When You Assume...

Over the years, so-called personal finance experts have provided valuable information—but also a smattering of misinformation—but I can think of none quite as egregious as some remarks recently made by Dave Ramsey.

By now I’m sure you’ve heard—or heard about—his “counsel” with regard to acceptable retirement withdrawal rates—and his disparagement of the “supernerds” who would dare to disagree with him. As for that counsel, at a high level, Ramsey maintains that an 8% withdrawal rate is not only doable, but sustainable. All you have to do is be invested 100% in equities—oh, and assume a 12% return.[i]

Of course, such machinations have always been predicated on assumptions—about inflation, about market returns and, most notably, about the length of life itself. That said, this didn’t become a specific focus—a so-called “rule of thumb”—until 1994, when financial planner William Bengen[ii] claimed[iii] that over every rolling 30-year time horizon since 1926, retirees holding a portfolio that consisted 50% of stocks and 50% of fixed-income securities could have safely withdrawn an annual amount equal to 4% of their original assets, adjusted for inflation without… running out of money.

That said, even though it was predicated on a number of assumptions that might not be true in the real world—a 30-year withdrawal period, a 50/50 portfolio mix of stocks and bonds, assumptions about inflation—oh, and a schedule of withdrawals unaltered by life’s changing circumstances—well, with the return of inflation as a reality (rather than a theoretical construct), it now seems that there’s an annual scramble to reassess that “safe” withdrawal rate. Indeed, a couple of years back a Morningstar paper challenged its conclusions in view of “current conditions”—opining that “using forward-looking estimates for investment performance and inflation,” the Morningstar authors said that the standard rule of thumb should be lowered to 3.3% from 4%.

That said, this is something of a moving target, and a few weeks ago Morningstar moved the target back to 4% (after having opined that a starting safe withdrawal rate for a 30-year horizon with a 90% probability of success was 3.3% in 2021 and 3.8% in 2022). Enter Dave Ramsey and HIS assumptions that allegedly support a much higher rate (though I don’t recall him offering a probability figure of savings lasting as long as your life[iv]).

Now, in fairness, even the Morningstar folks allow for some variance in “safe” withdrawal rates—explaining that the increase from 2022 in this “highest safest starting withdrawal percentage” for a 30-year horizon with a 90% probability of success “owes largely to higher fixed-income yields, along with a lower long-term inflation estimate.” Moreover, they assert that it’s predicated on assumed portfolios that hold “between 20% and 40% in equities and the remainder in bonds and cash”—which is, in itself, a fairly sizeable range.

There’s been plenty of evidence—both empirical and anecdotal—that retirement “spends” aren’t nice, even streams. Life’s circumstances change, of course—and our health care, and health care costs, are notoriously variable. There’s a sense that the pace of spending earlier in retirement is more like that anticipated in most retirement education brochures—travelling and such—but that pace slows down as we do.

At its core, once you stipulate certain assumptions about the length of retirement, portfolio mix/returns, and inflation, a guideline like the 4% “rule” is really just a mathematical exercise. A 4% “rule” may be simplistic, but it’s also simple—and when it comes to getting your arms around complex financial concepts and distant future events, there’s something to be said for that.

But—and as Dave Ramsey’s response should remind us—when you “assume” … (or when others assume on your behalf) make sure you understand the assumptions required to make it “work”—and perhaps more importantly, the likelihood/probability that those assumptions will be a reality. 

- Nevin E. Adams, JD

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[i] One of the more humorous—and insightful—rebuttals on all this came from SRP’s Jeanne Sutton: https://www.linkedin.com/feed/update/urn:li:activity:7130951358609838080/

[ii] https://www.forbes.com/advisor/retirement/four-percent-rule-retirement/

[iii] See www.portfolioconstruction.com.au/obj/articles_perspectives/retailinvestor.org_pdf_Bengen1.pdf

[iv] That said, Morningstar’s John Rekenthaler has—and you can read that analysis here

 

The 4% "Solution?"

A recent white paper has garnered a lot of discussion by casting “shade” on a traditional premise about retirement plan withdrawals.

The premise—a so-called “rule of thumb[i]”—isn’t all that old, actually; it dates back only to 1994, when financial planner William Bengen[ii] claimed that over every rolling 30-year time horizon since 1926, retirees holding a portfolio that consisted 50% of stocks and 50% of fixed-income securities could have safely withdrawn an annual amount equal to 4% of their original assets, adjusted for inflation without… running out of money. 

That said, even though it was predicated on a number of assumptions that might not be true in the real world—a 30-year withdrawal period, a 50/50 portfolio mix of stocks and bonds, assumptions about inflation—oh, and a schedule of withdrawals unaltered by life’s changing circumstances (not to mention a 90% probability of success)—a recent Morningstar paper challenged its conclusions in view of “current conditions.”

The controversy, if it warrants that name, was that Morningstar said that 4% might no longer be “feasible”—that there might be a better number—more specifically that the “confluence of low starting yields on bonds and equity valuations that are high relative to historical norms, retirees are unlikely to receive returns that match those of the past”—and thus, “using forward-looking estimates for investment performance and inflation,” the Morningstar authors said that the standard rule of thumb should be lowered to 3.3% from 4%. 

Said another way, your retirement savings likely won’t last as long as you might have thought they would, and with surging inflation in the headlines, that conclusion certainly engendered a lot of media attention.

Now, in fairness, the paper states at the outset that they are not recommending a withdrawal rate of 3.3%, which they characterize as “conservative.” How so? Well, they note that it is based on four factors: 

1. a time horizon that exceeds most retirees’ expected life spans; 
2. it fully adjusts all withdrawals for the effect of inflation; 
3. it does not react to changes in the investment markets; and 
4. it’s based on a “high projected success rate”—90%.

Moreover—and significantly, despite the ensuing headlines of other publications—they explain that “by adjusting one or more of those levers, current retirees can safely withdraw a significantly higher amount that the 3.3% initial projection might suggest.”

Now, there’s been plenty of evidence—both empirical and anecdotal—that retirement “spends” aren’t nice, even streams. Life’s circumstances change, of course—and our health care, and health care costs, are notoriously variable. There’s a sense that the pace of spending earlier in retirement is more like that anticipated in most retirement education brochures—travelling and such—but that pace slows down as we do. 

In fact, I remember my one and only conversation with my father about retirement income. He had already decided to quit working, and had gathered his assorted papers regarding his savings, insurance, etc. for me to review. Determined to “dazzle” Dad with my years of accumulated financial acumen, I proceeded to outline an impressive array of options that offered different degrees of security and opportunities for growth, the pros and cons of annuities, and how best to integrate it all with his Social Security.

And yet, when I was all done, he looked over all the materials I had spread out before him, then turned to me and said—“So how much will I have to live on each month?”

At its core, once you stipulate certain assumptions about the length of retirement, portfolio mix/returns, and inflation, a guideline like the 4% “rule” is really just a mathematical exercise. A 4% “rule” may be simplistic, but it’s also simple—and when it comes to getting your arms around complex financial concepts and distant future events, there’s something to be said for that. 

But looking for a 4% ”solution” is arguably looking to solve the wrong problem.  

- Nevin E. Adams, JD

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[i] And the origins of that phrase are likely different from what you’ve been told—see https://www.phrases.org.uk/meanings/rule-of-thumb.html.

[ii] Who, interestingly enough, opined earlier this year that it might now be a 4.5% rule… 

4 Things That Make Me Go ‘Huh?’

Ours is a business where surveys and trends often shape not only perceptions, but policy — though sometimes the conclusions drawn, and even the premise itself — make me go “huh?”

Here’s a sampling:

Citing a drop in deferral rates as a failure of automatic enrollment.

Every so often a personal finance writer will stumble across an industry survey that shows that the average deferral rate in 401(k) plans has declined, a problem they attribute to automatic enrollment adoption. We all know what is going on here; individuals who take the time to fill out a form and enroll in the plan manually tend to defer at a higher rate than do those who are automatically enrolled, the latter typically at a modest 3% rate. On the other hand, automatic enrollment has a dramatic impact on raising the participation rate. The rest is just math — more people, saving at lower rates = a lower average deferral rate.

Now, those individuals automatically enrolled at a 3% rate may draw down the average deferral rate of a plan, or the industry, but it’s almost certainly true that most people who are now saving 3% without automatic enrollment would likely have been saving — nothing at all.

Equating retirement confidence with retirement readiness.

Seems as though every other month we get yet another take on how Americans feel about their retirement prospects — and it’s never very reassuring. The Retirement Confidence Survey conducted by the nonpartisan Employee Benefit Research Institute (EBRI) and Greenwald & Associates has been chronicling that sentiment for a quarter century and over that span of time has tracked movements in confidence that mostly seem to mirror the markets, rather than any real cognizance of retirement preparations. Indeed, the RCS has routinely found that fewer than half of the survey respondents have made even a single attempt — including guessing — to ascertain their retirement needs.

It’s not that confidence about one’s retirement prospects isn’t a relevant consideration — but we shouldn’t equate an uninformed sense of that status with reality.

Comparisons of DB versus DC investment returns.

If ever there was an apples-and-oranges undertaking, it’s the comparison of defined benefit and defined contribution plan returns. The former is, of course, the return of a portfolio representing a single overriding investment philosophy designed to achieve a specific aggregate objective, and one overseen by a plan fiduciary (or plan fiduciary committee). The latter is little more than an aggregation of individually managed (or more frequently unmanaged) portfolios.

And yet, every so often someone wants to offer a comparison of the returns between the two as some kind of evaluation as to which is “better.”

In many of these comparisons, defined benefit portfolios have fared “better,” and the underlying explanation (implicit or explicit) for that differential has tended to be diversification (or “better” diversification), and in more recent years, lower fees have been credited. What we’re apparently supposed to draw from that is that DB plans are better-managed in terms of asset allocation by professionals, better able to negotiate lower fees than their DC counterparts, and generally provide a better return on investment. In other words, DB plans are “better.”

Now, I’m not saying that all, or even most, of those individually directed DC plan allocations are as well designed or maintained as those put in place by a DB investment committee, and however well negotiated it is, it’s hard to imagine that a DC plan with all its inherent complexities could (or should) get as good a deal on price as a DB offering. In fact, unless your defined benefit plan has a single participant, those programs have completely different objectives and timeframes.

You might as well be comparing a sports car to a Hummer; which is “better” depends on the distance, the terrain, the length of time you have to complete the journey, how much fuel you have — and how many people you have to transport.

Using average 401(k) balances as a proxy for retirement security.

If there is one number I wish our industry would quit publishing, it’s the average 401(k) balance. Here you have participants who may (or may not) have a DB program, who are of all ages, who receive widely different levels of pay, who work for employers that provide varying levels of match, and who live (and may retire) in completely different parts of the country. Frequently it is based only on the accumulations that have occurred during their tenure at an individual employer, and often only the balance that is found on the single recordkeeping system that is publishing the result. But in preparing this number, those widely varied circumstances are all slopped together to create — mush.

Worse than mush, actually. Because it is an average of so many varied circumstances, the result is almost never “enough” to provide anything remotely resembling an adequate source of retirement income, a point that is reiterated somewhat incessantly (and generally without the caveats about what it is an average of) in the press.

I’ll allow that some of the permutations of this calculation — such as when we see that average broken down by age demographic — can be instructive as to longer-term trends, but an average 401(k) balance is akin to an average reviewer rating on Amazon.com.

As with everything else on my “huh?” list, it’s mathematically accurate — and nearly completely useless.

- Nevin E. Adams, JD

The “New” Math?

One of my more frustrating memories of parenthood was trying to help my kids with their homework. Not because I hadn’t covered the territory once upon a time myself, or because I couldn’t manage to refresh my recollection(s) of the subject. It wasn’t enough to teach my kids a method sufficient to arrive at the correct answer, and to help them understand how we got there. No, it didn’t “count” unless I could arrive at the answer by adhering to what struck me as a weirdly inefficient and complicated regimen upon which their teachers insisted.

If this was the “new math,” I remember thinking at the time, I fear for the sanity of the next generation.

This past weekend The New York Times ran an article aptly, if somewhat awkwardly, titled, “New Math for Retirees and the 4% Withdrawal Rule.” The focus of the article, like the 4% rule itself, was how to pace withdrawals in retirement so that you don’t run out of money before you run out of retirement. However, like so many other things these days, it’s apparently not as simple as it once was, complicated by the low interest rate environment and the current high stock market values.

Though a lot of time, thought and attention has been paid to the 4% rule (and its progeny), to me it’s basically just math. After all, once you stipulate certain assumptions about the length of retirement, portfolio mix/returns, and inflation, a guideline like the 4% “rule” is really just a mathematical exercise.

‘Drawing’ Board

But if those rules purport to tell us how much we can draw from our retirement savings without running out, how does that compare with what people are actually withdrawing? The Employee Benefit Research Institute (EBRI) has previously examined withdrawal patterns in their IRA database, and found that the median IRA individual withdrawal rates amounted to 5.5% of the account balance in 2010, though among those 71 or older (when required minimum distributions kick in) were much more likely to be withdrawing at a rate of 3-5%.

Those median numbers don’t tell the whole story, of course. A separate EBRI analysis, this one based on data from the University of Michigan’s Health and Retirement Study (HRS), found that lower-income workers were withdrawing money from their individual retirement accounts in much greater numbers, earlier, and at much larger percentages, than other workers. In fact, the report noted that nearly half (48%) of the bottom-income quartile of those between the ages of 61 and 70 had made such an IRA withdrawal, and that their average annual percentage of account balance withdrawn was 17.4% — higher than the rest of the income distribution. In sum, a number of individuals, again, notably lower-income workers, were withdrawing more from their retirement savings accounts than those in higher income groups — and apparently more than the 4% “rule” would suggest would allow them to avoid running out of money in retirement.

Will these drawdown rates create a problem down the road? Will these individual run short of funds in retirement? Will those withdrawals, along with other resources that may be available, be sufficient to live on? The answers, of course, depend on the individuals, their circumstances, health, needs, expectations — and preparations.

Those ultimate realities may be new for some — but the “math” won’t be.

- Nevin E. Adams, JD

“Drawing” Board?

While drawing boards have been used by engineers and architects for more than two centuries, the phrase “back to the drawing board” is of much more recent origin, coined by the Peter Arno in a cartoon first published in the March 1, 1941 issue of New Yorker magazine.(1) The cartoon features a crashed plane in the background, a parachute in the distance, several military officials and rescue workers rushing to help/investigate—and one remarkably nonchalant individual, walking in the opposite direction with a rolled up document tucked under his arm as he comments, “Well, back to the old drawing board.”

For all the much-deserved focus on retirement savings accumulations, a growing amount of attention is now directed to how those already in (and fast-approaching) retirement are actually investing and drawing down those savings.

A recent EBRI analysis(2) found that at age 61, only 22.2 percent of households with an individual retirement account (IRA) took a withdrawal from that account. That pace slowly increases to 40.5 percent by age 69 before jumping to 54.1 percent at age 70, and by the age of 79, almost 85 percent of households with an IRA took a distribution.

IRAs are, of course, a vital component of U.S. retirement savings, holding more than 25 percent of all retirement assets in the nation, according a recent EBRI report. A substantial and growing portion of these IRA assets originated in other employment-based tax-qualified retirement plans, such as defined benefit (pension) and 401(k) plans.

The EBRI analysis also found that the percentage of households with an IRA making a withdrawal from that account not only increased with age, but also spiked around ages 70 and 71, a trend that appears to be a direct result of the required minimum distribution (RMD) rules in the Internal Revenue Code.(3) Those rules require that traditional IRA account holders begin to take at least a specific amount from their IRA no later than April 1 of the year following the year in which they reach age 70-½, or else suffer a fairly harsh tax penalty.

In fact, at age 71, 71.1 percent of households owning an IRA that took a withdrawal reported that they took only the RMD amount, increasing to 77.4 percent at age 75, 83.2 percent at age 80, and 91.1 percent by age 86.

However, the EBRI report noted that IRA-owning households not yet subject to the RMD—those headed by individuals between the ages of 61 and 70—made larger withdrawals than older households, both in absolute dollar amounts as well as a percentage of IRA account balance. Indeed, the bottom-income quartile of this age group had a very high percentage (48 percent) of households that made an IRA withdrawal—and their average annual percentage of account balance withdrawn (17.4 percent) was higher than the rest of the income distribution. Moreover, those younger households that made IRA withdrawals spent most of it.

While a significant percentage of those in the sample are drawing out only what the law mandates, the data indicate that more of those in the lower-income groups not only draw money out sooner, but also draw out a higher percentage of their savings—perhaps too early to sustain them throughout retirement.(4)

Planning and preparation matters—not only for retirement savings, but in retirement withdrawals. Because for those whose retirement resources run short too soon, it’s generally also too late to go “back to the drawing board.”

Nevin E. Adams, JD

(1) You can see the original cartoon online here.

(2) The data for this study come from the University of Michigan’s Health and Retirement Study (HRS), which is sponsored by the National Institute on Aging. See “IRA Withdrawals: How Much, When, and Other Saving Behavior,” online here.

(3) As noted in a previous post (see “Means Tested”), there are advantages to a drawdown strategy based on the schedule provided by the Internal Revenue Service (IRS) for required minimum distributions, or RMDs. See also Withdrawal “Symptoms.”

(4) The EBRI Retirement Readiness Ratings™ indicate that approximately 44 percent of the Baby Boomer and Gen-Xer households are simulated to be at-risk of running short of money in retirement, assuming they retire at age 65 and retain any net housing equity in retirement until other financial resources are depleted. Those individuals may well become part of the significant percentage of retirees who eventually must depend on Social Security for all of their retirement income. See “All or Nothing? An Expanded Perspective on Retirement Readiness.”

Means, Tested

Recently the Center for Retirement Research at Boston College released a paper titled “Can Retirees Base Wealth Withdrawals On the IRS’ Required Minimum Distributions?”¹ The answer to that question, according to CRR, is “yes.” A more complete response might be, “yes, or any number of other random withdrawal methodologies.”

There are some advantages to a drawdown strategy based on the schedule provided by the Internal Revenue Service (IRS) for required minimum distributions, or RMDs.² First off, and as the CRR paper notes, it’s relatively straightforward. Secondly, it effectively defers initiating withdrawals until age 70-½, which also provides some additional accumulation opportunity. Perhaps most importantly, it helps avoid the stiff penalties the IRS imposes on those who don’t withdraw funds from these accounts at least as rapidly as the RMD schedule provides. The CRR paper cites as an advantage the reality that those drawdowns are based on the portfolio’s current market value, though surely some people remember how the impact of the 2008 financial crisis on those accounts triggered a more aggressive withdrawal schedule than many found optimal or necessary.

A previous post dealt with another popular drawdown method: the so-called 4 percent rule (see “Withdrawal ‘Symptoms”). As with that 4 percent “rule,” once you stipulate certain assumptions about the length of retirement, portfolio mix/returns, and inflation, those type guidelines are really “just” a mathematical exercise that involves stretching a finite pool of resources over an estimated period of time.

The CRR paper outlines a series of reasons as to why the RMD approach might be superior to alternatives such as the 4 percent rule, but ultimately the biggest shortcoming of the RMD schedule as a basis for withdrawal may be that it fails to take into account how much income is needed, much less when it is needed—and it’s based on a series of assumptions that may or may not apply to an individual’s real-life circumstance.

Of course, in a very real sense, relying on any arbitrary systematic calculation to determine how much, and how fast, to drawdown savings can be seen as a way of living within your means—an approach that can work just fine if you have first made preparations to have adequate means upon which to live.

- Nevin E. Adams, JD

¹ The CRR report is online here.

² Information about required minimum distributions is available at the IRS website, online here. IRS worksheets to calculate the amount of the RMD are online here.

For some interesting data on actual withdrawal rates from individual retirement accounts, see “Withdrawal Symptoms.”

Withdrawal “Symptoms”

I was recently asked about the so-called 4 percent “rule.” That’s the rule of thumb(1) that many financial consultants rely on as a formula for how much money can be withdrawn from retirement savings every year (generally adjusted for inflation) without running out of money. Of course, like so many of the “assumptions” about retirement, certainly in the aftermath of the 2008 financial crisis, that withdrawal rule of thumb has drawn additional scrutiny.(2)

At the time, my comment was that the 4 percent guideline is just that—a guideline. What’s not as clear is whether adhering to that guideline produces an income stream in retirement that will be enough to live on.

How much are people actually withdrawing from their retirement accounts? At a recent EBRI policy forum,(3) Craig Copeland, senior research associate at the Employee Benefit Research Institute, explained that the median IRA individual withdrawal rates amounted to 5.5 percent of the account balance in 2010, though he noted that those 71 or older (when required minimum distributions kick in) were much more likely to be withdrawing at a rate of 3–5 percent (in 2008, that group’s median withdrawal rate was 7.2 percent, but in 2010, it was 5.2 percent), based on the activity among the 14.85 million accounts and $1 trillion in assets contained in the EBRI IRA Database.(4) Will these drawdown rates create a problem down the road? Will these individual run short of funds in retirement?

At its core, once you stipulate certain assumptions about the length of retirement, portfolio mix/returns, and inflation, a guideline like the 4 percent “rule” is really just a mathematical exercise.

However, trying to live on the resources you actually have available in retirement is reality—and those post-retirement withdrawal decisions are generally easier to make when you’ve made good decisions pre-retirement.

- Nevin E. Adams, JD

(1) Certified financial planner William P. Bengen is frequently credited with the concept, based on his article “Determining Withdrawal Rates Using Historical Data,” published in the October 1994 issue of the Journal of Financial Planning.

(2) It had drawn criticism before the 2008 financial crisis as well: See “The 4% Rule—At What Price?”

(3) The agenda, presentation materials, and a recording of EBRI’s May policy forum are available online here. Dr. Copeland’s presentation is online here.

(4) The results come from 2010 data in the EBRI IRA Database,TM which had 14.85 million accounts, held by 11.1 million individuals, with $1 trillion in assets—roughly one-fifth of both owners and assets in the IRA universe.