Thursday, March 1, 2012

Spending Flexibility and Safe Withdrawal Rates

The new March 2012 issue of the Journal of Financial Planning is out. 

A couple of noteworthy items...

In the letters to the editor, Dick Purcell has a letter included discussing the article I wrote for the January 2012 issue.  That letter had its genesis as a comment at this blog! Making comments here is useful :)

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Second, an article I wrote with Michael Finke and Duncan Williams of Texas Tech University appears in this issue.  It is "Spending Flexibility and Safe Withdrawal Rates." Traditional safe withdrawal rate research focuses on finding the highest withdrawal rate possible with a sufficiently small probability of failure. This ignores the tradeoff that lower withdrawal rates means less spending and less enjoyment in retirement. The more you spend, the more you can enjoy your early retirement, but the higher is your chance of running out of funds later in retirement. We try to balance this tradeoff by considering retirees who have different amounts of external income floors (such as Social Security) and different degrees of personal flexibility about how much spending fluctuations they are willing to endure.


The findings we describe are starting to get discussed at internet discussion boards and personal finance blog sites. This is primarily because Glenn Ruffenach wrote a column at SmartMoney juxtaposing the findings of this approach with the 1.8% withdrawal rate I described last August in the Journal of Financial Planning. The comments are along the lines of: these moronic researchers can't figure out if the safe withdrawal rate is 1.8% or 7%. A think a lot of confusion stems from this throwaway line in the introduction of Mr. Ruffenach's column: "a safe withdrawal rate for some individuals could be as much as 7%."

That 7% appears in Figure 3 of our article. But it is not correctly described as a safe withdrawal rate. As we add in this article, this 7% withdrawal rate has a 57% chance of failure over a 30-year retirement. It's not safe. But what is does is maximize the overall expected lifetime satisfaction for a fairly flexible retired couple who has a secured income base of $20,000 from Social Security. This is how the couple best balances spending more early in retirement with the tradeoff that they may have to spend less later in retirement.

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Third, though not a part of the journal issue, the journal website now includes a Podcast interview with me. The topic is mostly about my article that will be in the April issue next month, but I also talk about this article and all of the articles I've had in the JFP.

Safety-First Retirements Are Expensive with Low Interest Rates!

I’ve made a table that pretty much speaks for itself. The table provides some idea about how expensive it can be to build a safe retirement portfolio with TIPS. But even this is not completely safe, since the TIPS ladder only lasts for 30 years.
I assume different constant TIPS yields. With no changes in TIPS yields and with TIPS yields the same for all different maturities, this is too simplifying. There is no reinvestment risk or interest rate risk. But it gives an idea. Those yields are shown horizontally.
Vertically, I show different desired withdrawal rates from one’s portfolio. Some relief is that Social Security and other income sources would be added on top. These withdrawal rates (providing inflation-adjusted withdrawal amounts) are only for the part coming from the portfolio.
What the table shows is the percentage of your portfolio assets you would need to dedicate to building your TIPS ladder for different yields and withdrawal rates. Red cells represent the impossible, you would need more than 100% of your portfolio to pull off that spending rate.
Also, you really should have some sort of emergency fund in case of unexpected necessary expenses. This could be at least 10% of your portfolio, making anything in the table above 90% infeasible.
So, for example, with a TIPS yield of 1%, even a 3.5% withdrawal rate is pushing the limits of feasibility, requiring 91% of the portfolio.
With a TIPS yield of 0%, a 3% withdrawal rate is about the best that can be hoped for.
The main message here, for whatever it is worth, is that building an inflation-protected spending floor in retirement can be incredibly expensive in a low interest rate environment!


Since this was a short blog post, for fun, here is the MATLAB code I used to make the table:
r=[-.02:.01:.05] % TIPS Yield
C=[.01:.005:.1]  % Withdrawal Rate
N=30             % Ladder Length

table1=zeros(length(C),length(r));

for i=1:length(r)
    for j=1:length(C)
        table1(j,i)=100*C(j)*sum((1/(1+r(i))).^[1-1:N-1]);
    end
end