How to Make the 4% Rule Work for You

Posted On September 7, 2015 By Admin In Retirement Planning /

Retirement planning today has largely shifted from guaranteed income from pensions to withdrawal strategies from 401(k) accounts and IRAs. Most financial planners recommend retirees start with an initial withdrawal rate of 4%. This approach was developed because historically, a 4% withdrawal rate, adjusted for inflation each year, would allow a retirement portfolio to last for 30 years under almost all circumstances.

The market was up in each of the past six years, which can give retirees a false sense of security about increasing their spending. In recent years, investors could take out 5%, 6%, or more from their portfolio and still end the year with more money than they started with. Markets go up and down, and if you withdraw all of your gains when the market is up, you can run into trouble when the market drops by 20 or 30 percent.

I find the challenge many retirees face with the 4% rule is forgetting to budget for unexpected expenses. If they have $1,000,000, a 4% withdrawal would be only $40,000 a year (before taxes). They can get by on this amount, but when their car needs replacing, they want us to send another $25,000. Suddenly, their annual withdrawal is up to $65,000. The next year, they need $10,000 for a new roof, and the next year, it’s something else. The issue is rarely reckless spending, but failing to set aside money for these unanticipated expenses.

The danger is that if a retiree takes too much, too soon, there won’t be enough remaining principal in their account to last for 30 years. Diminishing your account early in retirement means that future dividends and capital gains will be smaller in dollar terms, and cannot adequately replenish the annual withdrawals. Then the retiree may have to make drastic changes in their spending and lifestyle to avoid depleting their account. If there is a multi-year correction (like 2000-2002), combined with several years of large withdrawals, it is possible a retiree could see their portfolio drop to one-half their starting value in just five years.

I write this because the first challenge with the 4% rule is that many retirees don’t follow it and take out much more when the market is up. The good news, however, is that for the great majority of history, a 4% withdrawal rate was actually extremely conservative.

In a recent article by Michael Kitces, he examined the 4% rule, looking at 115 rolling 30-year periods, invested in a 60/40 portfolio. He found that in more than 90% of the periods, after 30 years of inflation-adjusted 4% withdrawals, a retiree would have finished with more money than they had at the beginning of retirement. In fact, the median wealth after 30 years, was 2.8 times the initial principal. The 4% rule was not an average withdrawal rate, but based on surviving a steep and prolonged downturn like The Great Depression.

Looking at all 115 30-year periods, Kitces found that retirees could have withdrawn a range of 4-10% of their initial principal, with a median of 6.5%. The 4% rule is the lowest withdrawal rate that worked, and since we don’t know future returns, the safest assumption. While that’s no guarantee that the 4% rule will work in the future, investors should feel very confident with this approach.

Now for some even better news: looking at all 115 periods, Kitces found that whenever the portfolio had grown to 50% above the starting value, withdrawals could be increased by 10%. This “ratchet” approach could be done every three years, and is on top of annual increases for inflation.

For example, let’s consider a retiree who started with a $1 million portfolio and experienced 3% inflation for 5 years. The annual withdrawal amount would have started at $40,000 (4%) and grown to $46,371 with inflation. If the portfolio were now to exceed $1.5 million, we could ratchet up their spending by an additional 10%, to $51,008 and that would become the new annual withdrawal amount.

Here’s a summary of how to make the 4% rule work for you:

1) Make sure you stick to a 4% withdrawal and don’t forget to set money aside for unexpected expenses.
2) Remember that the 4% rule is based on the worst case scenario of terrible market performance.
3) You can plan to increase your withdrawals each year for inflation.
4) If your portfolio grows to 50% above your initial starting value, you can ratchet up your annual withdrawal by an additional 10%.
5) Finally, recall that the 4% rule worked for a portfolio comprised of 60% stocks, 40% bonds. Don’t think that you can apply the 4% rule to a portfolio that is 80% invested in cash or CDs. It’s stocks that fuel the growth which enables the withdrawals to be increased.

Guaranteed Income Increases Retirement Satisfaction

Posted On July 20, 2015 By Admin In Retirement Planning /

Several years ago, for a client meeting, I prepared a couple of Monte Carlo simulations to show a soon to be retired executive possible outcomes of taking his pension as a guaranteed monthly payment, versus taking a lump sum, investing the proceeds, and taking withdrawals. When I showed that the taking the pension increased the probability of success by a couple of percent, my boss promptly cut me off, and warned the client that if they didn’t take the lump sum they would have no control of those assets and would not be able to leave any of those funds to their heirs. That’s true, but my responsibility was to present the facts as clearly as possible for the client to make an informed choice, without injecting my own biases.

The fact is that retirees who are able to fund a larger portion of their expenses from guaranteed sources of income are less dependent on portfolio returns for a successful outcome. New research is finding that retirees with higher levels of guaranteed income are also reporting greater retirement satisfaction and less anxiety about their finances. Sources of guaranteed income include employer pensions, Social Security, and annuities. This is contrasted with withdrawals from 401(k) accounts, IRAs, and investment portfolios.

For the last two decades, the financial planning profession has been advocating 4% withdrawals from investment portfolios as the best solution for retirement income. Unfortunately, with lower interest rates on bonds and higher equity valuations, even a conservative 4% withdrawal today, increased annually for inflation, might not last for a 30+ year retirement. (See my white paper, 5 Reasons Why Your Retirement Withdrawals are Too High, for details.)

Professor Michael Finke from Texas Tech, writing about a Successful Retirement, found that, “The amount of satisfaction retirees get from each dollar of Social Security and pension income is exactly the same — and is higher than the amount of satisfaction gained from a dollar earned from other sources of income. Retirees who rely solely on a defined contribution plan to fund retirement are significantly less satisfied with retirement.”

Emotionally, there are a couple of reasons why guaranteed income is preferred. It mimics having a paycheck, so retirees are comfortable spending the money knowing that the same amount will be deposited next month. On the other hand, investors who have saved for 30 or 40 years find it very difficult to turn off that saving habit and start taking withdrawals from the accounts they have never touched. Although taxes on a $40,000 withdrawal from an IRA are the same as from $40,000 income received from a pension, as soon as you give an individual control over making the withdrawals, they want to do everything possible to avoid the tax bill.

The biggest fear that accompanies portfolio withdrawals is that a retiree will outlive their money. No one knows how the market will perform or how long they will live. So it’s not surprising that retirees who depend on withdrawals from investments feel more anxiety than those who have more guaranteed sources of income. The 2014 Towers Watson Retiree Survey looked at retirees’ sources of monthly income and found that 37% of retirees who had no pension or annuity income “often worry” about their finances, compared to only 24% of retirees who received 50% or more of their monthly income from a pension or annuity.

While I’ve pointed out the negative outcomes that can occur with portfolio withdrawals, in fairness, I should point out that in a Monte Carlo analysis, investing a pension lump sum for future withdrawals increases the dispersion of outcomes, both negative and positive. If the market performs poorly, a 4% withdrawal plan might deplete the portfolio, especially when you increase withdrawals for inflation each year. However, if the market performs on average, it will likely work, and if the initial years perform better than average, the portfolio may even grow significantly during retirement. So it’s not that taking the lump sum guarantees failure, only that it makes for a greater range of possible outcomes compared to choosing the pension’s monthly payout.

What do you need to think about before retirement? Here are several steps we take in preparing your retirement income plan:

1) Carefully examine the pension versus lump sum decision, using actual analysis, not your gut feeling, heuristic short-cuts, or back of the envelope calculations. If you aren’t going to invest at least 50% of the proceeds into equities, don’t take the lump sum. Give today’s low interest rates, the possibility of retirement success is very low if you plan to invest 100% in cash, CDs, or other “safe” investments.

2) Consider your own longevity. If you are healthy and have family members who lived for a long time, having guaranteed sources of income can help reduce some of the longevity risk that you face.

3) Social Security increases payments for inflation, whereas most pension and annuities do not, so we want to start with the highest possible amount. We will look at your Social Security options and consider whether delaying benefits may improve retirement outcomes.

4) If your guaranteed income consists only of Social Security, and is less than 25% of your monthly needs, you are highly dependent on portfolio returns. Consider using some portion of your portfolio to purchase an annuity. If you are several years out from retirement, we may consider a deferred annuity to provide a future benefit and remove that income stream from future market risks. If you are in retirement, we can consider an immediate annuity. For example, a 65-year old male could receive $543 a month for life, by purchasing an immediate annuity today with a $100,000 premium.

Annuities have gotten a bad rap in recent years, due in large part to unscrupulous sales agents who have sold unsuitable products to ill-informed consumers. However, like other tools, an annuity can be an appropriate solution in certain circumstances. While many financial planning professionals still refuse to look at annuities, there has been a significant amount of academic research from Wade Pfau, Michael Finke, and Moshe Milevsky finding that having guaranteed income may improve outcomes and satisfaction for retirees. This growing body of work has become too substantial to ignore. I believe my clients will be best served when we consider all their options and solutions with an open mind.

How Much Can You Withdraw in Retirement?

Posted On March 24, 2015 By Admin In Retirement Planning /

With corporate pensions declining in use, retirees are increasingly dependent on withdrawals from their 401(k)s, IRAs, and investment accounts. The challenge facing investors is how to plan these withdrawals and not run out of money even though we don’t know how long we will live or what returns we will receive in the market on our portfolio.

Pensions and Social Security provide a consistent source of income that you cannot outlive. When I run Monte Carlo simulations – computer generated outcomes testing thousands of possible scenarios – we find that the larger the percentage of monthly needs that are met from guaranteed sources, the lower chance the investor will run out of money due to poor market performance from their portfolio.

If you do have a pension, it is very important to consider all angles when deciding between a lump sum payout and participating in the pension for the rest of your life. It is not a given that you will be able to outperform the pension payments, especially if you are healthy and have a long life expectancy.

The most obvious way to avoid running out of money (called longevity risk by financial planners) would be to annuitize some portion of your portfolio through the purchase of an immediate annuity from an insurance company. While that would work, and is essentially the same as having a pension, very few people do this. You’d be giving up all control of your assets and reducing any inheritance for your beneficiaries. With today’s low interest rates, you’d probably be less than thrilled with the return. For example, a 65-year old male who places $100,000 in a single life immediate annuity today would receive $542 a month.

The problem with annuitization, besides giving up your principal and not leaving anything for your heirs, is that it doesn’t allow for any increase in expenditures to account for inflation. There are three approaches we might use to structure a withdrawal program for a retiree.

1) Assume a fixed inflation rate. In most retirement planning calculators, projected withdrawals are increased by inflation to maintain the same standard of living. After all, who doesn’t want to keep their standard of living? The result of this approach is that the initial withdrawal rate then must be pretty low. 20 years ago, the work of William Bengen established the “4% rule” which found that a withdrawal rate of 4% would fund a 30-year retirement under most market conditions.

On a $1 million portfolio, 4% is $40,000 a year. But that is just the first year. With 3% inflation, we’d plan on $41,200 in year two, and $42,436 in year three. After 24 years, withdrawals would double to $80,000. The 4% rule is not the same as putting your money in a 4% bond; it’s the inflation which requires starting with a low initial rate.

While we should plan for inflation in retirement, this method is perhaps too rigid in its assumptions. If a portfolio is struggling, we’re not going to continue to increase withdrawals by 3% and spend the portfolio to zero. We have the ability to respond and make adjustments as needed.

2) Take a flexible withdrawal strategy. We may be able to start with a slightly higher initial withdrawal rate if we have some flexibility under what circumstances we could increase future withdrawals. In my book, Your Last 5 Years: Making the Transition From Work to Retirement, I suggest using a 4% withdrawal rate if you retire in your 50’s, a 5% rate if you start in your 60’s, and 6% if retiring in your 70’s. I would not increase annual withdrawals for inflation unless your remaining principal has grown and your withdrawal rate does not exceed the original 4, 5, or 6%.

This doesn’t guarantee lifetime income under all circumstances, but it does give a higher starting rate, since we eliminate increases for inflation if the portfolio is shrinking. Under some circumstances, it may even be prudent to reduce withdrawals to below the initial withdrawal amount temporarily. That’s where having other sources of guaranteed income can help provide additional flexibility with your planning.

3) Use an actuarial method. This means basing your withdrawals on life expectancy. Required Minimum Distributions (RMDs) are a classic example of an actuarial strategy: you take your account value and divide by the number of years of life expectancy remaining. If your life expectancy is 25 years, we take 1/25, or 4%. The next year, the percentage will increase. By the time someone is in their 90’s, their life expectancy will be say three years, suggesting a 33% withdrawal rate, which may work, but obviously will not be sustainable. However, the more practical problem with using the RMD approach is that many people aren’t able to cut their spending by 20% if their portfolio is down by 20% that year. So even though it has a sound principle for increasing withdrawals, the withdrawal amounts still require flexibility based on market results.

But there are other ways to use the actuarial concept, and even my approach of different rates at different retirement ages is based on life expectancy. There’s no single method that will work in all circumstances, but my preference is to take a flexible strategy. But this does mean being willing to reduce spending, and forgo or even cut back inflation increases, if market conditions are weak.

We have a number of different tools available to evaluate these choices throughout retirement, but the other key factor in the equation is asset allocation. Bengen found that his 4% rule worked with equity allocations between 50% and 75%. Below 50% equities, the portfolio struggles to keep up with inflation and withdrawals become more likely to deplete the assets in the 30-year period. Above 75% equities, the portfolio volatility increases and rebalancing benefits decrease, increasing the number of periods when the 4% strategy would have failed.

When sorting through your options, you need candid and informed advice about what will work and under what circumstances it would not work. We hope for the best, but still have a plan for contingencies if the market doesn’t cooperate as we’d like. We will be able to consider all our options as the years go by and be proactive about making adjustments and corrections to stay on course. For any investor planning for a 30-year retirement, it’s not a matter of if the market will have a correction, but when. It’s better to have discussed how we will handle that situation in advance, rather than waiting until the heat of the moment.

Retirement Cash Flow: 3 Mistakes to Avoid

Posted On October 28, 2014 By Admin In Retirement Planning /

Living off your portfolio is unfamiliar territory for new retirees, and although it’s sounds simple, there are a number of common pitfalls which many people encounter in their first few years of retirement. Here are three mistakes you should avoid to help keep your retirement cash flow safe.

1) Not including everything in your budget

A retirement income plan establishes a safe withdrawal rate designed to last for 30 or more years of retirement. For example, we may determine that a couple can safely withdraw $4,500 a month from their accounts, in addition to their Social Security and pension. They set up a $4,500/month transfer and this works well until they encounter a large, unanticipated bill. Then, they require additional withdrawals to cover their expenses and suddenly their plan to withdraw only 4% that year balloons to 6% or 7%.

When we create a budget, it should include everything, and not just your ordinary monthly bills. The following are some “unexpected” expenses that have caused retirees to request additional withdrawals in recent years:

Home repairs, such as a new roof or AC
Needing $35,000 for a new car
Medical expenses not covered by insurance
Property taxes
Vacations
Buying a Vacation Home
Boats, or RVs

It’s easy to consider a 401(k) account or Pension Lump Sum payout as being all available, but it’s better to view the account as a 30-year stream of income. Rather than looking at the account as a $1 million slush fund, consider it a $40,000 salary with a 3% raise each year. A retiree needs to have an emergency fund just like everyone else and to budget and save for large expenses. The principal of your retirement account cannot be both your permanent source of income and your emergency fund.

2) Reinvesting Dividends in a taxable account.

If you are taking withdrawals, or will need to take withdrawals, from your taxable account, I’d suggest turning off dividend reinvestment on all your positions. Have your funds pay dividends and capital gains in cash and hold the resulting cash for your withdrawals. This will save you from having to sell positions and creating taxes on capital gains in order to access your money.

You probably have substantial gains in mutual funds if you’ve owned them for a long time. Mutual funds typically use the average cost basis method, so if you have a 75% gain in the position, any withdrawal will be considered to have a 75% gain. ETFs and individual stocks use the specific lot method, and sales are generally considered to be First In, First Out (FIFO), unless you specify lots at the time of the trade or change your default cost basis disposal method to another option. While that does give an investor more flexibility in managing the tax implications of ETF sales than with mutual funds, I find that most don’t bother and simply go with the default of FIFO.

The easiest way for retirees to avoid this headache is have distributions paid in cash. If you end up with more cash than you need at the end of the year, you can always use the money to rebalance your portfolio. (Which is preferable to having to make sales in order to rebalance the portfolio, anyways.)

3) Ignoring the Low Interest Rate environment.

Today’s low interest rates present a challenge for retirees and many of the conservative ideals of the past are simply not providing the same level of financial security today. This applies to both assets and liabilities. On the asset side, keeping the majority of your money in a bank account or CD may be safe in the short-term, but with today’s historically low interest rates running below inflation, you’ll lose purchasing power each year. We call this a negative real return. A balanced and properly diversified portfolio has short-term risk, but is likely to increase your wealth over time. If you’re investing for the long-term, make sure all your investments aren’t designed as short-term holdings, or they may be setting you up for eventual disappointment.

Many near-retirees have a goal of being debt-free, which is a laudable ambition, but with today’s low rates, you could lock in a mortgage in the 3% range. Selling investments or cashing out a 401(k) and paying taxes on the withdrawal to pay off a 3% mortgage could hurt your long-term financial strength, provided you are willing to hold investments that can potentially return more than 3%. By paying off their mortgages, some home owners inadvertently wind up house rich and cash poor, which does not give you much flexibility in paying your living expenses. From a cash flow perspective, you may be better off keeping a mortgage versus tying up a majority of your net worth in home equity.

One additional note on mortgages: eligibility for a mortgage is based largely on your income. If you are going to refinance a mortgage, do so while you are still working and before you retire. Once you are retired, it will be more difficult to underwrite a mortgage with no income, even if you have sufficient assets to buy the property outright.

These types of issues come up frequently with new retirees, and we give a lot of thought to the pros and cons of each choice. Individual situations can vary and there are sometimes reasons why no rule of thumb can apply 100% of the time. If you have questions about retirement cash flow and your personal portfolio, please send me a message and we can discuss your options.

5 Tax Mistakes New Retirees Must Avoid

Posted On September 8, 2014 By Admin In Retirement Planning /

New retirees often overlook the bite that taxes will take out of their income. Even though they are no longer receiving a paycheck, taxes can still add up in retirement. There are quite a few ways to reduce these taxes, which unfortunately, most people will miss on their own. Here are 5 mistakes you can avoid through careful planning.

1) Taking a large withdrawal from a retirement account in one year. If your income is modest and you will require $60,000 from an IRA, you will pay much less in taxes by taking withdrawals of $20,000 over three years versus taking $60,000 out in one year. Plan ahead and aim to smooth your withdrawals from qualified accounts, or better yet, take only RMDs. Don’t wait until an emergency or for a large expense to plan your IRA distributions.

2) Taking a withdrawal from a retirement account to avoid a capital gain on selling a stock. The IRA withdrawal will be fully taxable as ordinary income, but a long-term capital gain would be taxed at the lower rate of 15% (or 20% if you’re in the top tax bracket). Only the gains portion of the sale is taxable, whereas 100% of the IRA distribution is taxable. For ETFs and individual stocks, you can even specify which lots to sell, giving you the opportunity to sell the lots with the highest cost basis, rather than the default first in, first out, or average cost method used by mutual funds.

3) Inefficient Asset Location. I often see that portfolios are set up with bonds in a taxable account and stocks in the IRA, so that retirees can take the income from the bonds and avoid touching the stocks in the IRA. Actually, it would be much more tax efficient to reverse the locations and place the bonds in the IRA.

Bond interest is taxed as ordinary income, as are IRA distributions. Put your bonds in the IRA and take your bond income from the IRA, as the distributions will be taxed exactly the same. Place your stocks in the taxable account, and you can receive favorable tax rates (15%) on capital gains and dividends, and you won’t have any capital gains until you sell. (If you’ve been burned by taxable distributions from equity mutual funds, it’s time for you to learn about ETFs.)

Keeping high growth stocks out of your IRA will also reduce your future RMDs and reduce the taxes that will have to be paid by your heirs. Heirs receive a step-up in basis on stocks in a taxable account, but not in an IRA. By placing bonds in your IRA, you can reduce future taxes in many ways. This concept can often be difficult for people to grasp, so if you’d like an example, feel free to email me or give me a call.

4) Selling the oldest savings bonds. Many retirees hold EE savings bonds but are not managing these bonds. Some older bonds had fixed rates or guaranteed minimums, whereas bonds issued starting May 2005 currently pay only 0.50%. (This resets every 6 months, and this rate is current through 10/31/2014.) As a result, you’re better off selling your newer bonds and keeping the older ones (pre-2005) which have higher interest rates. Don’t forget that the bonds are guaranteed to reach their face value in 20 years, so you may be rewarded by holding on to a 17 year old bond for a couple more years. EE bonds will receive interest for up to 30 years, which is the maximum time you should hold bonds. By selling the newer bonds, you will pay less in taxes compared to selling older bonds which have appreciated more. Use the tools at TreasuryDirect.gov to keep track of the current values and interest rates on your EE bonds.

5) Failing to harvest losses on investments. While your heirs will receive a step-up in cost basis for an appreciated security, they will lose any tax benefits associated with a position at a loss. Sell the position and redeploy the capital as needed to maintain your target asset allocation. A loss can be used to offset any capital gains in that year, plus $3,000 can be used against ordinary income and any remaining loss will carry forward to future years.

New retirees can undermine their retirement planning if they ignore the impact of taxes. It can be costly to make changes after the fact, so it’s best to make sure you have a plan in place before retirement. It’s not a once and done event either, because managing taxes is an ongoing process. Many people turn to a financial planner for selecting investments, and discover that they receive even greater benefits from other areas such as tax management.

Retirement Withdrawal Rates

Posted On August 28, 2014 By Admin In Retirement Planning /

If you’re close to retirement, a key planning question is How much can I withdraw from my portfolio annually? Or in financial planning terms, what is a safe withdrawal rate? It’s a challenging question because we don’t know future rates of return. But what we do know is that you can’t just project “average” or historical returns in a straight line and use that as your basis for withdrawals.

Unlike a portfolio in accumulation, a portfolio under distribution is greatly dependent on the order of returns. We might have a 7% average return over 30 years, but in certain rare circumstances, a portfolio under distribution could be wiped out if there were negative returns in the first handful of years. This is known as sequence of returns risk.

Today, we have several reasons to believe that future returns may be lower than historical returns. This impacts the level of withdrawal that we can safely achieve in a retirement portfolio. In my planning process, I use projected returns rather than historical returns, because I am concerned that historical returns may over-estimate the likelihood of success.

This issue is too complex to address in the space of a blog post, but I want to educate as many people as possible about the challenges of funding a retirement in a lower return environment. I have written a whitepaper on this subject and strongly encourage anyone interested in their retirement to read more:

Five Reasons Your Retirement Withdrawals are Too High

If you’re not close to retirement, this is still a relevant issue because the amount you need to accumulate is determined on your future retirement withdrawal rate. A simple way to calculate your finish line is by multiplying the reciprocal of your withdrawal rate times your annual need.

For example, a 4% withdrawal rate (1/25), gives us a multiplier of 25. A 5% withdrawal rate equals a multiplier of 20. If your annual need is $100,000, your portfolio target would be $2,500,000 under a 4% withdrawal program. Decreasing the withdrawal rate from 5% to 4% would increase your portfolio target from $2 million to $2.5 million. And that’s why the safe withdrawal rate matters to everyone seeking financial independence.