How to Revise Your Spending Plan

 

The swift declines in most asset classes in late 2008 and into 2009 damaged many portfolios. For those who are retired or near retirement, one necessary step after such an event is to re-evaluate retirement spending. Specifically you have to check the rate at which you are withdrawing money from the retirement portfolio and decide if it needs to be adjusted to reduce the risk of running out of money.

In the past I have discussed the safe or sustainable withdrawal rate, especially in my newsletter Retirement Watch. The safe withdrawal rate is the percentage of the portfolio you can withdraw the first year, increase by inflation each subsequent year, and have a high probability the portfolio will last at least 30 years. The biggest risk to a retirement portfolio is a bear market or a long-term flat market in the early years of retirement. The second biggest risk is to withdraw money at an unsustainable rate.

Numerous studies have been done. They all indicate that to be safe, the first year withdrawal rate should be between 3% and 4% of the portfolio. The most commonly-cited sustainable rate is 3.6%. This assumes you invest at least 50% of the portfolio in stocks or assets that earn similar returns and the rest in bonds. If you invest a lower percentage in growth assets, the sustainable withdrawal rate is lower.

If you are fortunate enough to retire at the beginning of a bull market, a higher withdrawal rate is safe. But you won't know until after a few years of retirement the type of market that coincided with the beginning of your retirement.

Whatever withdrawal rate you choose the first year, the rate needs to be re-evaluated periodically. Especially with the current bear market, you need to re-examine the decision. Even the 3.6% withdrawal rate does not allow a portfolio to last 30 years 100% of the time. There still is a risk of running out of money in the case of a severe bear market. You want to be sure today’s nasty market environment does not tip you into that small percentage of times when even the historic sustainable withdrawal rate is too high.

Bear markets are followed by bull markets. Bull markets restore the retirement portfolio by accumulating gains faster than you spend. The key is to be sure the combination of the bear market and your spending does not bring the portfolio balance so low the subsequent bull market gains are not enough to sustain the portfolio through retirement.

If you retired a few years ago and still have a portfolio that is worth more than your starting portfolio, you probably are in good shape. The research shows you should be able to continue your planned withdrawal schedule with a very low probability of outliving your money. You might want to reduce spending a bit for the next few years to be on the safe side, but drastic measures should not be needed unless there is another significant downward leg to this bear market.

What if you now have less money than when you first retired? In that case, you need to consider changes. We will review some potential changes shortly. First, let's look at some more objective benchmarks of your spending rate.

One check is to assume an immediate single-premium lifetime annuity is purchased today with your entire retirement portfolio. Is the annual payout from that annuity similar to the amount you are withdrawing now? If you are withdrawing significantly more than the annuity payment, you are likely to have a problem sustaining the withdrawal rate. Insurance companies spend a lot of resources calculating life expectancies, devising investment strategies, and determining how much they can pay a person and still make a profit. If your withdrawals are significantly higher than what the insurers are paying, then you are assuming a significantly higher investment return or shorter life expectancy than the insurers. Keep in mind if you have a spouse you intend to provide for, the portfolio likely will have to last longer than for a single life annuity. Also, insurers usually do not index annuities for inflation. So if you are withdrawing significantly more than annuities are paying and you are increasing that for inflation, you need to re-evaluate the spending rate. Check annuity payout rates at web sites such as www.ImmediateAnnuities.com

Another objective warning sign is a withdrawal rate well above the historic safe rate. Surveys continue to show many people think they safely can withdraw 8% to 10% annually. Research does not back that up, except in strong bull markets.

Here’s another quantitative measure.

One study found a strong correlation between the safe withdrawal rate for the next 30 years and the current price/earnings ratio of the S&P 500. The higher the P/E ratio, the lower the safe withdrawal rate is for the next 30 years. P/E ratios tend to be high at bull market peaks, followed by years of below-average returns.

A simple rule is that when the P/E ratio is above the historic average, the safe withdrawal rate is on the low side. When the P/E ratio is low, withdrawal rates can be higher. When the P/E ratio is below 12, a withdrawal rate of 6% or more generally is safe. At extreme bear market bottoms, a rate of 10% can be sustained going forward. Right now, the P/E ratio is a little below the historic average but not near historic lows.

If your portfolio has declined and you are concerned how long it will last at the current spending rate, there are steps you should consider. One or more of these steps should put you back on the right track.

Ÿ Drop the inflation bump. Remember the studies all assume that after the first year the amount taken from the portfolio each year increases with inflation. A simple step is to stop the inflation increase for a while. Insurers generally do not increase annuity payouts for inflation because it is very expensive.

Ÿ Use a market-based formula. Instead of a formula that steadily increases spending, have spending rise and fall with the portfolio, though not by as much. One simple formula is to set your withdrawal rate, but apply it to the average account value at the end of each of the last five years instead of the current value.

Another option is what I call the Yale Endowment formula. Each year 70% of the distribution is the initial spending amount plus inflation. The other 30% is a fixed percentage of the portfolio's value latest year-end value. More details of the formula are in my book The New Rules of Retirement.

Either of these formulas will smooth distributions and their effect on the portfolio. They have the disadvantage of automatically reducing spending when the portfolio declines, but that makes the portfolio last longer. They also have the advantages of increasing spending as investment returns improve and the cuts are not as drastic as the portfolio’s changes.

Ÿ The safety fund system. Another approach I have recommended is to create a safety fund at the start of retirement. You put an amount equal to the estimated spending for two to five years in safe investments such as money market funds and certificates of deposit. The rest of your portfolio is invested for the long-term. You take money from the safety fund to pay expenses. At the end of each year you rebalance the long-term portfolio by replenishing the safety fund.

The advantage of the safety fund approach is that you do not feel pressured to sell investments after a steep decline, because you know there is enough money in safe assets to get through the two to five year period. Those who do not have large enough portfolios to create a safety fund should consider purchasing an immediate annuity with a portion of their portfolios. The steady annuity income gives your annual income a floor and can prevent you from taking extreme actions with the rest of your portfolio. Because of low interest rates now is not an optimum time to put a lot of money in an immediate annuity, but as rates rise it is a good long-term strategy.

Ÿ Change allocations and strategies. Retirees whose past investment strategies have let them down should consider changes. Some portfolios were too heavily weighted to equities instead of being diversified (though there were few asset classes that did not lose money in late 2008). Other investors could benefit by shifting from buy-and-hold to the more active strategies of our Retirement Watch Managed Portfolios. A long-term buy-and-hold strategy often is not a good strategy, because it puts you at risk of substantial losses during long-term bear markets.

Another possibility is to try to earn higher returns by taking more risk after the markets decline significantly.

Ÿ Spending cycles. For many people spending naturally varies during retirement. Spending tends to be relatively high during the early years as people are physically active and have a backlog of things they want to do. After a few years they settle into more of a routine. Spending tends to ratchet down a notch in this second phase because of less traveling and other big ticket activities. In the third phase people generally are less active as they get older and that leads to lower spending. In response to the bear market you might reduce spending a bit now but assume it will decline more later in retirement instead of taking a larger reduction now.

The wild cards in that plan are medical expenses and long-term health care. If you are well-insured these might not be issues. Otherwise, they might keep overall spending from declining in the second and third phases.

Most retirees are able to vary spending. They can postpone travel, spend less on restaurants and entertainment, and replace cars and other items less often. Spending adjustments are the best way to get a retirement portfolio and spending back on track. It is much better than permanently switching to only safe assets, though that is the temptation.

In our portfolios we reduced risk early and will keep it low until the financial crisis seems to be nearing an end. But we are not permanently switching to safe investments. That is a mistake many people make after a market downturn. Retirement lasts a long time, and your income needs to grow to maintain purchasing power.

When secular bear markets strike early in retirement and put the longevity of your portfolio at risk, adjustments are needed. First, adjust spending. You can reduce it for only a year or two or consider making a permanent change to the spending formula. Second, reconsider your investment policy. Do not give up on growth or risk or take too much risk, but be sure your strategy fits today’s markets.

 

Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site www.RetirementWatch.com. He also is author of numerous books and reports, including The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.





Posted 03-27-2009 11:24 AM by Bob Carlson