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."