Retirement withdrawal rates remain the subject of much debate.
Sometimes the simple little questions are the
hardest to answer. Such was the case over a decade ago when a client of
William Bengen asked, "How much can I spend without fear of running out
of money?" Ever since, the pursuit of an answer touched off debate and
an evolving string of research.
In 1993 Bengen, president of Bengen Financial Services Inc. in El Cajon, Calif., set about getting his client an answer. With a bachelor's of science from MIT in aeronautics and astronautics, his CFP designation and a master's degree in financial planning, he was probably as prepared for the task as any advisor. His findings were published in the October 1994 issue of the Journal of Financial Planning. Titled "Determining Withdrawal Rates Using Historical Data," the influence of this landmark article has been so significant that the Journal reprinted it last year, honoring it as one of the best in the publication's 25-year history.
Bengen's paper concluded that "a first-year withdrawal of 4 % ... followed by inflation-adjusted withdrawals in subsequent years, should be safe." Further, he noted the affect of the asset allocation decision on the outcome. He made special comment of the effect of having too little equity exposure. "One pattern that leaps out from the figure is that holding too few stocks does more harm than holding too many stocks. ... Too few stocks in the portfolio shortens the minimum portfolio life."
In the ensuing years, a slew of additional papers have been written expanding on Bengen's work. Bengen himself has written three follow-up pieces exploring different aspects of the problem. Most of them have placed the safe withdrawal rate in the 4% to 4.5% range. That is until last year.
Jon Guyton looked at the issue in a different way than most. He examined how some of the actual decisions people faced while withdrawing might affect the determination of a safe withdrawal rate. Recognizing that risk has many faces, Guyton defined "safe" as "the maximum rate that can achieve these conditions:
1. Never requires a reduction in withdrawals from any previous year.
2. Allows for systematic increases in withdrawals to offset inflation.
3. Maintains the portfolio's ability to satisfy the first two conditions for at least 40 years."
Dubbing it a "perfect storm" of adverse factors, he
then tested these conditions "... against the extreme period from
1973-2003 (two severe bear markets and a prolonged early period of
abnormally high inflation) by employing a balanced multi-asset-class
portfolio in conjunction with systematic decision rules to govern the
management of investment portfolios, funding sources for annual income
withdrawals, impact of years with investment losses, and increases in
withdrawals to offset ongoing inflation."
Like Bengen, Guyton was prompted by a question from a client. Says Guyton, "It was early in 2002. My client, retired less than two years, had grown increasingly worried by the ongoing declines he was witnessing in his investment portfolio-even as he and his wife continued to draw the income they needed to maintain their living standard. After sharing his concerns, he looked me squarely in the eye and asked, 'How do we know if we're still OK?'"
After reviewing the particulars, he found that his client's plan had nearly a 90% probability of success based on living to age 100. Guyton continues, "But then he asked me the question I could not answer: 'Jon, how do we know if we're in one of those scenarios that end in failure?' I knew a better answer was needed. I knew this unavoidable uncertainty needed a better framing."
His efforts to come up with an answer resulted in winning the Journal of Financial Planning's Call for Papers competition in the practitioner's division for 2004. The winning entry, "Decision Rules and Portfolio Management for Retirees: Is the 'Safe' Initial Withdrawal Rate Too Safe?" made a bit of a splash, even becoming the focus of a Wall Street Journal article. Guyton's conclusion was that a safe withdrawal rate seems to be between 5.8% and 6.2% if his "decision rules" were employed.
What are these rules and where did they come from? The rules came about from the observation that real-world behavior differed from the simplifying assumptions made in prior studies. For instance, Guyton noted that clients would not automatically increase their withdrawals in lock step with inflation. In practice many clients didn't feel a need to increase their withdrawals every year. After a few bad years for the market, he noticed that some clients even seemed inclined to cut back if it would help sustain their portfolio over the long term.
The decision rules were divided into three topic areas: portfolio decisions, withdrawal decisions and inflation decisions. Guyton never withdrew money from a portfolio on a pro-rata basis from all asset classes. He would always make a conscious decision about from which asset classes he would pull money. His portfolio decision rules reflected this real-world action. One of the rules is: "Portfolio withdrawals were funded each year on January 1 in the following order: (1) cash from rebalancing any overweighted equity asset classes from the prior year-end, (2) cash from rebalancing any overweighted fixed-income assets from the prior year-end, (3) withdrawals from remaining cash, (4) withdrawals from remaining fixed-income assets, (5) withdrawals from remaining equity assets in order of the prior year's performance."
For withdrawals, he examined the effect of two different rules. The first rule he considered prevents increases in years in which the ending value of the portfolio is less than the beginning value. Unless the portfolio returns enough to cover the withdrawal, the client will get no "raise." The second rule is an alternative to the first and prevents increases in withdrawals if the portfolio return is negative. With either rule, Guyton did not allow make-ups for missed increases in subsequent years.
The last set of rules related to inflation. Guyton capped increases to withdrawals at 6% in any given year. The theory here was that clients would be willing to accept a cap in years that would otherwise require abnormally high inflation adjustments if it meant a higher initial withdrawal rate. As with the case of the withdrawal rules, there is no make-up of capped increases in subsequent years.
In late April, I had the privilege of moderating a panel discussion with Bengen and Guyton. The session was part of Financial Advisor's inaugural Retirement Planning Symposium, held at the Mandalay Bay Resort in Las Vegas. It was clear from the beginning that these two advisors had a great deal of respect for each other and the work that had been done. This mutual admiration made the session enjoyable as well as informative.
In a response to a question about how clients have reacted to so many rules, Guyton echoed Bengen's sentiments that developing ways to present the information is an ongoing process. Each client has the potential to react and learn in a unique way. Nonetheless, Guyton has had some success by relating yearly changes in withdrawals to the experience of getting a raise while working. "Most people have had the experience at some point in their career that they did not get as big a raise as they had hoped because the company had a tough year," explains Guyton.
Questions from the audience were quite diverse. Panelists were asked to comment on everything from what mutual funds they used to the likelihood that future health-care breakthroughs would radically change the outcomes. The longevity issue came up a few times. Both panelists acknowledged that the planning process is made much more difficult because we rarely have a good estimate of a client's date of death. Accordingly, being too conservative about withdrawals may unnecessarily reduce a client's standard of living. Yet, being too aggressive could devastate an entire family's financial security, not just the current client's retirement lifestyle.
This discussion led to another lively exchange regarding spending patterns. Panelists gave some anecdotal credence to what several studies are showing: People tend to spend significantly more in the early years of retirement than the latter years. It made perfect sense to one audience member that "when you are younger and healthier, you are more likely to do things that cost more money."
Bengen and Guyton acknowledged the tendency for greater spending in the early years but were quite concerned about how to counsel clients effectively on the issue. "You might be encouraging a lack of restraint or discipline that could prove problematic," Bengen noted.
At that point I took the opportunity to ask how the panelists have fared when clients want to deviate from the spending plan. "We don't tell clients they can't spend their money. We help them understand what the ramifications of their choices might be," answered Bengen. Guyton agreed, noting that "their needs and desires change. Life brings change to us all at times."
Neither Bengen nor Guyton included the effect of taxation on their projections, so clients are left with actually spending less than the "headline" number. It was suggested by an audience member that, when it comes time for distributions, a dollar in an after-tax account is more valuable than a dollar in a tax-deferred account due to the lower rate applied to capital gains than ordinary income. The panelists both go to some lengths to make sure the client understands what is spendable. Taxation is yet another variable that is hard to pin down and is subject to change. "I mean really, how can we know what tax rates will be in 2030?" asked one audience member.
When an attendee wondered if a prospective client might hire Guyton instead of Bengen because of the higher withdrawal rate, both panelists rejected the notion that one could or should market a withdrawal rate as a value proposition. As Guyton summed it up, "The issue is so complex, so dependent on individual circumstances and affected by so many unpredictable variables that I doubt there is a 'right' answer. Our role is to provide our client with a way to sift through all these things and help them make the best choices for them."
Dan Moisand, CFP® is a principal of
Spraker, Fitzgerald, Tamayo & Moisand LLC, and has been honored by
several publications as one of the best financial advisors in America.
He can be reached at firstname.lastname@example.org.