Friday, April 28, 2017

Thursday, April 20, 2017

Spending Down Your Assets in Retirement – Finding the “Goldilocks” Solution

Typical spending goals for many retirees include:
  • maximizing spending while living 
  • not running out of accumulated savings 
  • avoiding year-to-year spending volatility 
  • having spending flexibility 
  • not leaving too much to heirs
Achieving these potentially conflicting goals generally involves gradually spending down most of one’s accumulated savings over the individual’s (or couple’s) remaining lifetime.  Helping individuals to accomplish these (and other) goals is our primary objective.  And while retirees understand that their financial plan in retirement may involve spending down most of their accumulated savings, they generally don’t want their assets to be depleted either too rapidly or too slowly, and they also want to achieve the other goals listed above.  In other words, they are looking for that “Goldilocks-just-right” solution.

Asset depletion that occurs too rapidly generally results from spending too much, from unfavorable investment experience or from a combination of the two.  Retirement experts generally refer to the risk of receiving lower or negative returns early in a period when withdrawals are made from an individual's underlying investments as sequence of return risk (SORR).  In his excellent recent article, Dr. Wade Pfau discusses four ways retirees and their financial advisors can manage SORR.  They include:

  1. Spend conservatively 
  2. Maintain spending flexibility 
  3. Reduce volatility (when it matters most) 
  4. Buffer assets – avoid selling at losses
As discussed by Dr. Pfau, addressing SORR generally involves managing one’s spending or one’s investments, and, like most financial decisions, managing SORR involves tradeoffs.  We have talked about SORR mitigation approaches in prior posts and how the Actuarial Approach can be used by retirees and financial advisors to mitigate such risk, but we feel that the concepts are worth repeating, so we will once again tackle them below, this time in the same order suggested by Dr. Pfau.  But, before we do, we want to set the stage by talking about the two generic types of approaches used today to help retirees achieve their spending goals.

Dynamic vs. Static Spending Approaches

In theory, managing SORR is a relatively easy process.  All one must do is adjust spending each year to reflect actual experience.  This is what the actuarially determined spending budget recommended in this website does.  It automatically “marks to market” and tells a retiree how much spending must be increased or decreased to balance the retiree’s assets with her spending “liabilities.”  Because the Actuarial Approach involves a dynamic re-measurement of assets and liabilities each year, it can result in spending volatility if it is used without adjustment and can, therefore, bump up against the “anti-volatility” retiree spending goal discussed above.  See our post of November 17, 2015 for more discussion of dynamic vs. static spending approaches.

By comparison, SORR is much more of an issue with more static spending approaches that decouple spending determination from actual investment experience.  Safe withdrawal rate approaches and stochastic Monte Carlo approaches that imply that there is a 95% probability that a specific level of spending can be achieved (without future adjustment) with a given asset mix are examples of these more static approaches.

Unfortunately, neither a pure dynamic nor a pure static approach is likely to satisfy all of a retiree’s spending goals in retirement.  The Goldilocks solution involves making further adjustments to these approaches to make them work better.  For example, the more dynamic approaches like the Actuarial Approach may require some smoothing of the effects of investment fluctuations from year to year, and, as discussed by Dr. Pfau in his article, the more static approaches may require adjustments in spending or investments.  The optimal solution lies in combining the positive elements of both approaches.

The following sections discuss the four ways Dr. Pfau suggests SORR can be lessened for more static spending strategies and how the Actuarial Approach can be helpful in this regard.

Spend Conservatively

The first step suggested by Dr. Pfau is to spend more conservatively, particularly if significantly invested in risky assets.

We believe the actuarially calculated spending budget developed using our recommended assumptions is a conservative approach for most retirees.  It is based on reasonably conservative estimates of future investment returns (rates consistent with current immediate annuity purchase rates) and longevity (approximately 25% probability level of survival for healthy individuals).  As indicated in our post of March 20 of this year, less conservative spending budgets can be developed by assuming more optimistic future experience, but by doing so, increases the likelihood that future spending budgets may decrease relative to today’s.

Maintain Spending Flexibility

The second key to reducing SORR for more static approaches is the willingness, if necessary, to reduce spending in years following a year of poor investment performance.

Maintaining spending flexibility is a clear strength of the more dynamic Actuarial Approach.  As discussed above and in our post of June 27th of last year, the Actuarial Approach automatically tells you each year how much you need to reduce your spending to maintain the actuarial balance between your new (lower) assets and your spending liabilities.  However, this doesn’t mean that you must reduce your spending to this lower actuarially determined level, but it does give you an important “data point” that you can use to mitigate your SORR.  The closer your actual spending is to the new lower actuarially determined budget, the more you have mitigated the SORR, all things being equal.  However, if you have previously established a rainy-day fund (discussed below), you may not need to reduce your spending following a year of poor investment performance.

By the same token, if you experience a good investment year, the Actuarial Approach automatically tells you how much you can increase your spending and still remain in actuarial balance.  Again, however, you aren’t required to increase your spending to this new level.  In this somewhat more pleasant event, some retirees may wish to keep spending unchanged in real dollars and “pocket” some or all of the investment gains in your rainy-day fund to be used in the future to offset future investment losses.

Reduce Volatility

For more static approaches where spending volatility is presumably not as much of an issue, Dr. Pfau discusses reducing portfolio volatility to mitigate SORR as an investment strategy.  Generally, we avoid recommending specific investment strategies since we rapidly wind up in an area outside our field of expertise, but we do want to point out that our Actuarial Budget Calculator workbook can be used to help retirees and their financial advisors quantify the actuarial spending budget implications of increasing or decreasing investment risk in the investment portfolio.  Our 5-year projection tab shows the impact on the actuarially determined spending budget of alternative levels of spending or different investment returns.  For example, this tab could show you the impact on your actuarially determined spending budget of a -40% return on equities (similar to 2008) next year for various asset allocations.  As noted above, there is no requirement that you drop your actual spending to the actuarially determined spending level because of such a negative return, but the more you smooth your spending in such an event, the more you are decreasing your SORR, all things being equal.

Buffer Assets

Dr. Pfau suggests that having other assets available in the year following a poor investment year is another good way to manage SORR.

This suggestion is also one of our favorite approaches to manage spending volatility.  We refer to this strategy as utilizing a rainy-day fund, and we discussed this concept in our post of July 4, 2016.  Under this approach, instead of using gains to increase your spending budget, you bank some or all of the gains in the rainy-day fund to be used to mitigate the effects of future investment losses.


SORR is generally not as significant of an issue with those who use more dynamic spending strategies that periodically adjust for actual investment experience.  It is more of an issue with individuals and their financial advisors who disassociate spending decisions from actual investment performance.  Rather than having faith that such a decoupling approach will work, we suggest that an actuarially determined spending budget be determined each year and that the resulting amount be used as another “data point” in making spending decisions.  We encourage retirees and their financial advisors to use the Actuarial Approach in combination with their more static approaches to periodically check to see just how far off the actuarially balanced track their actual spending and actual investment performance has led them.  Judiciously utilizing the Actuarial Approach in combination with a more static approach may just provide the necessary adjustments that will enable retirees to find their Goldilocks solution.

Thursday, April 13, 2017

Safe Withdrawal Rates—The Good News Bad News Story

This good news bad news story was inspired by Dr. David Blanchett’s recent article in the Journal of Financial Planning entitled, “The Impact of Guaranteed Income and Dynamic Withdrawals on Safe Initial Withdrawal Rates.”  Dr. Blanchett is head of retirement research at Morningstar Investment Management and is one of the leading retirement researchers in the country.

You want the good news first?  The good news is that Dr. Blanchett’s latest research shows that retirees:

  • with a larger percentage of their wealth invested in a specific type of guaranteed income, 
  • who are willing to commit to Dr. Blanchett’s complicated dynamic adjustments, 
  • who can achieve higher investment returns, or 
  • who are willing to live with lower probabilities of success
can use higher initial safe withdrawals rates when determining how much they can withdraw from their investment portfolio upon retirement (and subsequently increase this initial amount with inflation thereafter unless they also employ Dr. Blanchett’s dynamic rule adjustments).  We think that the good news in this research is that:
  • it is a mistake to view portfolio withdrawals in isolation from other sources of income (as is the common practice), and 
  • risks retirees face in retirement can be mitigated by investing in guaranteed lifetime income sources and using dynamic rather than static spending strategies.
The bad news in this story, however, is that Dr. Blanchett is even talking about utilizing safe withdrawal strategies with the implication that there are still financial planners out there who continue to use such strategies for their clients.  Since we here at How Much Can You Afford to Spend are not big fans of strategic withdrawal plans (SWPs) in general, and we are definitely not fans of the subset of SWPs known as Safe Withdrawal Rate approaches, we find the phrase “optimal safe withdrawal rates” to be an oxymoron.  Further discussion of why we are so negative about SWPs can be found in our posts of January 12, 2017 and October 27, 2016, and our website is littered with posts almost from its inception in 2010 of why we believe the 4% Rule and its safe withdrawal rate cousins are inferior to the Actuarial Approach.

A Few More Thoughts

As we have discussed in previous posts, in making SWPs work, researchers will generally pair the SWP with lifetime income streams that are paid in constant real dollars.  This is exactly the type of lifetime payment stream that Dr. Blanchett is referring to when he uses the term “guaranteed income.”  It is important to note that Dr. Blanchett would probably not reach the same conclusion if he defined “guaranteed income” as the far more common fixed dollar (constant nominal dollar) stream of payments, because, under this scenario, greater portfolio withdrawals would be needed in later years to provide total constant real dollar spending.  We caution financial advisors and retirees who may be misled by conclusions reached by Dr. Blanchett’s because of how he defines “guaranteed income.”

Dr. Blanchett goes to significant lengths in his article to point out that the methodology he uses in his analysis weights the probability of the retiree household surviving to each age rather than using “some arbitrary fixed period.”  We note, however, that Dr. Blanchett makes a number of significant assumptions in his calculations to simplify his calculations, so we find the implied precision of this one particular assumption to be grossly exaggerated.  And, we tend not to get as excited as Dr. Blanchett (and others) about assuming fixed lifetime planning periods.  We note that, in real life, whether one lives or dies is a binary process, and little pieces of us do not die each year.

While on the subject of implied precision, we will once again tackle the common misperception that, just because a researcher runs 10,000 scenarios using Monte Carlo modeling, that:

  • employs lots of assumptions about future experience, 
  • employs lots of simplifying assumptions about hypothetical retiree sources of income, and 
  • assumes retiree future spending will exactly follow certain sophisticated algorithms each year in the future,
the resulting spending solution will necessarily be more precise or more “optimal” than making best estimate deterministic assumptions about the future each year, and annually adjusting the spending strategy for deviations in actual experience and actual spending that will inevitably occur.  We caution financial advisors and others to be skeptical of optimal strategies that may be based on unrealistic modeling of retiree circumstances or of the future.

Finally, the Society of Actuaries 2012 IAM table(s) are the Individual Annuity Mortality tables, not the Immediate Annuity Mortality table, as stated in the article.


As discussed many times in this website, we think the safe withdrawal rate strategies are deficient in a number of areas, and attempts like Dr. Blanchett’s and others to modify them to make them work better are probably not worth the effort.  We know that you find this hard to believe, but we actually think a better answer lies with the Actuarial Approach we recommend.  And the really good news here is that the Excel workbooks that we provide to help you implement the Actuarial Approach are available for free and are just a click away.