When is it safe to tell clients that they can retire?
History can be dangerous for retirement planners
offering portfolio longevity advice. Even when they're right about the
long term, they can be very wrong in the short term, with disastrous
consequences for the health, or even the survival, of a retirement
portfolio.
Indeed, advisors must use historic averages
carefully when doing retirement planning. That's the message from
several planners and retirement planning experts, who are grappling
with the problem of clients living longer and markets that no longer
routinely provide double-digit returns.
"The order of the returns can be very important in
portfolio longevity," says Michael Kitces, an advisor with Pinnacle
Advisory Group in Columbia, Md.
So when is it safe for the client to retire? What is
the safe withdrawal rate? And, given the ravages of inflation and
unexpected bear markets, is a retirement portfolio ever safe? Does your
retirement planning, which includes everything from life expectancy to
projected rates of return, allow for the unexpected? Finally, as the
retirement advice business starts to explode as baby boomers approach
retirement, will some individuals be tempted to retain the advisor who
tells them they can withdraw the most?
Unless an advisor can answer those questions with
confidence, he or she probably does not have an effective portfolio
longevity model in place, a model that can weather some unexpected
events that happen early in a cycle. That puts clients at risk of
running out of money, or suddenly hearing that the minimum portfolio
allocation must be reduced.
Kitces generally sets an initial withdrawal rate of
4% on a typical portfolio of $1 million. That's a withdrawal number
endorsed by several other retirement planners. "Our feeling is that it
should be 4%, or sometimes we even try to get it a little lower," says
Diane Pearson, head of financial planning at Legend Financial Advisors
in Pittsburgh. Pearson says 4% makes sense, because her firm assumes
that, in many years, they'll be able to get 10% return on investments.
Her firm is moving away from just stocks and bonds, using more real
estate, hedge funds and other alternative investments, seeking creative
ways to get better returns.
Yet that 10% return number, Pearson admits, is going
to be more difficult to obtain over the next few years. This is a
persistent problem for many advisors, says a retirement expert.
"Overestimating the rate of returns on investments is the most common
error of retirement planning," warns Jules Lichtenstein, a senior
policy advisor with the AARP's Public Policy Institute.
The other big error, Lichtenstein adds, is that some
advisors expect that clients will agree with their assumptions that, if
they live much longer than expected, they will run out of money.
Clients, he adds, always want to have something even if they live to
the age of 100, maybe hoping to pass on assets to children. Here is why
the withdrawal rate, especially the initial withdrawal rate, is
critical.
Pearson's firm arrives at a 4% withdrawal rate by
assuming an annual average inflation rate of 3%, and that taxes will
eat up another 3% of returns. Several advisors stress that 4% is both
prudent and reasonable.
"But clients are often shocked when I tell them 4%,
that they're getting $40,000 on a $1 million portfolio," says Kitces.
He tempers the client's disappointment by noting that if returns are
better than expected, the 4% could be more.
"If we build the $1 million portfolio to one million and a half, then
the client can get $60,000. But our goal is to provide the client with
a base amount that he can get used to getting. But we also want the
client not to get carried away in good years, so that the client starts
to think we are going to constantly increase the allocation," Kitces
says.
Kitces adds that the second biggest mistake made by
retirement advisors is setting an initial portfolio withdrawal rate
that is too high, giving clients unreasonable expectations. Why do they
get it wrong?
That's because history can sometimes distort.
Historic return numbers can, at times, be very misleading. They tell
you what are the likely returns of the stock market over the long term,
but not where bumps will be over the course of 30 years, something that
no one can know with certainty.
These oft-quoted, long-term stock market return
numbers don't allow for the unexpected; the unusual two- or three-year
period that can suddenly wreck a plan. That's exactly what happened to
many who were unfortunate to start their retirements in the early 1970s
or in the 2000-2002 era. They don't take into account, Kitces notes,
"the order of the return." Order of return, some advisors say, is a
critical way to account for the bumps.
"It pays to look not just at averages, but at what
has actually happened, year-by-year, to investment returns and
inflation in the past," adds Bill Bengen, an advisor with his own
practice in El Cajon, Calif. He is the author of a Journal of Financial
Planning article entitled, "Determining Withdrawal Rates Using
Historical Data."
Planners sometimes go wrong by using long-term
thinking in a retirement plan and applying it on a short-term basis.
They assume the historic long-term returns of the stock market will
occur in every five- or ten-year period. That's the warning from
several advisors who work with clients who want to know when it is safe
to retire.
Indeed, Bengen's article was inspired by a similar
1994 article in the Journal of Financial Planning, which warned that
retirement planners are in error when they project constant rates of
inflation and return over a hypothetical future.
"This approach can create a false sense of security
for the client-investment returns and inflation are never the same over
time," wrote Larry Bierwirth, a certified financial planner in
Edgewood, Ken., in the article, Investing for Retirement: Using the
Past to Model the Future.
Bengen's article explores these investment and
inflation projection problems. What happens, he asks, if the client
retired just before the 1973-74 crash? That's when stocks lost some 37%
in an 18-month period and inflation was raging. Or what happens to the
client's retirement assets if he retires just before a repeat of the
1937-1941 period? That's when stocks lost 33%.
It won't help some of these clients to tell them to
hold on. Some will find their lifestyle dropping dramatically as their
allocation, which initially was set at too high a rate, must be cut
back. Others will have a bigger problem: They will run out of money.
The goal of portfolio longevity, advisors say, is to
develop a minimum payment that a client can learn to live with, even if
the bad years in the market begin just after he or she retires. This
floor is designed to carry them through even in the worst of times.
Then the more likely increases in the market can come as a kind of
"bonus," according to Kitces.
Bengen, who generally argues for a 60% stocks-40%
bonds portfolio allocation, has tried to come up with the worst-case
scenarios. In these, he believes his retirement portfolio model could
survive and eventually recover with the market, since he recommends
that just about every retirement client-especially those in their
sixties and early seventies-always should have a large equity
component. He generally tells clients that the initial annual
retirement portfolio withdrawal rate should be about 4%.
But before looking at Bengen's approach, let's
examine a case in which an advisor's portfolio longevity was right and
wrong with terrible consequences. The advisor was right over 30 years,
but wrong over the first 15 years.
Joe was a client with $250,000 in 1969. He was used
as an example of portfolio longevity gone wrong in a recent book, The
Savage Number: How Much Money Do You Need to Retire? by Terry Savage.
Joe's advisor, citing the long-term returns of the
stock market, recommended 60% stocks, 30% bonds and 10% cash, a normal
asset allocation. The recommendation was made based on the projection
of stocks returning between 10% and 12% a year over the next 30 years,
which they did. They actually earned 11.7%.
Unfortunately, the advisor's initial withdrawal rate
was wildly unrealistic. Based on the projection, Joe's advisor told him
he could take 9.5% every year, which is more than twice that
recommended by Bengen, in the initial withdrawal.
The result of the bad advice: Since the first decade
of the 1969-1999 period was horrible for stocks, Joe's portfolio ran
out of money in 1981, just as the stock market was about to go into the
longest bull market period in history. "The moral of the story: beware
of averages," writes Savage.
In contrast to Joe's advisor, Bengen, after the
initial 4% withdrawal rate, argues that the withdrawal rate can be
adjusted based on inflation. Just as Kitces and Bengen believe that
historical rates of return can distort based on bad short-term returns,
they also believe that, if withdrawal rates are not excessive, history
will eventually operate in favor of their clients.
Bengen maintains that his 4% initial withdrawal rate, followed by
inflation-adjusted withdrawals, is the best protection that can be
offered clients. He assumes an 8% growth in the portfolio. Again, like
Kitces' approach, a conservative figure that allows the client to
maintain a certain floor of income."In no past case has it caused a
portfolio to be exhausted before 33 years, and in most cases it will
lead to portfolio lives of 50 years or longer," Bengen writes.
"Four percent is not a magic formula, but it is
about as secure as we can get based on the last 80 years of the stock
market," Kitces maintains. "It's not a magic bullet, but it as close as
one can get to a magic bullet."
So why don't some advisors use this formula? Because
some advisors are still caught up in the past. Besides history, Kitces
explains that markets and client expectations are easily misled,
especially in unusual periods such as the late 1990s.
"I know a 9% withdrawal rate seems crazy now,"
Kitces notes. "But back in the 1990s, when the market was booming, it
actually seemed a ridiculous number. Clients expected that they should
be getting a lot more."