Posted on 11 March 2011
By Mark Miller
Saving and investing for retirement is tough enough. But making a plan to spend your nest egg is an equally critical challenge.
Most Americans don’t have a “decumulation” plan–that is, how much to draw down from savings and when.
A majority of pre-retirees (over age 55) can’t identify a “rule of thumb” for an appropriate annual percentage to draw down in retirement, a recent Fidelity Investments survey found. Most planners say that rule of thumb is 4 percent plus an annual increase for inflation. But Fidelity’s respondents were all over the map; their mean number was 8.4 percent, and answers ranged from 1 percent to 25 percent.
Fidelity’s findings are consistent with other studies showing a lack of long-term planning. For instance, a new Society of Actuaries survey finds that few individuals look 20 years or more into the future when making important financial decisions (13 percent for pre-retirees and seven percent for retirees).
Decumulation planning has become more important as workplace retirement plans have shifted away from defined benefit pensions and toward defined contribution retirement benefits–mainly 401(k)s. Social Security checks aside, the trend means most workers are in charge of determining how and when they’ll pay themselves in retirement from accumulated savings.
The trick is finding a balanced approach that meets income needs while avoiding the risk of running out of money. That challenge has been exacerbated by stock market volatility–as anyone who retired in the wake of the 2008 crash can attest.
T. Rowe Price examined this volatility challenge in a recent study investigating the impact on pre-retirees and current retirees of the two deep bear markets that occurred in the last decade. The researchers asked what, if anything, could retirees have done differently to avoid running out of money in retirement — and what could they do differently in the future?
The key finding: Retirees struggling in the past decade could boost significantly their odds of success by adjusting their withdrawal rates in the first five years of retirement. In this case, success was defined as not running out of money before age 95.
The analysis starts with a hypothetical worker who retires on Jan. 1, 2000, with a $500,000 portfolio invested 55 percent stocks/45 percent bonds. Four withdrawal strategies are analyzed using Monte Carlo probability analysis to understand the likely impact on the portfolio using actual returns for stocks and bonds in the following 10 years, including the bear markets of 2002 and 2008-2009:
Classic decumulation: The retiree withdraws four percent ($20,000) in the first year, and increases the annual withdrawal amount by three percent each year to keep up with inflation.
Temporary reduction: Withdrawals are reduced by 25 percent for three years after each bear market bottom (from 2002-2005 and again from 2009-2012).
No inflation increases: The COLAs are cut three years after each bear market bottom (from 2002-2005 and again from 2009-2012).
Bail on stocks: The investor switches to a 100 percent bond portfolio at the end of the first bear market in September 2002.
Here’s how those options play out in the T. Rowe Price simulation:
The 25 percent reduction option produced the best long-term result; by the end of 2010, the retiree’s odds of having enough money to last to age 95 (the remainder of the retirement period) jumped to 99 percent of the simulations. “This really boils down to cutting back on what you withdraw — but not everyone can stomach that big of a cut,” says Christine Fahlund, senior financial planner at T. Rowe Price. “So, the next best thing is not to increase your withdrawal amounts for inflation.”
In that scenario, the odds of success were restored to 89 percent of the simulations. The worst outcome was achieved by the all-bond portfolio, which achieved success in none of the simulations.
The T. Rowe Price study is a stress test for planning in the toughest market conditions, but it illustrates just how much withdrawals can impact long-term retirement planning success.
Says Fahlund: “Many of us think it’s impossible to cut our spending, but the truth is we live in such affluence that we can cut if we absolutely have to.”