This Week with J. Mark Nickell & Co.
This week we review recent research on safe withdrawal rates for retirees, present several points of view, with the final article summarizing the merits of several approaches.
The 4% Rule is Not Safe in a Low-Yield World: An Interview with Blanchett of Morningstar. The 4% spending rule is a guideline where retirees with a diversified portfolio withdraw 4% of their initial balance at retirement, and adjust the dollar amount for inflation each year thereafter. This rule has been around for a while, and is meant as a rule of thumb to provide a sustainable stream for 30 years based on historical returns for stocks and bonds. With recent bond yields as low as they are, and with uncertainty about how long they will remain low, a recent study questions the 4% rule and suggests that a 3% rule will help improve retirees’ probability of success.
Can Retirees Base Wealth Withdrawals on the IRS’ Required Minimum Distributions? An alternative to the 4% or similarly modified rule is to base distributions on the IRS’s Required Minimum Distribution (RMD). The annual withdrawal from investments is derived from taking the account balance and calculating a distribution based on IRS life expectancy tables. For a retiree at age 65 this results in a lesser percentage of wealth consumed in early years, but increasing with age as the retiree’s life expectancy decreases. A criticism of this method is that it results in relatively low consumption early in retirement when retirees are best able to enjoy it. On the other hand, it may be optimal for some households fearful of rising healthcare costs later in life. By following this method, consumption responds to fluctuations in market value of the financial assets; the discipline helps assure success of retirement spending plans. The authors also present a modified RMD approach, that results in somewhat greater distributions in the early years.
Smoothing Your Retirement Plan. One economist from MIT approaches retirement spending from a different perspective, but it can be pretty complicated to apply. It is based on the theory of “consumption smoothing”—the idea of maintaining a relatively level living standard over a lifetime. Many rules of thumbs or retirement savings calculators ignore how expenses change dramatically both before and in the various stages of retirement. While the theory behind this seems true to life, it is difficult to apply with precision, because you never know what life will bring.
How Do Spending Needs Evolve During Retirement? Most people’s spending patterns change over the course of retirement. This article critiques some recent studies on the issue. In conclusion, the author asks “which is the better baseline assumption to use: constant inflation-adjusted spending or decreased spending as one ages? This is a big question that is still not fully resolved…spending may decline and I would not fault anyone for using assumptions of gradual real spending declines along the lines of 10% or even 20% over the retirement period…though the standard assumption of constant inflation-adjusted withdrawals could be improved, it builds in reasonable conservatism and may not be too far off as a baseline.”
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J. Mark Nickell & Co.
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