And that's a problem, says Michael Williams, managing director of Genesis Partners in Chicago. "Most people underestimate how long they will need the money. The odds are higher than they think."
At the moment, Bengen and other advisors are focusing much of their attention on creating retirement income by using investment portfolios and asset allocation and withdrawal strategies focused on retirement stages, rather than income-producing insurance products. Studies, and books such as The Prosperous Retirement by Michael S. Stein, CFP, are suggesting withdrawal strategies for different phases of retirement-active (through age 75), transition (age 75 through 85) and passive (beyond age 85). Others are evaluating the most tax-efficient distribution strategies using totally tax-deferred funds, partially tax-deferred funds and after-tax funds.
That's the theory anyway. In reality it works this way: Polstra describes the case of a 75-year-old retired manufacturing executive who came to him with an investment portfolio of $616,258 and post-retirement annual income needs, excluding Social Security, of $47,000 per year (excluding inflation). That translated into a withdrawal rate of 7.6%, at least in year one.
"Clients tend to think that if their portfolio earns 8% they can pull out 7%," says Polstra. "Unfortunately, it doesn't work that way. The reality of the market is that you do not get consistent returns, and because of that you need to reduce the withdrawal rate to no more than 4% of the start-of-year investment portfolio value."
To help this client and other clients better understand the retirement income distribution issues, he's created a spreadsheet called "Why Returns are Rarely Average." With the spreadsheet, Polstra walked the former manufacturing executive, whose only other asset was his home, through various investment return scenarios in which the client withdraws $47,000 per year for 20 years until age 94. In Scenario 1, he assumes the client's portfolio (a mix of 60% stocks and 40 % bonds) would rise exactly 8% per year and that the client will be left with a tad more than $740,000 at the end of 20 years.
Knowing that markets never rise exactly 8% per year, Polstra showed the client Scenario 2, which uses a Monte Carlo simulation to depict the market experiencing bull and bear markets. The portfolio rises dramatically in the early years and less so in the later years, but ultimately averages 8% per year. In that scenario, Polstra says his client's portfolio would be valued at $1.26 million at the end of 20 years.
And in Scenario 3, Polstra showed the client a portfolio that rises, again using Monte Carlo simulation, only modestly in the early years and dramatically in the later years, but still averaging 8%. In that case, the client would run out of money at the end of 16 years. Polstra says he considered purchasing an annuity to create lifetime income, but that the client wished to leave an inheritance to his children, a feature that an annuity presently does not accommodate.
After sorting through various issues-including the client's bequest desires, the likelihood that his living expenses would decline in his later years (his wife's health being a chief issue today), the possibility of his returning to work part time if need be, the possibility of using a reverse mortgage to cover any income shortfalls, and the possibility of him moving in with his children-the client still opted for a high, fixed withdrawal rate. "The client is aware of the risk of running out of money," says Polstra, noting that the client feels comfortable that he has made an informed decision about his withdrawal rate.
An informed decision is the key to retirement income distribution questions, says Polstra. To help clients make informed decisions, Polstra has also created a timeline spreadsheet that helps clients understand when to withdraw money from different types of retirement accounts. "Clients view their accounts as different pots of money," says Polstra, who notes that the tool can help people see the "pots" as one.
For Bengen, the theory and reality of retirement income planning are a mismatched couple as well. Like Polstra, he recommends a 4% withdrawal rate. But the reality of a 4% to 4.5% withdrawal rate in year one, on the average lump sum payout of a 401(k) portfolio of $160,000, is a mere $6,400; hardly enough to achieve an average American's post-retirement income of $40,000. Even with Social Security, the income shortfall can be great.