three years to age 70, the age of maximum benefits, the $1.42 in benefits becomes $1.76, and increase of 24%. If you look at delaying social security as a type of investment those incremental benefits are your return for waiting. Translated into annual returns your looking at returns of about 7.3% for every year you wait. Even more important, those returns are real returns, i.e. after inflation. And guaranteed. Where can you get 7.3% real returns at that level of safety anywhere?

Such good returns from delaying social security could potentially lead to some big decisions as one nears retirement age. For example, this means you would be better off financially drawing down your savings/investments just to delay taking social security. You’d have to be pretty darn sure your investments could beat a 7.3% real return every year in order to justify taking social security early. Run the numbers with your own benefits and see what they say.

Of course, its not all about money. Many can’t afford to wait. For some, the social security benefits at 62 when combined with pensions are enough to live the retired life they want so working more years is not either necessary or worth it. For others, like my parents, it was more emotional. They had the financial wherewithal to retire without taking social security, live off their savings, and delay taking social security in order to increase their benefits. But they couldn’t do it. They couldn’t trade something tangible, their savings, for the promise (even though quite secure) of higher income later. Economists would probably call this a liquidity premium. For most it’s probably the ‘bird in the hand is better than two in the bush’ school of experience theory. Who said finance was all rational.

In short, delaying social security may be one of the best investments you can make. But it needs to be right for your situation. Personally, I plan on delaying to the max of age 70. But I’m 45, Ask me again in 20 years.

P.S. Maybe part of the irrationality regarding social security is fear over its future. It ain’t going anywhere and its actually an easy problem to fix. Even in the worst case, do nothing scenario young people today would be looking at receiving over 3/4s of their promised benefits. See this post for a great explanation of the current state of social security.


Bottoms up retirement planning

July 29, 2013

Sometimes it pays to go back to basics. With retirement planning it’s no different. The common, top down approach with retirement planning starts with total net worth and then uses a safe withdrawal rate (SWR), most commonly 4%, to figure out how much one can spend per year in retirement adjusted for inflation. See this series of posts if you’re new to this topic. But starting from the bottom, looking at spending first, can add a lot of insight into what investment returns a retiree needs during retirement and allows for the planning of various scenarios. In this post I’ll take you through a simple process that I use to think about various retirement scenarios and what impact those scenarios have on investment returns.

First thing to do is to come up with a simple starting retirement model. For this exercise I’m assuming a 62 year old couple, just retired, with a basic spending requirement of approximately $4K/month, or $48K per year. The couple has $1M in total assets. They also would like to delay taking social security until age 70 to maximize their payouts. At age 70 they would start receiving a total of $2K/month or $24K per year.

To make this basic scenario more flexible and realistic, to the base spending of $48K per year I add a 10% buffer for unforeseen circumstances and factor in a 15% average tax. With these two additions now we’re looking at withdrawing $62.75K per year from the portfolio. If using a 4% SWR from a tops down approach the $62.75K would be way too much. But it may not be necessary to give up on their retirement plans. In 8 years the couple starts receiving $2K/month from social security which needs to be taken into account. In order to do this we need to do a basic spending projection over time. This also allows for other changes in spending later in life. In fact research shows that spending for retirees decreases significantly as they get older.

The data are striking, suggesting that those in the later half of retirement (age 75+ by the BLS data) spend an average of almost 30% less than early retirees (those aged 65-74). In fact, Bernicke shows that this gap has been remarkably persistent over time; the difference is almost the same (on a relative basis) whether you look at the data from 2004, or 1984. The BLS data – along with data from the Health and Retirement Study conducted by the National Institute on Aging that show a smaller but similar decline – have also been widely examined in analysis by the Bogleheads community.

This changing income and spending over time is not part of a tops down model and yet can change the retirement equation entirely. So lets take the basic model and incorporate social security income starting at age 70 and two possible scenarios starting at age 85, no spending reduction and a 20% spending reduction. We’ll take the yearly spending forecasts and come up with an range of investment returns required to make the portfolio last for different longevity periods. I know, it sounds complicated in words but its just a simple excel spreadsheet. To make these models easier to understand I use constant dollars, ignoring inflation for the time being. Below is an example model for a life expectancy of 85.

bottoms up lifetime spending forecast july 2013

For a life expectancy of 85, $62.5K per year spending until age 85, $24K in social security income starting at age 70, and a $1M portfolio these retirees need real investment returns of 1.31% per year. We can then run through various scenarios and come up with a range of real investment returns needed to achieve those various goals. In the table below I modeled I show some results.

bottoms up range of investment returns required july 2013

For those interested I have out the basic spreadsheet model online at Google docs. (see here). I’m pretty sure some of you will add to it and make it better than mine.

The range of annual real returns required varies from 1.31% per year for an life expectancy of 85 to 3.79% per year for a life expectancy of 100 with no spending reduction at age 85. I think this approach gives the retirees a lot more information and confidence than just using a top down 4% SWR and not taking into account potential future spending changes. Armed with this information a retiree can now look at what the investment environment is offering. Once you build this basic model you can run through all kinds of possible life scenarios and think about your plans if those scenarios happen.

On the investment side, lets say this particular couple is very risk averse. A good first place to look for a conservative investment is what 30 year inflation protected bonds are paying. As of this Friday, the 30 year TIP was yielding 1.39%. That is a real yield. In a very risk averse scenario this couple could fund their retirement with 30 year TIPs. On the other end of the spectrum, in the most aggressive retirement scenario this couple could easily fund their retirement plans with a conservative portfolio of dividend stocks yielding 3.79% or higher, achievable even in today’s environment. The point is this range of required real returns allows more flexibility in investment choices, especially considering risk tolerance, than using a tops down SWR model. I’ll come back to the topic of real investment returns in future posts – there is a lot that can be learned from them.

On a personal note, in my plans I have always have a back door, escape scenario. In this scenario, the plan would be for the portfolio to completely run out by age 62, 17 years away for me, when my wife and I would begin living on our social security only. In order to make this work more easily the plan involves moving overseas in order to cut living expenses. Most likely we would move to Southeast Asia, possibly Thailand, where we could live on our social security and still maintain a very nice lifestyle. Maybe even Argentina so my wife, Nina, could finally learn Spanish. We’ve done this type of thing before for several months at a time and its highly do-able. For us having this plan gives us a huge sense of comfort, peace of mind, and freedom.

In summary, some simple bottoms up retirement scenario planning is easy to do and can give you some valuable insight. Most importantly it allows you to plan future changes in your retirement spending and income. It also allows you to figure out what investment returns you need to fund your retirement goals instead of taking for a given what the historical market portfolio has allowed in withdrawals. You may not need as much as you think.

P.S. In a future post I’ll address two real common fear mongering topics – the death of social security and runaway inflation.

The 4% rule lives despite what the NY Times says

May 18, 2013

OK, deep breaths, deep breaths….The drivel the passes for reporting on retirement issues never ceases to amaze me. But this time I found a real howler. The “paper of record”, the venerable NY Times, recently published a piece on the 4% safe withdrawal rule, titled “4% Rule for Retirement Withdrawals Is Golden No More”, that is truly a piece of garbage. I can only hope that it wasn’t really read that much but I cringe at the potential fear caused among many older Americans. I’m going to quote extensively from the piece here to shed light on this whole flawed concept of the 4% rule no longer being valid.

Ok, lets get to it. The premise of the article is that the 4% withdrawal rule in retirement is no longer valid. Due to the widely accepted premise that future returns will be low due to high stock prices and low bond yields retirees can no longer rely on the 4% rule. The first piece of data we get is in the second paragraph;

That percentage was calculated at a time when portfolios were earning about 8 percent. Not so anymore. Today portfolios generally earn much less, about 3.5 percent to 4 percent, and stocks are high-priced, which is linked historically to below-average future performance. Many financial advisers are rejecting the 4 percent rule as out of touch with present realities.

What portfolios earn 3.5% to 4% today? I wanted to give the author the benefit of the doubt so I had to really search for such portfolios. Going with the traditional 60% stocks, 40% bonds portfolio referenced elsewhere in the article and going back to the beginning of the year 2000 you get a compound annual return for the portfolio of 3.16%. Wow, scary right? But that’s the worst I could find. All other periods since 2000 are higher. And if you held a more broadly diversified portfolio like the IVY buy and hold portfolio or the Permanent portfolio your returns over this period would have been 6.5% and 7.9% respectively. Seems like poor returns are more a problem of asset allocation than a poor general return environment. Also, the highest safe withdrawal rates even using only US stocks and gov’t bonds comes from a 70% stock 30% bond allocation, not 60/40. If only we could get some good financial advice….but I digress.

Next, compound returns are only one component of successful retirement withdrawal rates. Inflation, volatility, and the sequence of returns are just as important. For example, lower compound returns at lower volatility lead to higher safe withdrawal rates (see here). A better question is how is the poor year 2000 retiree, who suffered 2 market crashes, doing using the 4% rule doing compared to history? Turns out that he/she is just fine and doing better than the worst times to retire in history. As I discuss in this post, the 4% rule is doing just fine for the year 2000 retiree, better than the worst times in history to retire – 1966, 1965, 1929, and 1973. And the 4% rule worked during those times as well.

But maybe the future will turn out to be different. That’s what some experts say.

Michael Finke, a professor in the department of personal financial planning at Texas Tech University in Lubbock, is a co-author of a paper critical of the rule, “The 4 Percent Rule Is Not Safe in a Low-Yield World.” He says Mr. Bengen’s rule doesn’t acknowledge the new economic reality of prolonged low returns. “There haven’t been any historical periods that look like today,” Mr. Finke said. “We’ve never had an extended period where rates of returns on bonds have been so low and valuation on stocks so high.”

Is this correct? Maybe but lets check the historical record first. The worst time to retire in history was 1966. What were stock prices, bond yields, and inflation back then? In 1966 stock valuations were similar to where they are today, based on the Shiller PE, the 10 year bond yielded 4.8%, and inflation was 2%. In 1929 stock valuations were much higher than today, the 10 yr note yielded 3.4%, and inflation was practically zero. History says we’ve had higher stock valuations before but that real bond yields today are lower than at these two times in history. Lower real bond yields could possibly lower safe withdrawal rates going forward but the data is not conclusive. In the 1929 and 1966 periods bonds went on to suffer massive bear markets in real terms with inflation peaking at 18% in 1947 and 12.2% in 1980. Imagine inflation adjusting your retirement withdrawals back then. Still, what if we have zero real yields going forwards as far as the eye can see? I went back to the historical data and forced real bond yields to zero and re-ran the safe withdrawal rate analysis. Guess what? Yes the SWR went down but  from 4.39% to 4% for a 70% stock 30% bond allocation. Still safe. What studies suggesting that the 4% rule is not safe anymore rely on is a combination of lower stock returns AND low bond returns AND higher inflation. I’m sorry but you’re cooking the books. You’re taking a forecast of low future returns for stocks and bonds and forcing it into a model.  I’d rather rely on history without much flawed human forecasting. By the way, the 100% safe withdrawal rate for a 30 year period that comes out of the study linked above is 1.8%! You could even easily construct a 100% bond portfolio to destroy that.

The next 3 paragraphs in the article are pure drivel.”Strict application of the rule also does not factor in how important returns are in the early years of retirement, something known as the sequence of returns.” Uh, yes it does. That’s how safe withdrawal rates are calculated. Next, we get “High inflation early in retirement can have a similar impact, especially if earnings are also low. Taking out more money just to keep up with the rising cost of living will accelerate the depletion of savings, Mr. Finke said” Duh. Again, safe withdrawal rates take this into account by adjusting withdrawals for inflation. Like some old commercial used to say…its in there! Next, “Many advisers recommend maximizing earnings by moving away from the 60 /40 portfolio allocation on which the 4 percent rule is based, says Jay Wertz, director of wealth advisory services at Johnson Investment Counsel Wait we may actually get some advice here…..nope, sorry, see link so you can pay fees.

Now comes the worst part of the article. “Retirees wanting more certainty in the future might consider investing in a deferred income annuity”…..”The annual income usually ranges from 5 to 6 percent of the amount paid for the annuity…” OK, wait. We are supposedly living in this new low return world right? How are the supposed professional investment managers at insurance companies supposed to generate 5-6% payouts in a world of low returns that you just told me I can’t even safely withdraw 4% from. These people buy the same asset classes at the same prices that we do. In a low yield world annuities tend to be a raw deal. Not to mention the fees, and the risk you take on by going with an insurance company. That’s the advice we get, buy annuities? Stunning is all I can say.

Finally, at the end of the article we get some common sense from the founder of the 4% rule, “Mr. Bengen still feels his rule is a good benchmark, but advises clients to spend more conservatively. When he first came up with the 4 percent rule, “people said, ‘How can anyone live on so little?’ Now they are saying it’s too high. I think it’s a lot to ask people who have saved their whole lives to live on 3 percent.” Exactly. After all this drivel your best advice for retirees is sorry you need to live on 3% or less, you better keep working. No other solutions to be offered? Better asset allocation models which maybe give you exposure to market beating assets like value and small cap stocks or lower valued equities like international or dividend payers? How about strategies to reduce volatility like the IVY timing model? How about starting with 4% but having an early warning indicator to tell us if/when we’re in trouble? Nothing. Just live on less and maybe buy an annuity.

In summary, the demise of the 4% rule is greatly exaggerated. It hasn’t failed yet. Even that year 2000 retiree is doing just fine. But yes the future is uncertain, there are no guarantees. The 4% rule may fail in the future. But before we go telling soon to be retirees or worse current retirees, sorry, your only option is to spend less or keep on working to save more, many other options should be considered. When other options are considered, like better asset allocations, volatility/drawdown reduction strategies, early warning indicators, and smarter withdrawal methods retirees can still enjoy 4% and even higher withdrawal rates. Articles like the NYT piece don’t help at all.



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