Note: This article is part of Morningstar's January 2016
5-Step Retirement Portfolio Assessment Week special report. An earlier
version of this article appeared on Jan. 25, 2015.
How
much can you spend in retirement without outliving your money? It's one
of the most fundamental questions confronting anyone who's retired--or
getting ready to.
But it's a head-scratcher for many, according to
a survey from the American College of Financial Services. Seven in 10
individuals between the ages of 60 and 75 with at least $100,000 said
they were unfamiliar with the oft-cited 4% withdrawal-rate guideline.
Meanwhile, 16% of survey respondents pegged 6% to 8% as a safe
withdrawal rate.
That's a problem. Because setting a sustainable
withdrawal rate--or spending rate, as I prefer--is such an important
part of retirement planning, pre-retirees and retirees who need guidance
should seek the help of a financial advisor for this part of the
planning process.
And at a bare minimum, anyone embarking on
retirement should understand the basics of spending rates: how to
calculate them, how to make sure their spending passes the sniff test of
sustainability given their time horizon and asset allocation, and why
it can be valuable to adjust spending rates over time.
How to Calculate ItTo
determine your own spending rate, simply tally up your expenses--either
real or projected--in a given year. Subtract from that amount any
nonportfolio income that you're receiving in retirement: Social
Security, pension, rental, or annuity income, to name a few key
examples. The amount that you're left over with is the amount of income
you'll need to draw from your portfolio. Divide that dollar amount by
your total portfolio value to arrive at your spending rate.
Say,
for example, a retiree has $60,000 in annual income needs, $28,000 of
which is coming from Social Security and the remainder of
which--$32,000--she will need to draw from her portfolio. If she has an
$800,000 portfolio, her $32,000 annual portfolio spending is precisely
4%. But if she needs to draw $50,000 from her portfolio, her spending
rate is 6.25%.
The 4% Rule, UnpackedThe
notion that 4% is generally a safe withdrawal rate was originally
advanced by financial planner William Bengen; it has subsequently been
refined--but generally corroborated--by several academic studies,
including the so-called Trinity study. Before retirees take the 4%
guideline and run with it, however, it's important to understand the
assumptions that underpinned it.
First, the research assumed that
retirees would wish to maintain a consistent standard of living, drawing
a steady stream of income--in dollars and cents--from their portfolios
each year. Thus, the 4% guideline assumes that the retiree spends 4% of
his or her initial balance in year one of retirement, then subsequently
nudges the amount up in subsequent years to keep pace with inflation. He
or she doesn't take 4% of the balance year in and year out, though
that's a viable spending-rate method, too (more on this in a moment).
Additionally,
the 4% guideline assumes a 60% equity/40% bond asset allocation and a
30-year time horizon, and that the 4%, whether it comes from income and
dividend distributions or from selling securities, is the total
withdrawal. Thus, a retiree whose portfolio was generating 4% in income
distributions couldn't take an additional 4% from her principal. This
article discusses the 4% guideline research in greater detail.
The
basic idea behind Bengen's research was to stress-test a number of
different withdrawal rates over various 30-year time periods in market
history. What was the most a retiree could take out, in even the worst
30-year market period, and still avoid running out of money? Bengen
arrived at 4% (with assumed inflation adjustments) by homing in on the
worst 30-year period, but it's worth noting that many other 30-year
periods would have supported a higher spending rate than 4%. The reason
that 4% (and not a higher number) is considered "safe" or "sustainable"
is that a retiree doesn't know what type of environment she'll retire
into, so it's best to assume a worst-case scenario.
Swing FactorsBecause
not every retiree's profile matches the assumptions Bengen used in his
research, not every retiree should take the 4% guideline and run with
it. Indeed, much of the recent research on spending rates has suggested
that rather than take 4% of a portfolio per year and simply
inflation-adjust that dollar value, retirees should be prepared to
adjust their spending rates up or down based on the following factors.
Time
Horizon: Retirees with time horizons that are longer than 30 years
should plan to take well less than 4% of their portfolios in year one of
retirement. On the flip side, older retirees--those 75 or older, for
example--might consider taking a higher withdrawal rate. David
Blanchett, head of retirement research for Morningstar Investment
Management, has suggested that retirees consider their life expectancies
when determining their spending rates. The life-expectancy factors used
to calculate required minimum distributions from IRAs and company
retirement plans could be helpful in doing so, as Blanchett discussed in
this video.
Asset Allocation: A retiree's asset allocation should
also be in the mix when calibrating sustainable spending rates. The 4%
guideline, as noted above, is centered around a 60% equity/40% bond mix.
But investors who want to employ a portfolio that includes more bonds
and cash should be more conservative in their spending rates, as
Blanchett discussed in this video. The reason is that bond yields have
historically been a reasonable predictor of bond performance in
subsequent years, and bond payouts are ultralow right now. Thus, the
bond-heavy investor can expect less help from the market in the years
ahead.
Market Performance: The bear market of 2008 illustrated
so-called sequencing risk (or sequence-of-return [SOR] risk): Retirees
greatly reduce their portfolio's sustainability potential when they
encounter a lousy market early on in their retirements and don't take
steps to reduce their spending. That's because if they overspend during
those lean years, they leave less of their portfolios in place to
recover when the market does. Sequence-of-return risk can be mitigated,
at least in part, by having enough liquid assets to spend from early on
in retirement so that the more-volatile assets that have slumped
(usually stocks) can recover.
The Right Spending Strategy for YouBecause
sequencing risk poses such a threat, much of the recent research on
sustainable withdrawal rates supports the idea of tying in withdrawal
rates with portfolio performance. The retiree takes less out in
down-market years and can potentially take more out in years when the
market performs well, such as in 2013.
The purest way to tie in
spending with portfolio performance is simply to take a fixed percentage
of that portfolio--say, 4%--year in and year out. Under this method,
the retiree could take $32,000 from her portfolio when its value is
$800,000, but would be forced to live on $24,000 if her portfolio
dropped to $600,000 in value. Using the fixed-percentage method, the
retiree would never run out of money, but she might not be able to make
do on the smaller amount.
For retirees who aren't comfortable with
such dramatic fluctuations in their standard of living, it's possible
to employ a hybrid approach: tying in spending with market movements
while also ensuring a basic standard of living. One such strategy,
discussed here, blends fixed-percentage withdrawals with a ceiling and
floor. A simpler strategy, advanced by T. Rowe Price, allows the retiree
to spend a fixed dollar amount, adjusted upward for inflation, as in
the 4% guideline. But the retiree simply forgoes the inflation
adjustment in lean-market years. T. Rowe's research found that even this
simple step helped improve portfolios' sustainability.
Culled from morningstar
