How Much Money do I Need to Retire? Heck if I Know or Anyone Else Does! - Part 5

In Parts 1-4 of this series, I reviewed various studies and commentaries to help you determine an appropriate safe withdrawal rate for your retirement nest egg. I also provided alternatives and/or variations to the safe withdrawal guidelines. Today, I examine the factors that can impact both the funding of your nest egg and your withdrawal rate in retirement. The unpredictable nature of most of these factors make it virtually impossible to determine a definitive retirement number and is why I say the "Heck if I Know or Anyone Else Does" how much money you need to retire.

Your Longevity - The Ultimate Wildcard

It goes without saying, that if we knew who long we would live, retirement planning would be a lot simpler. Unfortunately, the best we can do is plan based on longevity studies and family medical history. The Vanguard paper I referenced in Part 3 of this series cites such as study by the Society of Actuaries which found:

“there is an 80% chance that at least one spouse will live to age 85, a 55% chance that one will live to age 90 and 25% chance one spouse will reach 95.”

In Canada, the average male lives to approximately age 79 and the average female lives to approximately 84. Based on the above, your retirement planning should at a minimum assume one spouse will live to at least 95 years old.

Inflation – Grasping for the unknown

The rate of inflation can drastically alter your retirement savings and consumption. An economic environment of low market returns and high inflation can severely impact the funds you accumulate to fund your retirement and the real returns you achieve in retirement. Conversely, interest rates tend to rise with inflation, providing a potential buffer if you lock in higher interest rates and inflation subsides (I remember Canada Savings Bonds paying 19.5% interest in 1981 when inflation was around 12.5%, however, inflation was back down to 4.5% by the end of 1983 and many people were very pleased they had CSB's or GIC's paying very high rates of interest for many years). An average inflation rate of 2% will mean that the $50,000 you expect to spend in retirement in 2014 dollars will require approximately $61,000 in spending in 2024.

One of the criticisms of the 4% rule is that the models cumulative inflation adjustment may force you to take larger and larger withdrawals without regard to your actual spending requirements. Substantive evidence for this criticism is provided below by David Blanchett, the head of retirement research at Morningstar in Chicago.

In this Wall Street Journal article by Kelly Greene, Mr. Blanchett said the following about the correlation between spending and inflation. "Pretty much every paper you read about retirement assumes that spending increases every year by [the rate of] inflation." Ms. Greene went on to say that "when he analyzed government retiree-spending data, he found otherwise: Between the ages of 65 and 90, spending decreased in inflation-adjusted terms. Most models would assume that someone spending $50,000 the first year of retirement would need $51,500 the second year (if the inflation rate were 3%). But Mr. Blanchett found that the increase is closer to 1%, which has big implications over decades, 'because these changes become cumulative over time,' he says".

Sequence of Returns – Bull vs Bear Markets upon your Retirement

The various studies that support a 4% retirement withdrawal, included periods of both bear and bull markets. If you are lucky enough to retire at the beginning of a bull market, your retirement funding will be drastically different than if you retire at the beginning of a bear market. William Bergen in his original 1994 article said:

“This is a powerful warning (particularly appropriate for recent retirees) not to increase their rate of withdrawal just because of a few good years early in retirement. Their “excess returns” early may be needed to balance off weaker returns later.”

It is interesting to note that Mr. Bergen showed that even if you started retirement in the great depression or in the recession of 1973-1974 (which also included a period of high inflation); your money would still have lasted over 30 years, because of the power of stock market recoveries.

However, Moshe Milevsky and Anna Abaimova in this report for MetLife (see page 4 of the report, page 7 of the PDF), very clearly reflect the dramatic difference in retirement outcomes you will have when you have negative market returns early in your retirement vs later in your retirement.

In this blog, Wade Pfau states that:

“In fact, the wealth remaining 10 years after retirement combined with the cumulative inflation during those 10 years can explain 80 percent of the variation in a retiree's maximum sustainable withdrawal rate after 30 years.”

Thus, prudent planning would be to start your retirement following a bear market :).

Registered vs. Non-Registered Accounts

The allocation of your retirement funds between registered (RRSPs, LIRAs, Pensions, etc.) and non-registered accounts (bank, investment, TFSA, etc.) will have a significant impact upon your cash flow in retirement. If you consider all the money in those accounts as capital, the capital in the registered accounts is fully taxable, meaning that if you are a high income tax rate taxpayer, you may be paying as much as 46% or higher upon the withdrawal of those funds. For non-registered accounts, the withdrawal of capital is tax free. This issue raises the much debated question of TFSA vs. RRSP as you accumulate your retirement nest egg and for those who own corporations, the issue of salary vs. dividend (see my three part series "Salary or Dividend? A Taxing Dilemma for Small Corporate Business Owners" from last year on this issue and my 2014 Update). The drawdown of your RRSP/RRIF and/or funds from your holding company in a tax effective manner requires a detailed analysis of your specific situation and cannot be addressed here in a generic manner; however, suffice to say, it is an important cash flow issue. 

Home Sweet Home

Some planners such as David Aston suggest you try and exclude your home from your retirement savings and have it serve as a back-up for any retirement shortfall. However, for many people, part of their retirement will include at least the incremental benefit of downsizing their home. For others, their retirement will only be funded by selling their home and moving into an apartment or reverse mortgaging their home.

Spending in Retirement - Sharpen your Pencil

If you are diligent about this process, you should be able to at least determine a ballpark number for your anticipated spending upon retirement. The spending wildcard for many people is travel. Good health will allow for years of travel, while poor health will not only restrict how much you can travel, but could lead to significant medical costs. In a perfect retirement model you would factor in greater spending as you begin retirement and smaller spending as you grow older. In addition you need to consider occasional and lump sum expenditures.

The aforementioned David Blanchett suggests many peoples spending in retirement maybe overstated by as much as 20% in traditional retirement models. Mr. Blanchett details these views in a very interesting paper on “Estimating the True Cost of Retirement”.

You may also wish to consider your spending in context of the three stages of retirement Michael Stein CFP came up with in his book “The Prosperous Retirement, Guide to the New Reality". In his book Michael suggests there are 3 stages of retirement:

Go-Go Stage- Retirees maintain the same lifestyle and their spending remains fairly constant with their spending pre-retirement, essentially because they still consider themselves “young” and travel extensively.

Slow-Go Stage - Stein says that between the ages of 70-84, your budget will decline 20-30% as your body is not quite able to keep up with your mind and your intended activities or you just become weary of airports and trains.

 No-Go Stage - As you reach 85+, health issues tend to cause you to restrict travel and you are tied to a certain place, be it your home or a retirement home.

Pensions - The Older you are, the more you Appreciate them

If there is one thing this series has revealed to me, is that I truly underestimated the worth of a defined benefit pension plan. I had never really considered the possibility of purchasing an annuity in retirement, however, the more calculations I undertook, the more I realized that without a company pension plan, it may be prudent to consider purchasing at least a small annuity in my retirement. Moshe Milevsky suggest that annuities should be used to “pensionize” part of your retirement funds and that it may be worth the piece of mind to forgo potential growth of your nest egg to provide some comfort that you will not outlive your retirement funds.

If you have a pension plan that covers off most of your retirement spending needs, you are afforded the freedom to take greater equity risk in retirement; since you can withstand stock market swings, knowing your day to day costs are covered off by your pension. Those without a pension face the dilemma of whether to annuitize some portion of their retirement funds or not.

Healthcare coverage - Will we be Fully Covered in 25 Years

As Canadians, we assume we will always have full medical coverage. But who knows if the government will have the money in twenty-five years to support a top-heavy population. In addition, if your health deteriorates and you require private care, all your retirement funds could be eaten up by those costs.

Interest Rates – Will they ever Rise?

People have been expecting interest rates to rise for several years. Many of those same people now think the US government will be forced to keep rates low for the foreseeable future. Selfishly, higher interest rates would be welcomed by many people in or near retirement. A spike in interest rates would likely cause some disgruntled stock market investors to re-allocate their equity investments to fixed income instruments.

Inheritances - No One Plans for an Inheritance do They?

Baby boomers will inherit a massive amount of money in the next twenty or so years. However, the size of individual inheritances will fluctuate widely based on the longevity of their parents. I wrote a blog a while back on whether you should plan for an anticipated inheritance. I suggested that if you are certain you will inherit money, you should at least consider factoring a discounted amount of your potential inheritance into your retirement planning.

Lifestyle in Retirement

For Canadians who live in large cities, have expensive homes and lifestyles, an easy solution to an underfunded retirement is to downsize/sell your home and move to a less expensive city. Whether you are willing to do that is another question.

Evolving into retirement - Keeping the Income Stream Alive

Stan Tepner, CPA, CA, MBA, CFP, TEP, First Vice-President & investment advisor with CIBC Wood Gundy and an advisor to some of my clients, told me "he often finds many people consider retirement an absolute event. One day you are working and the next you’re golfing". He adds "that more and more people 'evolve' into retirement. They may shift into part-time employment or self-employment. This shift may be required for financial reasons or because you wish to keep your mind sharp. Either way, the extra income will assist in funding your retirement needs, especially if you have a savings shortfall because of poor market returns or you have just miscalculated your actual retirement needs".

Next Monday in the final instalment of this series, I will finally provide some numbers on how much you may need to retire.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.

How Much Money do I Need to Retire? Heck if I Know or Anyone Else Does! - Part 4

On Monday, I discussed modern studies that continue to view the 4% withdrawal rule as feasible in today's current environment. Today, I look at various reports and studies by retirement experts who feel the 4% rule of thumb is excessive based on statistical simulations and the inclusion of worldwide market data amongst other reasons. In addition, for those who feel a constant spending strategy is flawed, whether, the withdrawal rate is 2, 3 or 4 percent, I offer some alternative spending approaches.

The Naysayers: Studies that suggest a 2%-3% Withdrawal Rate may be a Good Starting Point

What William Bernstein has to Say

William J. Bernstein is a well-respected financial theorist, who is referenced in many of the articles I’ve read on the safe withdrawal question.

In this Wall Street Journal article by Jonathan Clements, Mr. Bernstein says the following: "Two percent is bullet-proof, 3% is probably safe, 4% is pushing it and, at 5%, you're eating Alpo in your old age...If you take out 5% and you live into your 90s, there's a 50% chance you will run out of
money."

For those who wish to read what Mr. Bernstein has to say, here is Part 1, Part 2 and Part 3 of his series titled “The Retirement Calculator from Hell”. In Part 3 he comments:

“The historically naive investor (or academic) might consider reducing his monthly withdrawals to a very low level to maximize his chances of success. But history teaches us that depriving ourselves to boost our 40-year success probability much beyond 80% is a fool’s errand.”….."But if you believe that we’re about to encounter a bad returns sequence or simply wish to leave a few baubles to your heirs, you’re right back to 3% again.”

What Wade Pfau has to Say

Wade Pfau is a vocal modern day opponent of using a 4% withdrawal rate. Wade is a retirement researcher who has a Ph.D. in economics from Princeton and is currently Professor of Retirement Income at The American College. Wade has a popular blog, called appropriately, Wade Pfau's Retirement Researcher Blog .

In Wade’s 2010 paper “An International Perspective on Safe Withdrawal Rates: The Demise of the 4 Percent Rule?” he makes clear his issue with previous withdrawal studies when he says:

“It is widely acknowledged and understood that the applicability of these withdrawal rate studies depends on the future behaving with the same patterns as the past. But a potential problem with the findings of so many of the existing studies is that they are based on the same Ibbotson Associates’ Stocks, Bonds, Bills, and Inflation (SBBI) monthly data on total returns for U.S. financial markets since 1926, a time interval for which there are fewer than three nonoverlapping 30-year periods. Either these data are used directly for historical simulations or bootstrapping approaches, or used to calculate parameters for Monte Carlo simulations. The problem is that the period covered by this data may have been a particularly fortuitous one for the United States. If one thinks of the world as a Monte Carlo simulation, then the single path observed in the 20th-century United States may not represent its true underlying distribution of returns, and future returns are likely to be lower.”

In this 2013 article in the Journal of Financial Planning, by Wade, Michael Finke and David M. Blanchett titled “The 4 Percent Rule Is Not Safe in a Low-Yield World” it states:

“Pfau (2010) showed, the demonstrated success of the 4 percent rule is partly an anomaly of U.S. market returns during the 20th century. In most other countries, sustainable initial withdrawal rates fell below 4 percent. This study indicates that there is nothing inherently safe about the 4 percent rule. When withdrawing from a portfolio of volatile assets, surprises may happen. This study demonstrates that when financial planners recalibrate assumptions for Monte Carlo simulations to market conditions facing retirees in 2013, the 4 percent rule is anything but safe. This research also shows that a 2.5 percent real withdrawal rate will result in an estimated 30-year failure rate of 10 percent. Few clients will be satisfied spending such a small amount in r­etirement.”

With all due respect to Wade, I certainly hope he is wrong, because you may not have to worry about retirement, as you may not ever be able to save enough to stop working.

The Journal of Financial Planning has a very interesting discussion involving William Bengen, Jonathan Guyton and Wade Pfau in this article titled "Safe Withdrawal Rates: What Do We Really Know?"

What Michael Nairne has to Say

After reading all these academic studies, I started wondering what someone who manages money for clients in the “real world” would say. This led me to ask Michael Nairne, CFP, RFP, CFA, president of Tacita Capital Inc. who writes the Serious Money column for the Financial Post, for an opinion. I solicited Michael’s opinion since we have mutual clients and I have come to appreciate he is not only technically savvy, but a stock market historian. Michael suggested the problem with the 4% rule is "that a singular historic 'backtest' represents just one perspective on withdrawal rates". As illustrated in his article, “The Plight of the Conservative Retiree”, Michael says "the underlying average annual real return experience that funded these assumptions was about 2% for government bonds and 7% for equities. Expected annual real returns going forward are much lower today – about 1% for government bonds and 5% or so for stocks. He feels that for the typical, large cap and bond portfolio, a lower number is better – say 3% or so".

Safe Withdrawal Rates - Tweaks and Variations for Today's World

So whether you are a William Bengen fan and have selected a 4% withdrawal rate or think Wade Pfau has it right and have selected a withdrawal rate of 2.5% -3%, you still may still hear Moshe Milevsky whispering in your ear, that any rule that has a constant withdrawal rate grown by inflation is a horrible rule. Well, don't fret. Colleen M. Jaconetti and Francis M. Kinnry Jr. wrote a 2010 research report titled "A more dynamic approach to spending for investors in retirement". The authors express some of the same concerns as Moshe Milevsky about the 4% rule (constant dollar amount withdrawal adjusted for inflation), most specifically that:

"This strategy is indifferent to the performance of the capital markets, with the result that investors may accumulate unspent surpluses when markets perform well and face spending shortfalls when markets provide poor returns. In either case, the strategy provides short-term spending stability; however, the long-term consequences (positive or negative) can be significant if an investor does not make as-needed adjustments along the way."

The authors note that the common alternative to the 4% rule; basing your spending on a percentage of your portfolios actual value at the end of the prior year can also be problematic in that your withdrawal rates may fluctuate widely in the short-term, while your actual short-term costs are fixed.

Jaconetti and Kinnry attempt to address the limitations of the two above alternatives by introducing a hybrid approach to sustainable spending. They suggest you consider applying a ceiling and a floor to percentage based withdrawals. Under this approach, you:

"calculate each year’s spending by taking a stated percentage of the prior year-end portfolio balance. The investor also calculates a “ceiling” and “floor” by applying chosen percentages to the prior year’s spending amount. The investor then compares the three results. If the newly calculated spending amount exceeds the ceiling, the investor limits spending to the ceiling amount; if the calculated spending is below the floor, the investor increases spending to the floor amount."


You can read the paper for more details, but the authors model portfolio using a constant dollar spending amount ran out of money 2,900 time out of the 10,000 computer simulations, while the model portfolio using the hybrid approach only ran out 1,100 times. In more than half the computer simulations, the percentage of portfolio approach resulted is having less money to spend than the retiree's initial spending target.

Todd Tresidder a financial coach wrote a terrific article titled "Are Safe Withdrawal Rates Really Safe". Unfortunately I did not discover this article until after I had wrote much of this series, but if you are not sick of this topic yet, I strongly suggest your read his article. He says that:

"unfortunately, no simple 'plug and play' model has surfaced to replace the 4% rule (which probably explains why is has persisted despite inaccuracy)."

He then provides a four step process to serve as a guideline for a safe withdrawal rate that includes a "correct and adjust" step. Essentially he is saying stay flexible. You should feel free to adjust a 4% withdrawal rate to 3%, reduce or eliminate the inflation adjustment or alter any part of your withdrawal strategy to protect your retirement fund.

Planning – It is not an Eight Letter Word

Please keep this very poignant excerpt from the Trinity Study in mind when considering your safe withdrawal rate.

“The word planning is emphasized because of the great uncertainties in the stock and bond markets. Mid-course corrections likely will be required, with the actual dollar amounts withdrawn adjusted downward or upward relative to the plan. The investor needs to keep in mind that selection of a withdrawal rate is not a matter of contract but rather a matter of planning”.

I would suggest that planning should not be limited to your withdrawal rate, but should also be considered in respect of the accumulation of your retirement nest egg.

Believe it or not, you are only two-thirds of the way through the series. In Part 5 you will read about the various factors that impact your retirement and make it virtually impossible to know how much money you really require to retire. Then finally, in Part 6, I provide some numbers to determine how much you need for your retirement nest egg.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.

How Much Money do I Need to Retire? Heck if I Know or Anyone Else Does! - Part 3

Last week in Parts One and Two of this series, you read about the commonly accepted 4% withdrawal rule. This rule of thumb suggests that if you have an equally balanced portfolio of stocks and bonds, you should be able to withdraw 4% of your retirement savings each year adjusted for inflation and those savings should last 30-35 years. Today, I consider an alternative point of view, and then review modern studies and reports on how the 4% withdrawal rule is viewed in the context of market returns over the last decade.

Set Retirement Withdrawal Rates Should Never be Used!

If you agree with Moshe Milevsky’s opinion (see his quote in Part 1) that any rule that starts with a set withdrawal rate, whether 4% or 3%, is a horrible rule, then you should just read to the end of this section and click the exit button (however, please come back for Parts 5 and 6). From what I can gather, Mr. Milevsky and many other retirement experts do not like the 4% rule because it uses a constant spending amount and does not adjust to your evolving level of wealth. By shunning a set withdrawal rate, retirees may avoid spending shortfalls where their investments underperform and will not accumulate surpluses when they outperform the market. My interpretation is that Mr. Milevsky feels you should spread your economic resources over your entire life and that your spending rate and retirement withdrawal number should not be fixed to an arbitrary level, but that your spending rate should depend upon your personal preferences and your views on longevity risks.

Mr. Milevsky may be critical of a set withdrawal rate, but he does not just point out the flaws and walk away. In his book The 7 Most Important Equations for your Retirement he provides a unique set of mathematical equations to determine your retirement needs.

These equations allow you to determine amongst other retirement issues, how long your nest egg will last, what is your suitable spending amount, and in his final chapter he helps you determine if your current plan is sustainable.

I found this book innovative and as entertaining as a math book could be (Moshe uses seven historically famous people to introduce his equations). However, to be honest, I had challenges with the math, especially the final equation in Chapter 7. You may want the math wiz in the family to assist you with your calculations. I would suggest at minimum, you use Moshe’s equations to back-test whatever retirement nest egg and spending rates you arrive at.

Michael James

Before I move onto the modern safe withdrawal rate studies, I have to give a shout out to Michael James, a fellow Canadian personal finance blogger who created his own strategy, which includes holding five years of savings in a savings investment account. His "Magic Number" calculator is here. The background to his calculator is discussed in his blog post titled "A Retirement Income Strategy" and in this second post on the topic.

Modern Studies and Reports

The Bengen and Trinity studies, from which the 4% withdrawal rule originated, utilized stock market data from 1926 to 1976 and 1926 to 1995 respectively. Many commentators feel this historical data is no longer applicable in today’s world.

To help you determine if 4% is a safe withdrawal rate for you (with the limitations I noted in my first post), I’ve summarized below several current studies and reports on this topic. Some of the studies/reports continue to condone the 4% withdrawal rate or are at least accepting of using a 4% withdrawal rate as a starting point. Others feel it is excessive and if you withdraw 4%, you will be eating cat food at some point in your retirement.

If you are like me, you will probably be overwhelmed by these reports, their arguments and their data. Although you will never achieve certainty, your withdrawal percentage is the vital wildcard in trying to estimate your retirement nest egg and, you must draw a line in the sand using a percentage within your comfort zone, assuming you believe in a constant withdrawal rate strategy or a variation of the strategy.

The Studies that suggest a 4% withdrawal is still a Good Starting Point.

 

What Charles Schwab has to Say

In this report by Rob Williams, Director of Income Planning for Schwab Center for Financial Research says that Schwab suggests “the 4% rule as a starting point for planning purposes. Then, it's important to stay flexible as you spend in retirement”.

However, the report goes on to say that “Based on Schwab's current expectations for market returns over the next 30 years, we calculate a 3% spending rate to begin retirement may be more appropriate—if you want to follow a rigid rule for spending, and have a high degree of confidence that your money will last.”

What Vanguard has to Say

In this excellent report, one of several Vanguard has written over the years, the report states:

“For the majority of years from 1926 through 2011, the yield or income returns on a 50% stock/ 50% bond portfolio exceeded 4%. Over the last several decades, however, the yield for such a balanced portfolio has

been steadily decreasing. At its peak, in 1982, the portfolio’s average yield was 10.6%; by year-end 2011, the yield had dropped to 2.8%.” Yet, Vanguard says that a 4% withdrawal rate is still a reasonable starting point.

The report goes on to say:

“Specifically, Vanguard’s market and economic outlook indicates that the average annualized returns on a balanced 50% equity/50% bond portfolio for the decade ending 2021 are expected to center in the 3.0%–4.5% real-return range (Davis and Aliaga-Díaz, 2012). Although this level is moderately below the actual average real return of 5.0% for the same portfolio since 1926, it potentially offers support for the continued feasibility of a 4% inflation-adjusted withdrawal program as a starting point for balanced investors.”

Vanguard also has an excellent report on alternative spending strategies for those who are concerned that the constant 4% plus inflation adjusted amount in the rule of thumb may result in excessive withdrawals in poor performing markets. I discuss that report tomorrow.

What David Aston has to Say

David Aston, a certified management accountant and contributing editor to MoneySense magazine, wrote an article for the September/October 2012 issued titled “Make your nest egg last”. In that article he says that if you want to stick with the 4% rule, there are four strategies to limit the risk. They are as follows:

1. Cut withdrawals if you suffer losses. “Bengen encourages retirees to keep an eye on their ‘current withdrawal rate,’ which is the annual drawdown as a percentage of a portfolio’s value today (as opposed to its initial value at the time of retirement). As a guideline he suggests cutting back if you exceed the following current withdrawal rates: 5.6% at age 65; 5.9% at age 70; 6.25% at age 75; and 7.5% at age 80.”

2. Use your home equity for backup

David feels you should exclude the value of your home from your initial retirement nest egg. You can always tap the equity as back-up in case your investment returns are not what you expect. I suggest this could be at least partially problematic for many retirees who plan to downsize to fund their retirement.

 3. Add annuities to the mix. David states that many experts suggest that age 70 is the sweet spot for purchasing an annuity. He notes that most annuities will pay nothing to your estate; they expire upon your death or the last spouse to die if you own a joint annuity. Many of the articles I read suggest that you consider annuities as a component part of your retirement. Moshe Milevsky in his book Pensionize Your Nest Egg is very keen on using annuities and other products to ensure you do not outlive your money, where you do not have a substantial pension in retirement.

4. Invest conservatively—This is self-explanatory.

On Wednesday, I will review comments made and studies undertaken by retirement experts that feel the 4% withdrawal rate is excessive.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.

How Much Money do I Need to Retire? Heck if I Know or Anyone Else Does! - Part 2

On Monday I introduced the 4% rule, the most commonly accepted rule of thumb retirement strategy. Today I discuss the guideline and its development in greater detail. As noted in part 1, Moshe Milevsky and other retirement experts feel the rule is misleading and a terrible rule. I hope by the time you finish reading this series you will have your own opinion on the 4% rule; whether that opinion is similar to Mr. Milevsky’s or whether you feel the rule has practical application for you, as a starting point for your

retirement calculations.

Conventional Wisdom – The 4% Withdrawal Rate

The 4% rule is a planning guideline for a sustainable rate of spending over a 30 year retirement. Years ago a brilliant financial planner by the name of William P. Bengen (an MIT graduate in Aeronautical Engineering) got tired of being asked how much money his clients needed to retire, so he initiated a study that basically concluded that if you retire with a diversified portfolio split 50/50 between bonds and stocks, you will be able to safely withdraw 4% of the initial balance, plus an inflation adjusted amount for the next 33 years and quite possibly as long as 50 years.

For example, if you have $800,000 when you retire, under the 4% withdrawal rate you can take out $32,000 the first year. If inflation is 2%, your second year withdrawal amount will be $32,640 ($32,000 + 2% x $32,000). If inflation is 1.5% in your third year, your withdrawal will be $33,130 ($32,640 x1.015%) and so on. It is important to note, this is not a percentage of portfolio withdrawal method where you take the ending balance at the end of each year and draw 4%; but is a consistent withdrawal amount based on your original nest egg adjusted for inflation each year, which some experts find distasteful.

If you wish to read Mr. Bengen’s initial paper, here is a link to his October, 1994 paper in the Journal of Financial Planning. It should be noted that in a subsequent study, Mr. Bengen added U.S. small-company stocks to the mix, which increased the portfolio's volatility and potential return. To adjust for this, he revised the withdrawal rule to 4.5%. However, I will continue to use the more conservative 4% withdrawal amount for discussion purposes.

So what does Bengen say today, with our historically low interest rates? In this MarketWatch article by Glenn Ruffenach, the author says “Bengen has never claimed that his findings are right for every retiree. Indeed, he thinks some of the latest research about market valuations is terrific."

                                                                                

Ruffenach goes on to say “He told me recently that he  started with a specific set of assumptions: a retirement lasting 30 years, with savings in a tax-deferred account and nothing left for heirs. Change just one of those parameters, he says, and your "safe" withdrawal rate may differ. Still, Bengen notes, 4% remains a prudent jumping-off point for calculating withdrawal rates from nest eggs. Just keep your plan open to some adjustments.”

In this 2012 paper written by Mr. Bengen, he discusses some contingency planning, which includes potentially reducing spending and increasing income.

Mr. Bengen did not provide a detailed summary of the market returns he used in his calculations, although he provided some returns for certain extrapolated years (10.3% for stocks, 5.2% for bonds and 3% inflation ). However, in this article by Joanna Pratt, she suggests that the 4% spending assumptions are based on a 9.2% stock return, 6.85% bond return and an inflation rate of 3%.

The Trinity Study – Support for the 4% Withdrawal Rate

A subsequent study, known as the Trinity Study by Philip L. Cooley, Carl M. Hubbard and Daniel T. Walz supports Bergen’s assertions. Some critics say this study supports Bengen because they use the same flawed data. Their 1998 paper can be found here. 

The Cooley, Hubbard and Walz study produced a number of conclusions, including:

• Early retirees who anticipate long payout periods should plan on lower withdrawal rates.
• Bonds in the portfolio increase the success rate for low to mid-level withdrawal rates, but most retirees would benefit from allocating at least 50% to common stocks.
• For stock-denominated portfolios, withdrawal rates of 3 to 4 percent represent exceedingly conservative behaviour and will likely leave large estates.

The authors comment that if history is any guide for the future, then withdrawal rates of 3-4% are extremely unlikely to exhaust any portfolio of bonds and stock (in almost any combination).

But what happens to your retirement planning if stock market history does not repeat itself? Poor stock market returns for the last few years (until last year), countries defaulting or close to defaulting, historically low interest rates and tough economic times have caused some pundits to say we are in different times and the 4% rule is outdated, as it only captures periods of great prosperity. In part three of this series, which I will post next Monday, I discuss Moshe Milevsky’s unique retirement calculations and then the various modern studies and reports on what is the proper withdrawal rate upon retirement.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.

How Much Money do I Need to Retire? Heck if I Know or Anyone Else Does! - Part 1

Let’s be honest. No one knows how much money they really need to retire. My own attempt to quantify my “retirement number” results in a range of hundreds of thousands of dollars. Unless you fancy yourself a two-headed economist/soothsayer, you can only plan based on historical investment returns, anticipated spending requirements and assumed inflation rates. That does not even account for wild cards such as your longevity and the random sequence of returns you will get from the stock market. The best laid retirement plans of mice and men can often go awry… when bam -- you get a sudden economic shock or stock market aberration and your retirement plan becomes as worthless as the paper you wrote it on (those of a cynical nature have be known to say; all any retirement plan proves is ink sticks to paper).

I’ve been pondering this question for over a year as I have attempted to figure out the nest egg I need to fund my own retirement. My final conclusion: the financial and economic variables you need to consider to even attempt to answer this question are staggering (I detail these in Part 5 of this series) and I will never come to a definitive answer. This realization is actually liberating yet frightening. Liberating as I realize the best I can do is to create a plan that is based on a framework of historical data, actual data and my best guess estimates. Frightful in the sense that I may not know until it’s too late if I have grievously miscalculated my retirement needs. While going through this nest egg building process, I made some notes and read various papers. I soon realized I had a blog post in the making; in fact a six- part series that I will post throughout February.

For some, this series may be far to detailed. For others, these posts will provide food for thought. For the mathematicians and academics out there, the discussion will not be “academic” enough (although the problem with many academic papers is that only the author and other retirement/mathematical experts understand what the heck they are proposing). However, in all cases, despite the difficulty I see in making a definitive determination of how much money you or I need to retire, burying your head in the sand and ignoring the issue is not an option. It is imperative you try and at least get a ballpark number for planning purposes and continuously refine that number over time. I hope this series of blog posts will provide you the impetus to plan for your own retirement if you have not yet done so.

So where does one start? The 4% withdrawal rule is one of the most commonly accepted rule of thumb retirement strategies. Simply put, the rule says that if you have an equally balanced portfolio of stocks and bonds, you should be able to withdraw 4% of your retirement savings each year, adjusted for inflation, and those savings will last for 30-35 years.

If you embrace this rule of thumb, then in theory you should be able to determine how much money you need at retirement by working backwards. Unfortunately, as I will discuss, it is not quite that simple. The 4% withdrawal rule has some inherent flaws which I discuss below and therefore should only be used as part of your retirement framework to provide you an idea of what would be a sustainable nest egg.

Whether the withdrawal percentage is reduced from 4% to 2%, or you modify the formula, everyone is still searching for the holy grail of retirement planning, that being, what is your safe withdrawal rate? I.e.: How much money can you safely withdraw from your nest egg each year and not run out of money before you pass away.

Some retirement experts feel the search for a safe constant withdrawal rate is a foolhardy. In this Toronto Star article, Moshe A. Milevsky, a well-respected finance professor at the Schulich School of Business at York University says the following:

“If the rule means that you start by withdrawing 4 per cent of the value of the portfolio at retirement — and then adjust that by inflation every year regardless of how markets perform over time, then it is a horrible rule of thumb. The spending rate over time should depend on the markets, interest rates, how your portfolio is performing and your attitude to longevity risk. You cannot pick a rule at the age of 65 [and say] that is how you will behave over the next 30 years.”

Mr. Milevsky has some very interesting original thoughts on retirement that I discuss in the third part of this series. In fact, if you agree with his views, I tell you to exit the series at that point and return for Parts 5 & 6. Notwithstanding his comments (which I believe have validity), because of the simplicity of the calculation, many people and Financial Institutions still feel the 4% rule is an excellent starting point in the determination of your retirement nest egg if you understand its limitations and flaws. I agree that this rule is simple to apply and understand and thus over the next few posts, I will discuss various studies and papers that deal with the determination of a safe withdrawal rate and whether 4% is a safe withdrawal rate in this day and age. Finally, I will discuss variations of the rule put forth by retirement experts to adjust/correct for the perceived/flaws of the rule of thumb.

Limitations of the 4% Rule

Some of the criticisms of the 4% model include:

1. The model does not account for income taxes on non-registered accounts and registered accounts. Michael Nairne in this National Post article descriptively calls the deferred tax liability on registered accounts

the “Dark Side” of RRSP’s.

2. The model does not account for transaction fees or management fees related to your investments.

3. The model treats everyone exactly the same.

4. The data for the model was based on only historical U.S.stock data and does not include foreign equity data.

5. The model builds in an inflation adjustment; however, some commentators feel the cumulative inflation adjustment may force you to take larger and larger withdrawals.

A Tax Centric Variation on the 4% Withdrawal Rule

As result of the omissions above, especially the income tax component, I created a very crude tax centric variation of the 4% rule to provide an alternative comparison to some of the other retirement formulas I discuss in Part 6. (Please note I said crude and tax centric. When I posted last Monday I was going to run this series, I got various comments on the blog and to my inbox that people were excited to see what I came up with and did I use a Monte Carlo simulation etc. I do not have the qualifications, let alone the time, to run statistical simulations to come up with a unique formula that like every other formula will be flawed because of the unquantifiable variables that must be considered in determining your retirement number).

Now that I have dampened your expectations for my crude variation, I simply determined my spending requirements in retirement and subtracted from my spending requirement, my estimated sources of income outside of retirement (Old Age Security, CPP etc.) which results in a retirement withdrawal shortfall.

Here is where my calculation gets tax centric. I first calculate the income tax owing on my total estimated retirement income. This tax liability causes my retirement shortfall to increase. The next calculation is a bit circular, but I then come up with a revised withdrawal amount that after-tax covers my anticipated spending shortfall.

I then divide my required retirement after tax withdrawal above by 4% (3% for a conservative approach) which tells me how much money outside of any CPP, OAS or company pension (which I don’t have) I need to accumulate for retirement. When I post actual numbers in part 6 this will be much easier to follow and make a little more sense.

This crude estimate will give mathematicians heart palpitations. I know this tax centric variation does not address multiple issues, but bear with me until you see where I go with this in Part 6.

In no way should you rely on this framework as the sole determinant for your own retirement planning. However, as you will see in my last blog post, this number is not that far off from what I get when I have a financial planner use his software to provide me with “a number” and the number I get when I compare to some other calculations suggested by retirement experts.

I feel like a Lawyer with all these Caveats

One last final caveat before I discuss some data and analysis. Please be aware that I am not a retirement expert, financial planner, mathematician (I dropped statistics in University), or a psychic and understand this series should not be construed as specific personal retirement planning advice. The intention of this series is to:

• summarize prior research (the information is overwhelming and the arguments made by some brilliant people, hard to disprove)

•  assist you in determining your safe withdrawal rate percentage or provide you with an alternative method to the constant withdrawal methodology

•  provide links to the articles I read

•  share my thought processes in trying to determine my own retirement needs

Hopefully all this will provide you with a launching point to help you consider what may be a reasonable retirement nest egg and/or a reasonable spending amount for your retirement.

On Wednesday I discuss the history of the 4% withdrawal rate rule of thumb in greater detail.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.

How Much Money do I Need to Retire? Heck if I Know or Anyone Else Does!

I will not be posting a blog this week. I am spending my time editing a six-part series which I will post during the month of February. This is a bit of an experiment – an entire month examining one topic.

The six-part series deals with retirement rules of thumb, studies and papers on the topic by various retirement experts, issues to consider and finally, some calculations to come to a "number". I am not sure if this is going to be one of my best blog series or my worst. I will leave that determination to you. The initial feedback on my drafts has been very positive; if not that the series is overly ambitious.

The premise of this series came about as I started trying to determine how much money I needed to retire and I was having trouble coming up with a number. Fortunately for you… or unfortunately, during the Christmas time ice storm in Toronto, the power was out at the office and I was stranded at home. With my two now very independent children home for the holidays, and my in-laws moving in (they had no power), I retreated to my computer and decided to detail my thought process on the various papers and studies I have reviewed on this subject. 

I determined most experts in retirement planning are very good at telling you about all the flaws and variables not considered by the current retirement withdrawal rule of thumb, but they provide limited assistance in trying to come up with a number that at least forms the basis of your future planning. Even though we know that number will not be definitive, we are programmed to need a number. 

In the end, I created my own crude and admittedly tax centric model that I compare to other models and methods to determine that ever elusive "magic number". You will have to wait until Part 6 of the series for that revelation. Hopefully you are still reading at that point. See you next week for Part 1.

New Will Provisions for the 21st Century – Reproductive Assets

In my wildest dreams, I would never have imagined ten years ago I would be posting a blog on how you address reproductive assets in your will. Yet today, I have a guest post by Katy Basi on this topic. This is Katy’s third post in this series on New Will Provisions for the 21st Century.

Her first post in the series dealt with how you handle RESPs in your will and her second post discussed will provisions related to Digital Assets.

I thank Katy for this very informative and enlightening series. I have received excellent feedback on all of Katy’s posts.

Does your Will address your Reproductive Assets?

By Katy Basi

“My what?” you may ask. Do you have sperm/ova/embryos in a clinic somewhere? Have you banked cord blood for your child? (Okay, cord blood isn’t really a “reproductive asset” but I’m throwing it in as a two for one promotion). If so, what are your intentions with respect to these “assets” in the event of your death, and does your will tell your executor what these intentions are? If reproductive technologies were involved in creating your children or grandchildren, does your will adequately define “child” and “issue”?

Medical technology is able to leap tall buildings in a single bound these days, and estates law is hard pressed to keep up. For example, the drafting of most wills implicitly assumes that your ability to have children dies when you do, but medical reality tells a different story. If your DNA is banked in any form, your ability to reproduce may long outlive you, potentially creating “after-born children”. (In one of the few instances of the Canadian legal system addressing these issues, your written consent is required in certain cases for the use of your reproductive assets (see the Assisted Human Reproduction Act)). 

You may be able to have your estates lawyer deal with the possibility of after-born children in drafting your will, or you may have no reproductive assets banked and therefore not be very worried about this issue. If you fall in the latter camp, consider whether part or all of your estate may be inherited by your grandchildren. For example, if your son Clark predeceases you having his own children, should a grandchild conceived by your daughter-in-law after your death, using Clark’s banked sperm, be included or excluded from your estate?

Regardless of the after-born children consideration, what should happen to any sperm/ova/embryos banked in a clinic upon the death of the donor? The contract signed with the clinic in question may provide an answer, e.g. the donor may have given the clinic permission to donate or destruct these materials upon his or her death. Otherwise, does the residuary beneficiary inherit these materials? Is an embryo even capable of being inherited, i.e. is it property? Ideally these issues should be dealt with before the death of the donor, while his or her intentions can still be ascertained.

Clearly we are just starting to address this somewhat murky area of estates law. In my practice, reproductive assets currently come into play in three additional areas:

1) Parents have banked cord blood for their child. I often include a provision in the parents’ wills (i) directing the trustee of their child’s trust to continue paying storage fees for the cord blood until the child reaches a certain age, and (ii) instructing the trustee to transfer ownership of the cord blood to the child once he or she attains that age. We do not yet know the limitations of cord blood, and it may end up being the most valuable asset in your estate if a member of your family has certain medical issues (yes, potentially more powerful than a locomotive….)

2) A couple with fertility issues has found a surrogate or gestational carrier. There is usually a surrogacy contract in this scenario, and the contract often requires the couple to have properly executed wills providing for the child that may result from the surrogacy. This requirement can lead to last minute, faster than a speeding bullet wills, which may not be as carefully drafted as they need to be under these circumstances (see #3 below). Expert advice is strongly recommended!

3) A client has a child (or is planning to) where the child is not biologically related to the client, and the child has not yet been adopted by the client. Careful drafting of the client’s will is required to ensure that the child will inherit regardless of the status of any planned adoption. Often a will refers to “my child” generically, without naming the child, either because the child is not yet born, or the client intends to have additional children and does not want to revise his/her will immediately upon the birth of the next child. If not specifically defined in the will, “my child” refers to a person’s child by blood or adoption. If a client has not yet adopted a child, and is not related by blood to the child (e.g. a donor was used), a broader definition of “child” needs to be included in the client’s will. Conversely, if a client has donated reproductive material (e.g. sperm or eggs), his or her will should be carefully drafted to exclude any children related to the client only by virtue of this donation. (While other provinces have legislation clarifying that sperm and egg donors are not parents, Ontario currently does not.)

Clients who have been involved with reproductive technologies have often been through significant stress and, in some cases, heartbreak. Reproductive technologies are incredibly costly, so credit cards are maxed out and wills and estate planning are very low down the priority list. Once the time comes to address your estate plan, alert your lawyer to these issues if they pertain to you – protect that child you worked so hard for!

Katy Basi is a barrister and solicitor with her own practice, focusing on wills, trusts, estate planning, estate administration and income tax law. Katy practiced income tax law for many years with a large Toronto law firm, and therefore considers the income tax and probate tax implications of her clients' decisions. Please feel free to contact her directly at (905) 237-9299, or by email at katy@katybasi.com. More articles by Katy can be found at her website, katybasi.com.

The above blog post is for general information purposes only and does not constitute legal or other professional advice or an opinion of any kind. Readers are advised to seek specific legal advice regarding any specific legal issues.