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RMDs and Retirement Spending Strategies

After last week’s article about retirement spending strategies, several readers wrote in with questions about the interaction between required minimum distributions (RMDs) and such strategies.

The most common question was whether RMDs would get in the way of implementing a retirement spending strategy.

To be clear, the RMD rules say that you have to take money out of the account in question, but they do not force you to actually spend the money. Nor do they force you to change your asset allocation in any way. (That is, after taking the money out of your retirement account, you can re-buy the very same asset in a taxable brokerage account, if you want to.)

That said, there is some interaction between RMDs and spending, simply in the fact that if your RMDs are going to cause your tax bill to increase over time, that’s something you have to budget for — much as you might budget for, say, increasing health care expenses over time.

In other words, if increasing RMDs cause your tax bill to make up a larger and larger portion of your annual spending amount, it can force you to cut other expenses in order to stay within the spending range you’ve set for yourself.

RMDs Affecting Spending by Reducing Returns

One reader asked whether RMDs would eventually have a downward effect on portfolio returns (because more of the portfolio will be in a taxable account as time progresses) and whether that should be factored in when determining an initial spending rate.

It’s true that once the money is reinvested in a taxable account, the rate of growth will (generally) be lower than it would have been in a retirement account. But this would have a very minor effect on a person’s achievable level of spending through an entire retirement, given that:

  • RMDs have no effect whatsoever until age 70.5,
  • RMDs only affect a portion of your money (i.e., accounts that require RMDs have pretty small RMDs in the first several years, and RMDs have no effect at all on money that was already in a taxable account or a Roth IRA),
  • Even once the money is in a taxable account, you will still get to keep most of the earnings (especially with stock holdings, given the favorable tax treatment of dividends and long-term capital gains), and
  • Much of your ability to spend in retirement comes from the fact that you can spend principal as well as earnings.

RMDs as a Spending Strategy

One reader asked about the strategy of using RMD tables as a means of calculating your spending each year (i.e., each year, calculating what the RMD would be if your entire portfolio were in a traditional IRA, and using that amount as your annual spending amount).

A study by David Blanchett, Maciej Kowara, and Peng Chen found that such a strategy was more efficient than either the “percent of portfolio each year” strategy or the “inflation-adjusted spending” strategy that we discussed last week. And a study by Wei Sun and Anthony Webb had similarly positive findings for an RMD-based spending strategy. In other words, based on what I’ve read, I think that’s one of several reasonable approaches to selecting an annual spending amount.

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Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

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There is No Perfect Retirement Spending Strategy

Brief administrative note: to everybody who found this site via last week’s mention in the WSJ, welcome! I hope you find the articles helpful. If you ever have any topics you’d like to see me address in an article, feel free to shoot me an email.

Lately a few readers have written in asking about strategies for determining how much to spend each year from a retirement portfolio.

Personally, I think there are many parallels between selecting a spending strategy and selecting an asset allocation. That is, in each case you have an endless list of options, and there’s a ton of research on the topic. But no matter how sophisticated the research, nothing can actually tell you the future. Nothing can give you certainty about the best strategy.

In short, as with asset allocation, there is no perfect spending strategy, but there are many perfectly fine spending strategies. So the goal is to understand the pros and cons of each strategy, then pick one that suits you and move on with your life.

The Spectrum of Spending Strategies

I like to think of a spectrum of retirement spending strategies. At one end of the spectrum is a strategy in which you simply spend a fixed percentage of your portfolio balance each year (e.g., spending 4% of your portfolio balance each year). The advantage of this strategy is that you’ll never fully deplete your portfolio. The disadvantage is that your spending can vary dramatically from one year to the next.

At the other end of the spectrum is the strategy used by the classic “4% rule.” According to this strategy, you spend a certain percentage of your portfolio balance in the first year of retirement (e.g., 4%), then you adjust your spending upward each year in keeping with inflation, regardless of how your portfolio has performed. The advantage of this inflation-adjusted spending strategy is that it keeps your spending predictable. The downside is that it can lead to portfolio depletion, if your initial withdrawal rate turns out to have been too high relative to how long you end up living and how well your portfolio ends up performing.

And in the middle of the spectrum are an assortment of hybrid strategies that either:

  • Start with the “percent of portfolio each year” strategy, but then add a provision that attempts to control the variation in spending, or
  • Start with the “inflation-adjusted spending” strategy, but then add a provision that allows for a modest degree of adjustment based on portfolio performance.

For instance, Vanguard’s Managed Payout Fund uses a “percent of portfolio” strategy, but it smoothes the variation in spending by basing the payout on the average share price over the last three years.

Similarly, Colleen Jaconetti of Vanguard recently wrote about a “dynamic retirement spending strategy” that is essentially the “percent of portfolio” strategy, but with “floor” and “ceiling” amounts that are based on the prior year’s spending level, so as to limit the variation from year to year.

Yet another alternative is to use an inflation-adjusted spending strategy, but with a provision that “ratchets” spending slightly upward or downward if the portfolio grows/falls by a certain percentage.

Broadly speaking, the two principles that are always true are that:

  1. Regardless of which spending strategy you choose, selecting a lower annual spending amount at the outset makes you safer.
  2. A strategy that adjusts spending downward when portfolio performance is poor is safer than one that does not.

And by “safer” I mean, “less likely to lead to portfolio depletion.” The flip side, of course, is that the safer your spending plan, the more likely you are to die with a pile of unspent money — which may be acceptable or unacceptable to you, depending on how motivated you are by the idea of leaving a bequest to heirs/organizations.

Retiring Soon? Pick Up a Copy of My Book:

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Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

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Are Guaranteed Living Withdrawal Benefit (GLWB) Riders a Good Idea?

A reader writes in, asking:

“What do you think of the ‘Secure Income’ rider product for the Vanguard Variable Annuity? I find the combination of safety and flexibility to be very appealing, yet I have learned from bogleheads that a 1.2% fee is not something to be taken lightly.”

As we discussed earlier this year, in general I think that deferred variable annuities are most useful either as:

  1. A tax planning tool in uncommon circumstances, or
  2. A tool to get out of an even less desirable insurance product via a 1035 exchange.

What is a Guaranteed Living Withdrawal Benefit (GLWB)?

For those who are unfamiliar with the product, the “Secure Income” rider for the Vanguard variable annuity is a “guaranteed living withdrawal benefit” (GLWB) rider. With a GLWB rider, you agree to pay an extra annual expense, and in exchange you are guaranteed to be able to withdraw a certain amount per year from the account for the rest of your life.

In other words, a GLWB is kinda-sorta like having the benefit of a regular lifetime annuity, without having to annuitize the account (i.e., without having to turn over the assets). But you pay a significant annual cost for that benefit.

In the case of Vanguard’s GLWB, the annual cost is 1.2% of the “Total Withdrawal Base.” And the amount you are guaranteed to be able to withdraw per year is also a percentage of the Total Withdrawal Base (e.g., 4% for an individual who starts taking withdrawals between ages 59 and 64).

The Total Withdrawal Base starts out as the account value when you activate the GLWB rider. And each year it is recalculated as the greater of either 1) the existing Total Withdrawal Base or 2) the current account value. In other words, the Total Withdrawal Base will not go down as a result of poor investment performance — which means that your annual guaranteed withdrawal will also not decrease as a result of poor investment performance.

Are GLWB Riders a Good Idea?

Relative to simply owning the same variable annuity (without purchasing a rider) and taking the same size distribution each year as would be provided by the rider, the rider’s overall effect is to:

  1. Accelerate the likelihood and rate of account depletion (because of the additional cost), but
  2. Guarantee that income will still continue to be paid in the event that the account is depleted (because the TWB is locked in at a higher value).

Increasing the annual withdrawal rate from a portfolio by 1.2% (as would be the case when the Vanguard GLWB is activated) significantly increases the rate at which the portfolio will be depleted. In addition, if/when the account value does fall at some point, because the TWB is “locked in” (i.e., it doesn’t fall), the GLWB fee (1.2% of the TWB) will actually be more than 1.2% of the account value, which will cause the account to deplete even faster.

In short, the GLWB rider has the effect of guaranteeing some level of income, at the cost of reducing the amount that is ultimately left to heirs. Of course, that in itself isn’t necessary a bad tradeoff. Plain-old lifetime SPIAs involve the same tradeoff, and they’re broadly considered to be a useful tool in financial planning.

So the question is primarily: is the GLWB a good deal? That is, is the safety added by the guarantee worth the cost? Or would there be a more cost-effective way to get the same level of safety?

For instance, for a 62 year old male, the Vanguard GLWB rider guarantees a 4% income stream. So a $100,000 account would produce $4,000 of annual income (to start with — it could go up if the portfolio performs well soon after activating the rider).

Conversely, based on a quote from immediateannuities.com, $64,620 would be enough for a 62 year old male to purchase a lifetime SPIA that guarantees $4,000 of annual income. And that would leave $35,380 to be invested as desired to leave to heirs, provide for spending increases later, or some combination thereof.

Which is likely to work out better? That depends on investment performance as well as how long the person lives. In short, it’s not an easy question to answer.

And this, to me, is one of the reasons why I think most people (not necessarily everybody) should stay away from riders (and to a lesser extent, variable annuities in general) — it’s quite hard to analyze whether a specific guarantee is worth the cost. Earlier this year I wrote the following about variable annuity riders in general, and I think it’s applicable here:

The insurance company has a team of actuaries, financial analysts, and attorneys working together to create the product in such a way that they believe it will be profitable for them. The consumer, on the other hand, doesn’t have nearly the same level of information or analytical ability.

And when a financial services company has a significant information advantage over the client (that is, when the client can’t really tell whether they’re getting a very good deal, a very bad deal, or somewhere in the middle), it is not usually the financial services company that gets the short end of the stick.

As far as analyses that have already been done by smart, qualified people, here are a few that may be of interest:

One thing we can say with a high degree of confidence is that if our hypothetical 62 year old male has a desire for safe lifetime income, one thing he should definitely be doing before purchasing either type of annuity is delaying Social Security. With interest rates as low as they are right now, the deal offered by delaying Social Security is meaningfully better than the deal any insurance company would offer on an annuity.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

How Do You Know if You Need an Annuity?

Last Monday’s article briefly touched on some of the factors involved in whether or not it makes sense for somebody to purchase a single premium immediate annuity (“SPIA” — essentially a pension from an insurance company) with part of their portfolio. Several readers wrote in with related questions, such as this one:

“My question is related to SPIA and when to buy them. How do you know if you need a SPIA? Example: If you have a $1 million portfolio (60% bonds 40% equity) and you need to take 4% a year out are you a candidate for a SPIA?”

Generally speaking, a SPIA is useful when you want to increase the amount that you can safely spend from your portfolio per year. Said differently, it’s useful when your desired spending level might not be safe, given your portfolio size and given the other characteristics of your situation.

Based on the example the reader provided, there’s no way to know whether the person is a candidate for such an annuity. Much more information is needed. I would ask the person in the example the following questions.

How old are you? What kind of health are you in? Are you married? If so, how old is your spouse and what kind of health are they in? The key point with all of these questions is that the longer your life expectancy — or joint life expectancy — the riskier that 4% withdrawal rate is. If you’re 80 and single, a 4% withdrawal rate is super duper safe. If you’re 55, married to a 52-year-old, and you’re both in great health, that 4% withdrawal rate is quite a bit riskier.

Also, when you say that you “need” to spend 4% per year, what do you mean by “need”? For example, if the portfolio’s returns were poor within the first 5 or 10 years of retirement, how much of a disaster would it be to spend, say, 3% or 3.5% from the portfolio instead? The more flexibility you have, the safer the 4% initial withdrawal rate and the lower the need for an annuity.

And have you already claimed Social Security? If you haven’t, delaying Social Security (especially for the higher earner of the two of you, if you’re married) is a great way to increase your level of guaranteed income, and the payout is much better than the payout from annuities purchased from insurance companies. Conversely, if you’re already age 70 (or are already planning to delay until 70) and you are thinking (due to the factors discussed above) that your 4% necessary withdrawal rate is riskier than you’d like, a SPIA becomes more relevant.

And, speaking of Social Security, how much total safe income do you have? For example, if you’re planning to spend $40,000 from the portfolio per year but you also have $80,000 per year of Social Security/pension income, the impact of portfolio depletion would be much less dramatic than if you have $15,000 per year of Social Security/pension income. And, therefore, holding all else constant, a 4% withdrawal rate is much riskier if you have a lower level of guaranteed income from other sources than if you have a higher level of guaranteed income. (This was the major point of the article from David Blanchett that we discussed last week.)

And how strong is your “bequest motive”? That is, how much do you care about leaving money to heirs? One of the big drawbacks of purchasing a SPIA is that it reduces the size of your portfolio, so if you die soon after purchasing the annuity, your heirs will receive less than they would have received otherwise.

Overall point being: In some cases, a person with a $1,000,000 portfolio who plans to spend $40,000 per year (adjusted for inflation) from that portfolio has absolutely no need for a SPIA. Another person with different circumstances — but still with the same portfolio and still planning to spend the same amount from it — should think very seriously about purchasing a SPIA.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

The Relationship Between Guaranteed Income and Safe Withdrawal Rates

Spending from your portfolio in retirement is always a balancing act between two competing goals:

  1. Minimize the likelihood of depleting your portfolio during your lifetime (i.e., don’t overspend), and
  2. Have as high a standard of living as possible (i.e., don’t underspend and end up with a giant pile of unspent money when you die).

In a recent paper David Blanchett of Morningstar looked at how that balancing act is affected by the portion of your spending that comes from guaranteed sources (e.g., Social Security, pension, lifetime annuities) as opposed to from a portfolio of stocks/bonds with unpredictable returns.

If your spending is primarily portfolio-funded (rather than coming from guaranteed sources), you cannot afford to take significant risk of depleting the portfolio. That is, Goal #1 (don’t overspend and deplete your portfolio) is so much more important than Goal #2 (don’t underspend) that you can’t really afford to think about Goal #2 very much. Conversely, if your overall spending is funded primarily by guaranteed sources, then Goal #1 becomes less important relative to Goal #2 and the “just right” rate of spending from your portfolio is going to be higher.

A lot higher, as it turns out. Here’s one of Blanchett’s findings:

“Results from this analysis suggest that optimal initial safe withdrawal rates varied significantly when guaranteed income was considered, from approximately 6 percent when 95 percent of wealth was in guaranteed income, versus approximately 2 percent when only 5 percent of wealth was in guaranteed income.”

In other words, holding all of the other variables constant, it’s reasonable for a person with a very high level of guaranteed income to spend from their portfolio at roughly three-times the rate of a person with a very low level of guaranteed income.

An important takeaway here is that if you are basing your own spending rate upon one or more specific pieces of “safe withdrawal rate” research, you should check that their assumptions are a good fit for your own personal circumstances. Does the research demand a higher (or lower) level of safety than you require given your own circumstances?

Another important point is that this factor (i.e., the percentage of your spending that comes from guaranteed income sources rather than from a stock/bond portfolio) is under your control to a significant extent. If you want to increase your level of safe income, you can delay Social Security and/or purchase a lifetime annuity with part of your portfolio. These are not things that everybody should do. But they do meaningfully increase the amount you can safely spend per year, because:

  1. The payout on the part of the portfolio that gets annuitized (or the part that gets spent down to delay Social Security) is higher than the safe withdrawal rate from a stock/bond portfolio, and
  2. As Blanchett discusses in the paper, your safe withdrawal rate from the rest of the portfolio can now be higher because it’s less problematic if the portfolio is ultimately depleted.

To be clear though, while this one factor does have a big impact, it’s not the only thing influencing the appropriate spending rate from a portfolio. The appropriate spending rate also varies significantly depending on:

  • The expected returns from stocks and bonds,
  • Your life expectancy (an 85-year-old can safely spend a higher percentage of their portfolio per year than a 65-year-old),
  • Your flexibility to adjust spending, and
  • The strength of your “bequest motive” (i.e., your desire to leave behind a lump-sum for your heirs).

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

Is Your Retirement Portfolio Less Liquid Than You Think?

While reading Wade Pfau’s recent paper “Retirement Income Showdown: Risk Pooling Versus Risk Premium,” I came across a topic I wanted to share with you. (For reference, this is not the main point of the paper but rather one of a handful of points discussed in a comparison of partially-annuitized portfolios to regular “investments-only” portfolios.)

I think the concept is best explained with an example.

Imagine that you retire at age 65, and you decide on the date of your retirement to use all of your retirement savings to purchase a Treasury bond ladder extending 30 years into the future. That is, you plan to have Treasury bonds maturing each year for the next 30 years, and you plan to use those bonds to fund your retirement spending.

In this example, how liquid is your portfolio?

In one sense, it’s super liquid, given that Treasury bonds are one of the most liquid assets in the world. At any given moment, there are countless parties who would be willing to buy your Treasury bonds.

But from the perspective of your own personal retirement, your portfolio is not nearly so liquid. For example, in Year 1 of retirement, you can really only afford to spend the money from Year 1’s Treasury bonds. If you find yourself liquidating Year 2’s bonds and spending that money prior to Year 2, you have a problem.

Pfau explains it this way (while referencing another article by Curtis Cloke):

“In a sense, an investment portfolio is a liquid asset, but some of its liquidity may be only an illusion. Assets must be matched to liabilities. Some, or even all, of the investment portfolio may be earmarked to meet future lifestyle spending goals. In Cloke’s language, the portfolio is held ‘hostage to income needs.’ A retiree is free to reallocate her assets in any way she wishes, but the assets are not truly liquid because they must be preserved to meet the spending goal. While a retiree could decide to use these assets for another purpose, doing so would jeopardize the ability to fund future spending.

This is different from ‘true liquidity,’ in which assets could be spent in any desired way because they are not earmarked to cover other liabilities. True liquidity emerges when excess assets remain after specifically accounting for ongoing lifestyle spending goals. This distinction is important because there could be cases when tying up part of one’s assets in something illiquid, such as an income annuity, may allow for the spending goal to be covered more cheaply than could be done when all assets are positioned in an investment portfolio.”

In other words, a typical “investments-only” portfolio of stocks/bonds/mutual funds is liquid in the sense that you can sell your holdings at any time. But if the portfolio is just barely large enough to be expected to satisfy your lifetime spending, it’s illiquid in the sense that you have no flexibility in terms of how much you can spend per year. You can’t really afford to spend a higher-than-planned amount in a particular year.

Conversely, if you took part of the portfolio and used it to purchase a lifetime annuity, your remaining portfolio would be smaller, but because of the relatively high payout on such annuities, you would have more flexibility with your remaining portfolio — more “true liquidity” in Pfau’s terms.

How About an Example?

For those of us here in the U.S., the best deal we can find on an annuity purchase is from delaying Social Security.

Imagine you have a retirement portfolio of $800,000, and you estimate your annual expenses to be $50,000. With regard to Social Security, you have a full retirement age of 67, and your primary insurance amount (i.e., your Social Security benefit at full retirement age) is $2,000 per month, meaning that you would get:

  • $1,400 per month ($16,800 per year) if you file ASAP at age 62, or
  • $2,480 per month ($29,760 per year) if you wait until age 70.

If you file at age 62 your portfolio will have to satisfy $33,200 of expenses per year (that is, $50,000 of total expenses minus $16,800 of Social Security income). With an $800,000 portfolio, that’s a 4.15% initial withdrawal rate — putting you squarely in the “probably fine, but who really knows?” zone. (That is, you’re in the zone where you likely can’t afford to have a big spending shock, especially not in early retirement.)

Conversely, if the plain is to wait until age 70, the portfolio can be split into two sub-portfolios:

  1. One portfolio that will have to satisfy $20,240 of annual expenses every year, starting at age 62, and
  2. One portfolio that will have to satisfy the remaining $29,760 of annual expenses from 62 until 70 (at which point Social Security will kick in).

The second portfolio will have to be $238,080 (i.e., $29,760 per year for 8 years), and it should be put in something very safe (e.g., money market account, an 8-year CD ladder, etc.). That leaves $561,920 for the first part of the portfolio, resulting in a spending rate of 3.6%.

In other words, the portion of the portfolio that is intended to last throughout retirement now has a spending rate of 3.6% rather than 4.15%, meaning that there’s more flexibility to handle unexpected spending shocks.

To be clear, this is a simplified example, in that it ignores investment returns, taxes, and the complexity that arises with regard to Social Security benefits for married couples. But even when you build out a more detailed analysis, the same overall concept holds true. Delaying Social Security means you’ll have a smaller portfolio, but you will have greater flexibility in terms of what you can do with that portfolio — more “true liquidity.”

The same concept holds true with purchasing lifetime annuities from insurance companies, though the effect is not as powerful, given that the payout per dollar spent on premiums is not as high as the payout per dollar spent to delay Social Security.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."
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