In-Retirement Withdrawal Rates & Cash-Flow Needs

Transcription

1 ? In-Retirement Withdrawal Rates & Cash-Flow Needs Christine Benz s Talking Points June 2017 Talking Points The "right" withdrawal rate for any given retiree is necessarily an educated guess, based on what we know about market history. Focus on what we know for sure about withdrawal rates to help guide retirees' decision-making, then craft a withdrawal strategy that's customized to the situation, provides peace of mind, and allows for flexibility. Most retirees don't want huge swings in their portfolio paychecks (and standards of living) determined by outside forces but in reality, spending changes throughout retirement. Contents 1 Talking Points 2 What We Know for Sure About In- Retirement Withdrawal Rates 5 Forget Income Replacement, Focus on Supplying Cash-Flow Needs Over many retirement periods, the 4% withdrawal-rate guideline has been too conservative, but many retirees would rather be safe than sorry. Lower expected returns put the 4% guideline at risk, especially for bond-heavy portfolios. New and soonto-be retirees should be prepared to rein in spending. Income-centric strategies aren't a shield. Confusion over income-replacement rates combined with huge variations in actual incomereplacement needs among different cohorts highlights why I think most pre-retirees should bypass income-replacement rates and instead use their expected cash-flow needs to help determine how much money they'll need in retirement. To arrive at anticipated in-retirement spending needs, start with today's expenditures. Then consider any housing changes and anticipated lifestyle changes. Add in higher health-care costs. And be sure to leave room for unexpected expenses, such as repair bills.

2 Page 2 of 8 What We Know for Sure About In-Retirement Withdrawal Rates You'll never be able to calibrate your withdrawal rate perfectly, but the body of research can point you in the right direction. By Christine Benz Published May 11, 2017 A retiree's portfolio withdrawal rate can make or break her plan. Take too much and she runs the risk out of running out of money prematurely. Take too little and she reduces her standard of living and potentially her quality of life over her retirement years. Yet as important as the topic of withdrawal rates is, the "right" withdrawal rate for any given retiree is necessarily an educated guess, based on what we know about market history. As with the perfect asset allocation, the optimal withdrawal rate will be apparent only in hindsight. It will depend on the performance of stocks and bonds over the retiree's time horizon (not just his rate of return over the whole time horizon, but the sequence of those returns), as well as the investor's own allocations to each of those asset classes and the inflation rate. Given the inherent guesswork of sustainable withdrawal rates, retirees planning portfolio drawdowns shouldn't get too bogged down in precision. Rather, focus on what we know for sure about withdrawal rates to help guide their decision-making, then craft a withdrawal strategy that's customized to the situation, provides peace of mind, and allows for flexibility. And reassuringly, there's broad consensus in the retirement-planning community about many withdrawal-rate matters. Here's a roundup of some of the widely agreed-upon points. 1. Most retirees don't want huge swings in their portfolio paychecks (and standards of living) determined by outside forces. Much of the retirement research centers around the notion that retirees would like their incomes to be stable in retirement similar to what they had when they were earning a paycheck. Indeed, supporting a stable standard of living is what financial planner Bill Bengen had in mind when he developed the widely used 4% guideline for retirement-portfolio withdrawals. Thus, the 4% guideline assumes that a retiree takes out 4% of his portfolio in year one of retirement, then inflation-adjusts that dollar amount in ensuing years. For example, a retiree with an $800,000 portfolio who's employing the 4% guideline would take $32,000 initially, $32,960 in year two of retirement (assuming a 3% inflation rate), and so on. 2. But in reality, spending changes throughout retirement. That said, anyone who's managed a household budget knows that spending isn't a flat line. There might be several years when spending clusters in a tight range, as well as budget-busting periods when there are splurges for the big-ticket vacation or multiple unplanned expenses car repairs, big outlays for home repairs or improvements, vet bills, and so on. Retirement is no different. In fact, due to lifestyle factors, retiree spending may be even more erratic than spending during the working years. Morningstar

3 Page 3 of 8 Investment Management's head of retirement research, David Blanchett, has examined retiree spending patterns and arrived at what he calls the "Retirement Spending Smile." His research has found a tendency for retirees to spend more during the early years of retirement (for heavy travel, for example), a bit less during the middle years of retirement, and more toward the end of life, when healthcare and long-term care outlays often increase (but not enough to completely offset lifestyle-related spending declines). How retirees expect their lifestyles to evolve during retirement along with whether they've purchased long-term care insurance should play a role in their spending plans. Some retirees even create spreadsheets where they model out their expected outlays on a year-by-year basis, factoring in lumpy expenses like new car purchases and big travel expenditures. 3. Over many retirement periods, the 4% guideline has been too conservative. The original impetus behind the 4% guideline was to determine the most a retiree could have taken out initially without depleting a balanced portfolio, even if he or she encountered a terrible market. Financial planner Bill Bengen's subsequent conclusion of 4% as a sustainable withdrawal rate centered on the time frame between the late 1960s and late 1990s; the front end of that period was marked by runaway inflation and rising interest rates in the 1970s and a terrible equity market in Over many other 30-year windows, however, 4% would be much too low. 4. But many people would rather be safe than sorry. Yet even as the safe withdrawal rate has been well over 4% for most rolling 30-year periods (assuming a balanced portfolio), many people would rather forego consumption (and take a lower withdrawal rate) if it means that they'll reduce the likelihood of running out of money later in life. That s why the 4% guideline has enjoyed such widespread acceptance as a starting point in the financial-planning community because it factors in a catastrophic market environment. 5. Lower expected returns put the 4% guideline at risk, especially for bond-heavy portfolios. An open question, however, is whether the catastrophic market environment that led to the 4% guideline, while the worst in history, is the worst we'll see. Blanchett and co-researchers Michael Finke and Wade Pfau made waves a few years ago with their paper, "The 4% Rule Is Not Safe in a Low-Yield World." In it, they argue that low bond yields, which typically portend meager returns from the asset class, increase the probability of failure for retirees employing the 4% guideline. Other retirement researchers aren't as pessimistic that the 4% guideline won't hold going forward. One key takeaway from the research from Blanchett et al., however, is that investors employing overly conservative portfolios (that is, holding 50% or more of their portfolios in bonds) ought to also be conservative when setting their withdrawal rates. 6. New and soon-to-be retirees should be prepared to rein in spending. Moreover, the combination of low starting bond yields and relatively high equity valuations make this a particularly challenging time for sequence-of-return risk that is, that new retirees could encounter a lousy confluence of events at the outset of their retirements that in turn could crimp their portfolios' sustainability. Taking too much out of a portfolio in a weak market environment can deal a portfolio a blow from which it might never heal. That argues for recently retired and soon-to-be retirees taking a cautious tack on their upcoming withdrawals, beginning with withdrawals of less than 4% and being

4 Page 4 of 8 willing to rein them in further if a calamitous market drop materializes early on in their retirements. Retirees who have been drawing for their portfolios for several years already are less at risk for a market shock; they'll have losses amid an equity-market downturn, too, but they've already made it through their most vulnerable years. 7. Income-centric strategies aren't a shield. One other fact to remember is that portfolios don't know where withdrawals come from: Spending a portfolio's bond and equity-dividend income counts as a "withdrawal," just as withdrawals of capital gains and principal do. I'm a believer in staying flexible on a portfolio's source of cash flow, being willing to harvest income distributions as well as to engage in rebalancing to help source the cash flow needed. I'm also a fan of employing a cash "bucket" to provide liquidity in years when tapping principal or harvesting income is ill-advised (like when the market is down). K

5 Page 5 of 8 Forget Income Replacement, Focus on Supplying Cash-Flow Needs Income-replacement rates are a convention whose time has come and gone. By Christine Benz Published May 14, 2017 When it comes to helping retirees figure out the financial aspect of their retirement plans, one of the conventions is "income-replacement rate." How much of the income you had while you were working will you need in retirement? The discussion of income-replacement rates has its roots in the pension world, where an employee's pension income is typically expressed as being "X" percent of his or her final salary. That convention has been ported over to the nonpension world, too. Rules of thumb for incomereplacement ratios abound, with planners and financial firms urging retirees to shoot for replacing between 70% and 85% of their working incomes. Retirement planning experts arrive at those percentages by reducing gross income by taxes and savings, mainly. State of Confusion Such rules of thumb may be helpful to early and midcareer accumulators who need to plug in a desired in-retirement income when setting their savings targets for retirement. However, the whole concept seems to create more confusion than it helps, if my interactions with actual pre-retirees and retirees are any guide. When I asked a group of retirees how much of their working incomes they wanted to have in retirement, they didn't skip a beat. To a person, they said 100%. That's probably because most of us who earn salaries are already thinking in terms of our take-home income, not gross. Most of us operate in a world where much of our tax bills are extracted directly from our paychecks. Much of our savings may be, too, if we're investing via our 401(k) plan contributions and other automated investments. Meanwhile, the foundation of the income-replacement rate is raw income before taxes and savings come out. It's likely the group of retirees I interviewed said they wanted a 100% income-replacement rate because they were thinking about their actual incomes the amount they had each month or each year to spend on their actual needs and wants, once taxes and savings were accounted for. Asking them to think about their gross incomes was going to create confusion in their minds, even though there wasn't any. The retirees had already asked the really important question: Did they want their standards of living to change in retirement? And their answer was no. Your Mileage May Vary There's also the not small matter that income-replacement rates can vary tremendously, making rules of thumb blunt instruments, at best. Research from Morningstar Investment Management's head of

6 Page 6 of 8 retirement, David Blanchett, illustrates just how broadly income-replacement rates can vary, with factors such as pre-retirement income and savings rates serving as key swing factors. Blanchett's research notes that higher-income, higher-saving households may well need just 60% (or even less) of their preretirement income during retirement, while lower-earning, lower-saving households may need closer to 90%. Confusion over income-replacement rates combined with huge variations in actual incomereplacement needs among different cohorts highlights why I think most pre-retirees should bypass income-replacement rates and instead use their expected cash-flow needs to help determine how much money they'll need in retirement. (Note that I've supplanted "income" with "cash flow" here, because income is another one of those words that just seems to confuse people.) The following process is a reasonable way to do so. Step 1: Start with Today's Expenditures To help arrive at anticipated spending needs, begin with an assessment of household living expenses today, both fixed and discretionary. If you're saving on an ongoing basis but expect that to cease in retirement, you'll obviously want to adjust your cash-flow needs downward to account for the subtraction. Step 2: Consider Housing Changes Apart from likely decreases in your savings, do you envision any other substantial changes in retirement? Housing costs are one line item with the potential to change substantially in retirement. Is your plan to come into retirement without a mortgage, for example? Or perhaps you intend to relocate or downsize in some fashion? Even though the main goal of downsizing may be to add the home-sale proceeds to your retirement kitty, it can have the salutary effect of reducing property taxes and lowering outlays for insurance, utilities, and maintenance. As a senior homeowner, you may also be able to qualify for a reduction in your property taxes, depending on where you live. Of course, not every household sees a drop in housing costs during retirement; some retirees stay put in their primary residences while also purchasing second homes that actually add to their total housingrelated outlays. Step 3: Factor in Anticipated Lifestyle Changes How about other living expenses? In his paper, Blanchett cited previous research pointing to food costs as one of the expense items likely to decline the most in retirement; one paper showed a 5% to 10% drop in food expenditures for households following retirement, while another showed a 6% decline. Not only do retirees have more time to prepare food at home than they did while they were working, the researchers conjectured, but they also have more time to shop for grocery bargains. As with housing costs, lifestyle-related outlays aren't guaranteed to decline in retirement, so don't assume a reduction in yours without crunching the numbers. If a heavy travel schedule or an expensive hobby are on your retirement to-do list, you might see any cost reductions on line items like food offset

7 Page 7 of 8 by increased expenditures elsewhere. Bear in mind, however, that big spending on travel often occurs in the early years of retirement but then tapers off later on, as discussed in Blanchett's research. Step 4: Add in Higher Healthcare Costs Thus far, we've focused on ways that retirees might expect to see their expenses drop in retirement. But there's one major area where they're likely to increase, and that's in the realm of healthcare. A recent Fidelity study showed that the average out-of-pocket healthcare outlay for a retired couple was $260,000, and that figure doesn't even include long-term care expenditures. Of course, costs aren't a brand-new expense in retirement. Even if you had employer-provided health coverage, you likely had premiums and other out-of-pocket outlay. But Blanchett's research has demonstrated that healthcare expenditures are a bigger share of the consumption basket for elderly households in the Bureau of Labor Statistics' Consumer Price Index calculations. Blanchett also notes that increases in healthcare costs at large are a key reason that the CPI-E has tended to be about 5% higher than the general inflation rate. Not only have healthcare costs outstripped the general inflation rate, but they also tend to trend up through retirees' own life cycles. Higher healthcare costs later in life are the key reason that Blanchett identified what he calls the "Retirement Spending Smile." That's the tendency for household expenses to be on the high side just after retirement (when spending on travel and leisure is apt to be high), dip in midretirement, then head back up toward the end of life as healthcare costs increase. If you're someone who's going without long-term care insurance, in particular, recognize that your household's total healthcare-related outlay could spike dramatically toward the end of your or your partner's lives. Step 5: Add a Fudge Factor Working through each of these line items may get you closer to your actual income-replacement rate rather than relying on rules of thumb such as 75% or 80% for income replacement. At the same time, it's worthwhile to approach the exercise with the knowledge that there's much about your future spending that you can't foretell. Long-term care costs are the biggest wild card for people who don't have longterm care insurance or for those who have policies that are capped at specific benefits. Many seniors have also been called upon to help their adult children or their families, unexpectedly increasing their financial outlays in retirement. Homeowners, too, can incur costly and unexpected repair bills at random times. All of these factors can send your expenditures out of line with what you thought they would be. The potential for those unanticipated expenses argues for nudging your own income-replacement rate a bit higher to allow for some wiggle room in your planning. Some pre-retirees go so far as to model out their annual expenses in retirement using a spreadsheet. That allows them to depict how they expect their outlays for various expenses to change throughout their retirement years: Travel expenses may taper down, while healthcare outlays have the potential to jump up. Such an exercise also allows retirees to plan for lumpy, big-ticket outlays such as new cars or expected home repairs (new furnace, roof, etc.). K

8 Page 8 of 8 About Morningstar Morningstar, Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. The company offers an extensive line of products and services for individual investors, financial advisors, asset managers, and retirement plan providers and sponsors West Washington Street Chicago, IL USA 2017 Morningstar. All Rights Reserved. Christine Benz's Talking Points is produced and offered by Morningstar, Inc., which is not registered with the U.S. Securities and Exchange Commission as a Nationally Recognized Statistical Rating Organization ( NRSRO ). Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. The information, data, analyses and opinions presented herein do not constitute investment advice; are provided solely for informational purposes and therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. The opinions expressed are as of the date written and are subject to change without notice. Except as otherwise required by law, Morningstar shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information contained herein is the proprietary property of Morningstar and may not be reproduced, in whole or in part, or used in any manner, without the prior written consent of Morningstar. To order reprints, call To license the research, call