Viewpoints

Needlessly Scrimping?

Faced with gyrating markets, many retirees worry about exhausting their savings. To calm nerves, some clients may insist on reducing their spending. But if withdrawal plans have been carefully designed, advisors have little reason to make major alterations now. Most clients are not likely to run out of money provided they have invested in a sensible portfolio and take reasonable withdrawals, says

Faced with gyrating markets, many retirees worry about exhausting their savings. To calm nerves, some clients may insist on reducing their spending. But if withdrawal plans have been carefully designed, advisors have little reason to make major alterations now. “Most clients are not likely to run out of money — provided they have invested in a sensible portfolio and take reasonable withdrawals,” says Stephen Utkus, head of Vanguard Group's Center of Retirement Research.

Utkus notes that many desktop software packages suggest withdrawing 4 percent of assets the first year, and then increasing the amount by the inflation rate in subsequent years. So a client who retired in October 2007 with $1 million could take out $40,000 for the first year. This October, the portfolio value might well have dropped to less than $800,000. But Utkus says that the client could stay on course, withdrawing $40,000 plus an inflation adjustment for the current year.

A growing body of research suggests that retirees can confidently continue planned withdrawals in turbulent times — and not run out of money years down the road. In the 1990s, financial advisors began examining how portfolios would have fared in different periods. Bill Bengen, a financial advisor in El Cajon, Calif., found that investors who used a 4 percent withdrawal rate would not have exhausted their assets during any 30-year period.

More recently, advisors have fretted that the 4 percent figure is too low, causing retirees to scrimp needlessly. According to some studies, an investor who retired in 1950 could start with a 10 percent withdrawal rate and not go bankrupt in 30 years. But how can an advisor predict when, and whether, the markets will support hefty distributions?

To determine the best withdrawal rate, consider whether the stock market is cheap or expensive, says Michael Kitces, director of financial planning for Pinnacle Advisory Group, a registered investment advisor in Columbia, Maryland, that clears trades through Charles Schwab Institutional. Kitces arrived at his conclusion after studying historical market performance going back to 1871. He noted that the safe withdrawal rate varied from year to year. In the late 1920s, retirees could have withdrawn only about 4 percent of assets without exhausting their nest eggs. But in good retirement years, such as 1948 and 1955, an investor could have withdrawn 6 percent.

Examining the data, Kitces noted that the safe withdrawal rates were higher in years when the price-earnings ratio of the stock market was lower. In other words, market returns were greater in periods that began with low P/E multiples.

As a guideline, Kitces suggested that when the P/E ratio is more than 20, retirees should start by taking a 4.5 percent distribution. If the multiple is below 12, investors can take up to 5.7 percent. With the multiple currently around 13, he suggests withdrawing around 5 percent.

FLEXIBLE WITHDRAWALS

While many financial advisors agree that the withdrawal rate should be around 4 percent or 5 percent, they believe that distributions should be customized for each client. Some advisors adjust the rate to suit a client's life expectancy. “If someone is retiring at 55 and could live 40 years, then maybe you want to set the rate at 3.5 percent just to be on the safe side,” says Utkus. “For someone who is 75, it may be reasonable to withdraw more than 5 percent.”

Once the withdrawal rate is selected, it need not be carved in stone, Utkus says. An advisor should check the portfolio periodically, running projections to see whether the client can afford to maintain withdrawals. After a market downturn, clients may decide to reduce distributions. Many advisors examine withdrawal rates as part of an annual review process. Besides analyzing market performance, the advisor will also consider special circumstances. If a spouse dies, the living expenses may decline, and the withdrawals can be reduced. During some years, the client may have extra expenses and need to take bigger withdrawals for health costs or for situations like having to pay for a wedding.

Advisors have different approaches for insuring that withdrawals are not eroded by inflation. Some advisors suggest increasing withdrawals by 3 percent annually, the historical average inflation rate. But Kitces and others say that the payout should be adjusted to match the consumer price index. That way the client's purchasing power will not be eroded during periods of high inflation. Currently, the CPI is rising at an annual rate of 5.4 percent, so withdrawals should be increased by that amount.

Advisors may sometimes want to tinker with the CPI adjustment, says Utkus. Say a nervous client this year wants to reduce the withdrawal rate. Instead, the client could take the same basic withdrawal and forgo the inflation adjustment. That could help to calm the client's nerves without throwing the entire withdrawal plan off course.

Advisors who put a portion of assets in fixed annuities may still need to calculate withdrawal rates periodically, says Utkus. Say a client with $1 million puts half in mutual funds and half in an annuity that pays a fixed rate of 8 percent for life. If the client can postpone touching the mutual funds then there is no need to calculate withdrawals from the funds right away. But once the saver begins tapping the funds, the advisor should calculate the withdrawal rate. If the client wants the mutual funds to last for 30 years, then he should start with the normal withdrawal rate of 4 percent or so.

For $250, an investor can get advice on withdrawals from a T. Rowe Price consultant. The fee is waived for clients who have $500,000 invested at the fund company. The T. Rowe Price consultants run Monte Carlo simulations, estimating how portfolios would perform under hundreds of different scenarios. Then the consultants present clients with estimates of the odds for success. For example, 5 percent withdrawals could result in success under 90 percent of scenarios. That might seem like a comfortable approach for a client who can accept moderate risk. A more conservative saver might insist on taking smaller withdrawals and achieving a 97 percent success rate.

Some planners prefer to run simulations every year. Say a portfolio has a 90 percent chance of success. Then, after a bad year in the markets, the chance of success drops to 80 percent. The client can elect to continue withdrawals — and hope that a market recovery improves the portfolio's odds. Some clients may insist on immediately reducing withdrawals, maintaining the 90 percent figure every year. “We see conservative clients who always want the likelihood of success to be 97 percent or higher,” says Stuart Ritter, a financial planner with T. Rowe Price.

To insure complete success, a cautious advisor could adjust withdrawals annually, taking 4 percent of the total remaining assets each year. If the market soared, withdrawals would climb. And in a bear market, the client would have less spending money.

BE FLEXIBLE BUT NOT TOO

Still, Kitces argues that constant shifts could annoy clients. “For most people, it is incredibly disruptive to suddenly reduce withdrawals by 40 percent,” he says.

Kitces suggests setting a withdrawal rate and sticking to it for three to five years. At the end of the time, the advisor can run the numbers again. Often there will be no reason to make major adjustments. In a typical market cycle, there are up and down years. But throughout the cycle, an investor would be well served by sticking to withdrawal plans of 4 percent or 5 percent.

To illustrate the hazards of changing withdrawals every year, Kitces points to the extreme conditions of the late 1990s. If an advisor insisted on changing withdrawal rates annually, he would have raised distributions sharply in 1998 and 1999. Then, for the next three years, the advisor would have lowered withdrawals. In the end, clients may have been happier with a strategy of taking consistent withdrawals.

Kitces says that any increases in withdrawals should be made gradually. “If your portfolio is up 50 percent in the first three years, then maybe you can increase your spending by 10 percent,” he says. “You should only spend part of your gains because you still need a cushion for the hard times.”

Bengen has suggested adjusting withdrawal rates within strict limits. In a bull market, the withdrawals can be increased up to 25 percent above the original annual target. During hard times, the distribution can be reduced by up to 10 percent. Bengen says that by starting with a 4.58 percent withdrawal rate and sticking within the limits, an investor should not go bankrupt in 30 years. If the investor starts with a 5.50 percent withdrawal and uses the limits, the portfolio has a 77 percent chance of success.

No matter what withdrawal rate you use, Kitces cautions that the first five or 10 years are particularly important. When clients suffer big losses in the early years, advisors may be forced to reduce withdrawals sharply. On the other hand, strong markets in the first few years can enable the retiree to spend more lavishly than he ever thought possible. “If you have good returns for 15 years, you can wind up with four times the amount of money that you expected,” says Kitces. “Then you can raise the spending limit and not worry much about exhausting the assets.”

Use — Don't Abuse — The Nest Egg

Americans have become more and more dependent on 401(k)s, which put the market risk right on their shoulders rather than traditional pensions, in which the employer bears all the risk.

P/E range Lowest safe withdrawal rate for portfolios with 40% in equities Lowest safe withdrawal rate for portfolios with 60% in equities
5.4 to 12.0 5.2% 5.7%
12.0 to 14.7 4.5 4.8
14.7 to 17.6 4.3 4.9
17.6 to 19.9 4.2 4.9
19.9 to 28.7 3.9 4.4
Source: The Kitces Report
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