As a percentage of retirement date assets, what is the highest amount you can withdraw, while adjusting this amount for inflation in subsequent years, without running out of funds for a sufficiently long period of time?
This is a question plaguing retirees and near-retirees as lifespans and retirements lengthen, and as traditional defined-benefit pensions are falling by the wayside. Since William Bengen’s seminal investigation of the US historical data in his 1994 Journal of Financial Planning article, answers have tended to center around 4%, with perhaps 4-5% being a comfortable range for many retirees and planners.
For retirement planning research, I paid my dues by looking at three different methods (international data comparisons, speed of wealth depletion in the years since retirement, and impact of market valuation and yield measures at the retirement date) which each question whether recent retirees can still consider 4% to be safe over a 30-year horizon despite its historical success for retirements beginning up to 1980.
The question of safe withdrawal rates certainly does matter. My title is overly provocative. A 2011 Financial Planning Association survey described by Jonathan Guyton indicates that 75% of surveyed financial planners either always or frequently use systematic withdrawals with their clients. For them, the safe withdrawal rate is relevant. But my point is that safe withdrawal rates may be less important than I earlier thought.
That’s because for a lot of people involved in the retirement income debate, even when using a well-diversified portfolio of stocks and bonds (which is the recommendation in the safe withdrawal rate literature), the only safe withdrawal rate is 0%. We are deluding ourselves to think otherwise.
An alternative approach to retirement income planning that is gaining traction is the “guaranteed floor / upside potential” approach. With this approach, you first build a floor of very low-risk guaranteed income sources to serve your basic spending needs in retirement. The guaranteed income floor is built with Social Security and any other defined-benefit pensions, and through the use of your financial assets to do things such as building a ladder of TIPS or purchasing single-premium immediate annuities (SPIAs). GLWBs could also play a role here. Not all of these income sources are inflation adjusted, and you do need to make sure your floor is sufficiently protected from inflation, but this is the basic idea.
According to the Retirement Income Industry Association (disclosure: I am on their Academic Advisory Board), a fundamental goal of retirement planning is to “first build a floor, then expose to upside.” This is also the approach Moshe Milevsky has in mind when he recommends that you “pensionize your nest egg” and it is the way that Zvi Bodie suggests you can “risk less and prosper” in retirement.
Once you have a sufficient floor in place, you can focus on upside potential. With any remaining assets, you can invest and spend as you wish. Since this extra spending (such as for nice restaurants, extra vacations, etc.) is discretionary, it won’t be the end of the world if you must stop spending at some point. You still have your guaranteed income floor in place to meet your basic needs no matter what happens. With this sort of approach, withdrawal rates hardly matter. (Another note from the Jonathan Guyton article linked above: he suggests that retirees may not be as blasé as I’ve just made it appear about their abilities to fund even their ‘discretionary’ expenses).
“Safe withdrawal rates” and “guaranteed floor / upside potential” are really two competing approaches to retirement income planning. How can we reconcile them?
I think they can be reconciled by broadening some aspects of safe withdrawal rate studies. First, these studies ask the question about how much can be withdrawn over time from a risky portfolio, and so they do not directly incorporate other income sources such as Social Security, annuities, or pensions. Second, these studies focus on the probability of failure (also called shortfall risk, it is the probability of running out of wealth while still alive), without giving consideration about what is lost in terms of life satisfaction by using a lower withdrawal rate and spending less. The fact that with low withdrawal rates, people will typically leave behind a large pot of wealth (unless their retirement matches the worst-case scenario) is not something included in the analysis.
I have been part of a research effort with Michael Finke and Duncan Williams of Texas Tech University to incorporate the sustainable spending “safe withdrawal rate” framework into the “guaranteed floor / upside potential” framework. We look at safe withdrawal rates after adding other income sources from outside the retirement portfolio (such as Social Security and pensions). We also leave behind the safe withdrawal rate objective of worrying only about a low failure rate (low shortfall risk), and instead try to balance the competing tradeoffs between wanting to spend and enjoy more while one is still alive and healthy, against not wanting to run out of portfolio wealth while still alive (the guaranteed floor will always be in place though). We find that someone with flexibility about how much they can spend and with more outside sources of income may be willing to accept rather high failure rates as a part of balancing these competing tradeoffs.* Life is indeed a balancing act. Our study, “Spending Flexibility and Safe Withdrawal Rates,” can be downloaded now as a working paper, and it has been accepted for publication in an upcoming issue of Journal of Financial Planning.
Moshe Milevsky and Huaxiong Huong earlier produced a related work, and what we think of as “spending flexibility,” they call “longevity risk aversion.” Joseph Tomlinson will also have a paper exploring these sorts of concepts in an upcoming issue of Journal of Financial Planning.
I do have an article on safe withdrawal rates in the current January issue of Journal of Financial Planning. I generalize the framework for safe withdrawal rates to include any assets or assumptions, and it think it can really serve as a final word from me about traditional safe withdrawal rate studies (except, I still want to look at variable withdrawal rates).
But the next generation of studies with a more comprehensive view toward withdrawal rates and retirement income is already on the way.
* This finding puts me in the rather odd position of having first recommended rather low withdrawal rates in earlier research, but now suggesting that much higher withdrawal rates (and chances for failure) may be acceptable in certain circumstances. If you are confused about this, Doug Nordman wrote a nice summary of these two competing viewpoints called, “Is the 4% withdrawal rate really safe?”
Update: just to clarify, when I talk about "safe withdrawal rates," I refer to the classical approach to safe withdrawal rates using a diversified portfolio of stocks and bonds. William Bengen and the Trinity study suggest stock allocations in the neighborhood of 50-75%. So it's a matter of how much can be safely withdrawn from a volatile portfolio. The "floor/upside" approach rejects this sort of view about the matter: volatile portfolios are inherently not safe.
I got this plan in place by moving my portfolio assets slowly and methodically over a few years
