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 [email protected].