People’s greatest fear (besides death) is outliving their retirement assets. They want to know how to make their money last. Accountants can help.
Some Applicable Assumptions
Let’s assume the following:
- They Have Substantial Assets: Your client has followed instructions and saved money with retirement in mind.
- Retirement is About 30 Years: Your money should last that long.
- Spending It All is Okay: Your client is fine not leaving a windfall for their heirs.
- There Will be About 3 Percent Average Inflation: Research by Ibbotson Associates shows a 2.9 percent average rate between 1926 and 2019.
One more optional assumption: Your client is in a position to put two years of future retirement income into Treasury Bills or cash equivalents. This is their safety net. It’s not part of the analysis below.
Let’s look at five scenarios:
1. The 4 Percent Annual Withdrawal Rate: William Bengen, author of the 1994 paper “Determining Withdrawal Rates Using Historical Data” (Journal of Financial Planning), is widely credited with popularizing the 4 percent withdrawal rate as an accepted standard.
The client’s logic: Use a 50/50 split between stocks and bonds. Bergin’s study, using the period 1926-76. Clients withdraw 4 percent, adjusting for 3 percent inflation moving forward. The client is also rebalancing the asset allocation each year. Although his analysis stops at 1976, this time period includes the Great Depression and the 1973-74 Recession. FYI: His analysis assumes withdrawals at year end.
The flaw: The long Treasury bond is yielding only 1.57 percent currently (10/6/20) far below the historical 5.5 percent government bond yield.
- 4 percent is pretty safe. A withdrawal rate of 4.25 percent might work too, although Bergin’s analysis showed the portfolio might last 28, not 30, years.
2. The 5 Percent Annual Drawdown: Kiplinger did an analysis over a 30-year period, covering 1989-2019. Now the dates seem more relevant to your client. Although the Kiplinger analysis used investment funds, the historical returns of equities (10.2 percent) and bond (5.5 percent) are almost identical to Bengen’s 1926-1976 average returns of 10.3 and 5.1 percent, respectively.
The client’s logic: They have a 50/50 split between stocks and bonds. The 5 percent withdrawal rate worked over the 1989-2019 period, This assumes taking the same dollar amount withdrawal, bumped up for 3 percent inflation.
The flaw: Some decades got better returns. The years 1989-98 averaged $14.09 percent per year, while 1999-2008 averaged a 2.59 percent return. If you reordered the decades, starting with the worst, you ran out of money after 25 years.
- 5 percent might work if you are lucky.
3. The 10 Percent Annual Drawdown Rate:
The client’s logic: Their retirement assets are invested completely in equities, 100 percent in large capitalization stocks. Historical research done by Ibbotson Associates shows between 1926 and 2019, large cap stocks have averaged a 10.2 percent return.
The flaw: There are down years. The client isn’t withdrawing 10 percent of the current asset value, it’s 10 percent of the amount they started with. The assumption is a 10 percent annual return will top them back up. Consider the following: Suppose they start at $ 1,000,000. Drawing down $ 100,000 leaves $ 900,000. The market has a bad year, losing 10 percent. The year-end value is $ 810,000. They draw the next $ 100,000 on New Years Day. They are at $ 710,000. The market declines 10 percent again. They end the year at about $ 640,000, so 36 percent of their starting amount is gone.
- A 10 percent withdrawal rate is too optimistic.
4. Required Minimum Distribution Rules: The federal government has other ideas how much you should be withdrawing.
The logic at the IRS: The money is withdrawn based on the life expectancy of the owner of the retirement account or the joint life expectancy. The withdrawals must start by age 72. Their tables show a 72 year old having a life expectancy of 25.6 years, bringing them to about age 97. That initial distribution equates to about a 4 percent RMD at age 72. At age 82, they project your life expectancy to 99. The RMD rate is about 5.85 percent. At age 102, it’s now 107. That distribution rate is 18.18 percent.
The flaw: The calculation isn’t based on what you need to live. It’s based on giving the IRS the opportunity to tax your retirement savings during your lifetime.
- Just because you are required to withdraw doesn’t mean it must be cash. You can take your withdrawal in securities, pay taxes and continue holding them in your name.
5. Buying an Annuity: In the previous four examples, your money remains your property. If you get great returns or die early, there’s a residual for your heirs to inherit. You also run the risk of outliving your assets.
The client’s logic: I will give up ownership of these assets for a guaranteed income for the rest of my life. Assume buying an immediate annuity at age 65 from a well-rated insurance company provides a guaranteed annual payout of about 5.80 percent.
The flaws: You have given up ownership of your money. If you die suddenly, the insurance company benefits. If you live to 115 it was a pretty good idea. That’s the age of the oldest living American. Keep in mind, 5.80 percent is the rate of distribution. Each payment includes earned interest and a portion of your principal. It’s a mortgage payment in reverse. In this example, it isn’t adjusted for inflation.
- It’s an option for people terrified they will outlive their assets.
Your client has many choices. The 4.00% to 4.25% distribution rate should be one of the least risky options.