Archives for August 2011

Connie writes in to ask,

“I’m 58, and I just found out that I’m going to be laid off in less than a month. My previous plan had been to work until 62, then retire and start Social Security right away. Still, it looks like I might have enough money not to have to go back to work if I cut my expenses just a little.

I’ve decided that I’m comfortable with a 4% withdrawal rate. But how do I account for the fact that the amount I’ll need to spend from my investments will decrease in a few years once I start claiming Social Security?”

This type of situation is very common–people whose income will increase at some point during retirement (usually due to Social Security) or whose expenses will decrease at some point (due to a mortgage being paid off or due to qualifying for Medicare, for instance).

In general, the way I’d approach the analysis for such situations is to use some mental accounting. Mentally separate your portfolio into two parts:

1. The part that will satisfy your ongoing expenses (using whatever long-term asset allocation and withdrawal rate you choose to use), and
2. A lump sum that will be used to pay the additional expenses for the first several years.

So How Much Money Does Connie Need?

So that we can walk through an example, let’s make up a few numbers for Connie. Let’s assume that:

• Her expenses are $35,000 per year (and, aside from inflation, she doesn’t expect that to change),
• She has no pension or other sources of non-investment income, and
• If she claims Social Security at her full retirement age (FRA) of 66, her benefits will amount to $17,000 per year.

Important note: I’m only using this claim-at-FRA scenario for the sake of our first-glance analysis here. It’s not a suggestion that claiming at FRA is necessarily the best approach for early retirees. In some cases it makes sense to take Social Security early, and in other cases it makes sense to delay all the way to age 70.

This means that, for eight years (from age 58 to 66), Connie needs her portfolio to fund $35,000 of expenses. Then, starting at age 66, it will only have to fund $18,000 of expenses ($35,000, minus $17,000 Social Security).

Or, said differently, her portfolio must fund $18,000 of expenses every year for the rest of her life, plus $17,000 of additional expenses for the eight years until she reaches age 66.

Given that Connie is comfortable with a 4% withdrawal rate for the rest of her life, she needs $450,000 ($18,000 ÷ 0.04) to fund the $18,000 of annual expenses.

To that, we add $136,000 (8 x $17,000) for her eight years of higher spending prior to claiming Social Security. (The assumption here is that Connie puts this short-term money in something low-risk like a CD/bond ladder and that it ends up earning a 0% real return.)

So, in total, Connie needs $586,000.

Complicating Factor: Taxes

As you’ve probably noticed, we’ve completely ignored taxes here. Given the numbers we’ve assumed, this isn’t too terrible of an oversimplification.

• At these income levels, Connie’s Social Security benefits would be mostly tax-free,
• At these income levels, long-term capital gains and qualified dividends from taxable accounts would be taxed at 0%,
• Some of her holdings may be in a Roth IRA, which would be entirely tax-free, and
• The first $9,500 ($10,950 once she’s age 65) of otherwise-taxable income would be free from tax due to Connie’s standard deduction and personal exemption.

In other words, given the assumptions we’ve made, Connie’s overall effective tax rate is likely to be less than 5% for most of her retirement. Naturally, your own situation could be quite different–thereby necessitating that you increase the amount of savings needed to fund a given level of retirement spending.

If you’ve read much about retirement planning, you’ve probably encountered the “4% rule,” which suggests that investors withdraw no more than 4% of their portfolio per year during the early stages of retirement.

The 4% rule is the result of various studies (most famously this one), which showed that using a withdrawal rate much higher than 4% leads to an undesirably-high probability of running out of money over a 30-year retirement — the underlying assumption being that 30 years is a conservative (on the high end) estimate of how long retirement might last.

But just how conservative is that 30-year assumption? For a 65-year-old or a 65-year-old couple, it turns out it’s quite conservative. According to a handy calculator from Vanguard (which uses data from the Society of Actuaries):

• A male age 65 has just shy of a 6% chance of living another 30 years,
• A female age 65 has a 13% chance of living another 30 years, and
• A male/female couple age 65 has an 18% chance that one of the spouses will live another 30 years.

So, for example, for a spending strategy that has a 20% historical failure rate over 30-year periods, the historical chance that an actual 65-year-old married couple would have run out of money during retirement is actually significantly below 20%. To run out of money, they’d need to have a poor-returns outcome and a living-longer-than-average outcome.

Incorporating Life Expectancy Data

Fellow blogger Wade Pfau recently ran the numbers and put together some handy charts to show the historical probability of running out of money (given various asset allocations and withdrawal rates) for a 65 year-old couple using actual life expectancies rather than an assumption that they’ll automatically live for 30 more years.

Of course, as with any study based on historical data, it’s only useful as a predictor to the extent that future returns look like past returns. And many experts believe that stock returns going forward are unlikely to be as high as those of the previous century.

Still, I find the results at least a little encouraging.

For example, according to Pfau’s research, a married couple both age 65 using a 4% withdrawal rate has a less than 10% historical probability of running out of money at most asset allocations. (Interestingly, at a 4% withdrawal rate, the failure rate is barely affected by asset allocation. Portfolios of 30% stocks, 70% stocks, and everywhere in between have nearly identical failure rates.)

Even if you bump the withdrawal rate up to 5%, the probability of running out of money doesn’t exceed 20% for most moderate asset allocations.

Admittedly, the idea that we might not live as long as we’d planned isn’t exactly an overwhelmingly positive message. But at least we might not have to be as stingy with our money as we’re often told to be.