Retirement Focus - The All-Important Withdrawal Percentage
FORECASTS & TRENDS E-LETTER
By Mike Posey
IN THIS ISSUE:
1. A Brief Review of Previous Issues
2. Taking Fixed-Dollar Distributions
3. The Mysterious Withdrawal Percentage
4. Giving It Away
5. Handling Income Shortfalls
6. Wrapping It All Up
It’s hard to believe, but it’s been over two months since my last Retirement Focus issue. My, how time flies when economic and market events are in a constant state of flux, not to mention politics, and these issues have been taking up most of our weekly E-Letter slots. Thus, I’m glad to have this opportunity to continue my retirement series on converting your nest egg to income, as it has become clear to us that this topic is important to many of our readers.
On that note, I want to tell you about a recent financial industry publication that contained a headline declaring, “Market’s Woes Complicate Retirement Planning.” As my 22-year-old son would say, “DUH.” Then came an even more emphatic statement of the obvious: “Some investors will take less from their nest eggs – or keep working.”
These two headlines were such statements of the obvious that I almost expected to see other features noting that GM engineers have discovered that their cars can run out of gas, or that NASA has determined that the need to get astronauts back to earth has “complicated” the shuttle program. I’m speaking in jest, of course, but these retirement issues are very important.
I hate to be the one to break the news to these financial media masterminds, but the concepts of bear markets and taking less or working more were already well founded before the recent market downturn. In other words, such retirement planning decisions should have long since been “complicated” by the inevitability of down markets. To suggest that they might not have been is, to say the least, a bit simpleminded and naive.
I have a different opinion as to the effect of the recent dip in the market. I believe it has introduced a sense of reality into retirement planning. No matter what retirement projection software or assumptions you are using, the market doesn’t always go up. In fact, the market can go down further, faster and stay there longer than at any time in the past. Therefore, it should have already been standard practice to factor in the possibility of bear markets and investment losses in order to stress-test any retirement projection.
I’ll climb down from my soapbox now to continue the task at hand. Since it’s been a while since we visited the subject of taking income from your investments during retirement, I’m going to take part of this week’s issue to do a bit of review. Then, I’m going to launch into a discussion of the remaining options for converting your nest egg into income.
A Brief Retirement Planning Review
Back in my July 24, 2007 Retirement Focus E-Letter, I kicked off a series of articles designed to help you become more knowledgeable about the various options available to you at retirement, and which may be the best for your financial situation. In that E-Letter, I discussed the various ways to take annuity payouts from retirement plans that provide for monthly benefits.
Then, in my August 21, 2007 Retirement Focus issue, I took somewhat of a detour on the road to regular retirement payouts to discuss the various issues related to lump-sum distributions. After all, if you choose to not take advantage of your retirement plan’s annuity payout options, then you must determine how best to handle the alternative of a lump-sum distribution.
Then, in my November 13, 2007 Retirement Focus, I offered a series of articles that provide guidance in regard to living off of the income from your accumulated retirement savings. I provided a listing of the five basic ways a retiree can handle his or her accumulated assets. Since then, I have been covering each of these options in more detail in my periodic Retirement Focus issues. Looking back, we have already covered the following alternatives:
With those alternatives covered, we still have three of the original options to go. In this week’s E-Letter, I’ll cover the remaining options for taking retirement income, including:
After covering these last three options in this week’s issue, I’ll then begin a discussion about how to invest for periodic distributions in the next Retirement Focus.
Retirees who elect a fixed-dollar amount to be distributed from retirement savings each year often do so to be able to better budget income and expenses. The distribution may be annual, quarterly, or monthly; whatever works best for the individual. Many retirees set up monthly distributions to mimic their regular pre-retirement paycheck.
Unlike taking a fixed percentage of assets that can vary with investment gains and losses (as I will discuss below), the fixed-dollar distribution is the same until changed by the retiree. While this makes budgeting easier, it can also become a disadvantage if investment losses reduce principal, especially in the early years.
As I noted above, the idea of taking fixed dollar amounts from accumulated retirement assets can be indicative of both success in saving and investing over the years, or because of having an insufficient amount of assets at retirement. I’ll handle each of these situations separately below.
The first group I’ll discuss are successful investors who have sufficient retirement income from other sources such that they need only to supplement their retirement income with flat-dollar distributions. Needless to say, depletion of principal is usually not an issue with these retirees, unless they have imprudently invested in high-risk investments that may be subject to significant losses.
For those taking supplemental distributions, the fixed-dollar withdrawals are sometimes less than income earned on investments, so the difference continues to stay invested and retirement assets can actually grow, depending upon the investment strategy. In fact, retirees who find that relatively small fixed-dollar distributions sufficiently meet their needs often incorporate legacy planning and/or charitable giving to address the eventual disposition of their ever-growing nest eggs. If only we all had this problem….
The next group is made up of those retirees who have saved a substantial nest egg, but must take substantial withdrawals to supplement Social Security and any other sources of income. This group differs from the first in that the withdrawals are necessary for the bulk of their retirement income, and usually include distributions of both income and principal. Thus, the possibility of running out of money can become a real problem if proper planning and monitoring is not done.
Actually, this second group of retirees is very similar to those who elect to take a fixed percentage of income made up of both principal and income, in that the amount withdrawn must take into account assumed rates of investment earnings, probability of losses, inflation and a number of other factors. Thus, much of the section below covering sustainability of fixed-percentage distributions will generally apply to these retirees as well, except that periodic distributions will not vary as they do with a percentage withdrawal.
The last group of retirees who may elect fixed-dollar distributions are more unfortunate, and I will spend the most time on them. These individuals have not saved sufficient assets for retirement, so they must take larger distributions in order to have enough money, when combined with Social Security benefits and any other retirement income, to meet basic necessities. However, the distributions are such that their nest egg cannot continue to support the higher withdrawal rate indefinitely.
Let me clarify that I’m not talking about retirees who find it inconvenient to scale back their standard of living to be within their post-retirement means. I read a recent article from Forbes magazine lamenting about how some retirees with as much as $4 million in the bank are upset because they are not able to enjoy a post-retirement lifestyle in the manner to which they have become accustomed. What a shame!
In my opinion, anyone with $4 million can scale back their lifestyle such that their money will last them through retirement. The ones I feel for are those for whom scaling back is not an option, and who must withdraw larger distributions because they are barely able to cover food, clothing, shelter and medical expenses. For these individuals, running out of money during their lifetime is not only likely, but almost guaranteed – unless they take action.
The All-Important Withdrawal Percentage
Taking a fixed percentage of your retirement nest egg is similar to taking a flat-dollar distribution, except that the percentage of assets withdrawn is what remains constant, rather than the dollar amount. This method is considered to be a more conservative way to take income, since the constant percentage will result in lower dollar distributions should investment losses reduce the size of the nest egg.
Depending upon the withdrawal rate selected and actual investment returns, a flat-percentage withdrawal strategy can sometimes result in a steadily declining periodic withdrawal as principal is invaded to provide current income. This is especially true in a bear market. Thus, the flexibility inherent in this withdrawal method can also mean that distributions may be less than what is needed to cover post-retirement expenses.
That’s why pre-retirement planning in regard to the proper withdrawal percentage and investment strategy is so important. The withdrawal percentage must take into account assumed rates of investment earnings, probability of losses, inflation and a number of other factors, just as with flat-dollar distributions.
As I noted above, a fixed withdrawal percentage is similar to a fixed-dollar distribution in that retirees utilizing this method will range from those who only need to supplement other income, to others who may have to have a withdrawal rate so large that it’s likely they’ll deplete their assets during retirement. However, most using this method are those in the position of needing to draw down on both principal and interest, but in such a way as to have the best chance of not running out of money in retirement.
This differs from my earlier discussion in the December 11, 2007 E-Letter about living on the income produced by investments, in that distributions are made whether or not there are any positive investment gains. Thus, a great deal of attention has been paid to the calculation of an optimum withdrawal percentage for these individuals.
I have read numerous articles filled with mind-numbing calculations, all designed to support one withdrawal rate or another. While I would love to be able to tell you that my research has found the optimum withdrawal rate, I have to admit that no single solution exists. There is, however, some general guidance I can provide in regard to deciding how much to take out of your plan.
In a perfect world, the withdrawal percentage would be sustainable, in that it could remain constant without depleting accumulated assets during the retiree’s lifetime. Unfortunately, that’s not always the case. Since the distribution is based on a percentage of accumulated assets, in some years the withdrawal percentage may actually be less than investment earnings. In others, however, it may be greater, so part of the principal is also distributed. In years when there are investment losses, the fixed percentage will be taken out on top of such losses, thus increasing principal shrinkage.
You should be aware that there are some articles and studies out there that are dangerous, in my opinion. For example, I have actually seen articles suggesting that withdrawal rates as high as 10% per year are reasonable, based on the fact that long-term stock market returns are in that same 10% range. But no one can guarantee that stock market returns will continue to average 10% per annum over time. Since no one knows what future stock market returns will be, it could well be that a 10% withdrawal rate will cause you to run out of money, and you are taking a big chance if you elect this amount, in my opinion.
In his book, “Live Long & Prosper!,” author Steve Vernon cites the results of a computer projection of retirement outcomes for a 65-year-old female, based on an investment portfolio made up of 50% stocks and 50% bonds, with an annual inflation rate of 3%. The results show that at a 4% withdrawal rate, the retiree has only a 4% chance of running out of money during her lifetime. However, at a 10% withdrawal rate, the chance of running out of money jumps to a whopping 67%. I don’t like those odds.
So, what is the best percentage? Is 8% or 9% sufficiently below the long-term stock return average to be conservative enough? Should it be 3% to err on the side of caution? Looking back at the studies, articles, white papers, etc. that I have read promoting “safe” withdrawal rates, I have seen anywhere from 4% to almost 7% given as the optimum rate, but there is no wide agreement as to which is the best.
The problem with selecting the wrong withdrawal percentage is that, if it’s wrong and you run out of money, you can’t go back and get another crack at it. Therefore, I always counsel retirees to be conservative in determining their withdrawal percentage, and keep it around 5% if possible. Of course, that assumes that a 5% withdrawal rate will result in an income sufficient to meet your needs.
It also stands to reason that taking a fixed-percentage distribution will result in a lower level of withdrawal if the assets decrease in value due to investment losses. This is especially true if losses are concentrated in the early years of retirement. If the principal is reduced enough, income distributions will follow suit and the fixed withdrawal percentage may have to increase in order to produce a level of income sufficient to meet post-retirement expenses. Unfortunately, this could result in reducing the principal even faster and actually increasing the risk of running out of money.
The best way I have found to address this issue is to use some of the retirement planning software available to do “what-if” calculations, similar to those discussed above in Vernon’s book. The better of these software packages have ways to run literally thousands of possible outcomes based on your assumptions about withdrawal percentages (or fixed-dollar distributions), investment strategy, inflation, etc. and provide you with the likelihood of various outcomes. The goal is to select a withdrawal rate that both meets your income needs, and has a high probability of not depleting your retirement assets too soon. Of course, the outcome is only as good as your assumptions.
I call this “stress testing” your retirement plan and, while not perfect, it helps to provide a realistic view of the various outcomes of your assumptions. I’ll address these software programs and simulation techniques in more detail in the next Retirement Focus, but what I want to drive home now is that such tools are valuable assets in your retirement planning quest.
Giving It Away
While it may sound counterintuitive to discuss giving retirement assets away rather than using them for income needs, there are some retirees who do not need to draw down their retirement assets, and have other options for creating a legacy for their heirs. This is due to the taxable nature of retirement assets, which are often subject to both income taxes AND estate taxes, if applicable.
You may have seen some of the sensationalized marketing material trumpeting that the IRS may get up to 85% of your retirement plan or IRA balance that you leave to your heirs – unless you take the right steps (which they will gladly provide to you for a fee.) It’s rarely as bad as these claims, but leaving IRA assets to heirs does involve a tax consequence.
Thus, there are situations in which leaving your IRA or other retirement assets to charity might be a wise part of your estate planning process. It may be more beneficial for the charity to inherit retirement assets and your heirs inherit non-retirement assets, since the non-retirement assets may have already been taxed. The charity will not owe income taxes even though retirement distributions are usually taxable, and this option may effectively remove the asset from your estate.
In fact, the Pension Protection Act of 2006 contained a provision that allowed IRA account holders who were 70½ or older to directly transfer up to $100,000 of IRA value to a charity of their choice. However, this provision only applied to 2006 and 2007 tax years, and was not extended by Congress. Some believe a bill to extend this provision may be introduced in Congress again before the end of 2008. If so, it would bear looking into if you are seeking a way to transfer part of your IRA money directly to a charity.
Even with the failure to extend the direct IRA transfer, there are still ways to transfer money from your retirement plan or IRA to charities. One alternative is to transfer retirement account balances by naming a charity as the beneficiary of your account. This way, the charity is seen as having received the distribution, and no taxes will be owed on the transfer by the estate or the charity. The amount transferred will usually be deemed part of the estate, but an offsetting charitable deduction may be available that offsets any negative tax implications.
If you are considering naming a charity as a beneficiary of your IRA or qualified plan, be sure to consult with your IRA custodian or plan administrator to determine if there are any restrictions for such a beneficiary designation. You may also have to obtain the consent of your spouse. In addition, be aware that it may be best to establish multiple accounts rather than naming a charity as a partial beneficiary of a larger account that also has family members as co-beneficiaries.
Another way to transfer retirement assets to a charity is to do so during your lifetime. Essentially, this means taking distributions from your traditional IRA and claiming a charitable deduction. However, keep in mind that distributions from an employer retirement plan may not be allowed if you are still working and participating in the plan, so lifetime distributions may not be an option from that source.
One negative for lifetime gifts is that the limitations on charitable deductions might mean that the IRA distribution given to the charity may need to be restricted to the amount that can be deducted by the donor. In addition, gifts from retirement plans should be made only after age 59½ to escape the 10% premature distribution penalty tax.
Those with more complex estates may want to consider setting up trusts with charitable provisions, such as a “charitable remainder trust.” Such arrangements often allow heirs to receive income from accumulated assets over their lifetimes, and then provide for the remaining value to be transferred at a later date. Correctly established, such trusts can allow you to exert at least some control over the assets of your estate even after your death.
It is very important that you consult with a qualified estate planning or tax professional prior to taking any action in regard to leaving your retirement assets to a charity. The above represents just a brief overview of what can be a very complex process, and should not be taken as legal or tax advice. A qualified professional can help you make sure your assets are handled in the way you want, both before and after your death.
The benefits of donating retirement assets to charities extend beyond the satisfaction of helping a worthwhile organization. Donating fully taxable retirement assets to a tax-exempt charity can help you maximize the tax planning opportunities for your estate. In addition, the charity gets the benefit of 100% of the value of the account since it does not have to pay income tax on the distribution. Properly done, leaving retirement plan assets to a charity can be a win-win-win benefiting your estate, the charity and your heirs.
Handling Income Shortfalls
As I have discussed the various options in regard to converting your nest egg into income, one overriding consideration is that the income is sufficient to cover post-retirement living expenses. While many retirees do have a large enough nest egg to produce an appropriate amount of income, this is certainly not true with all of the Baby Boomers.
When faced with the prospect of retiring with insufficient funds, there’s little choice as to what actions to take: either cut back on your post-retirement standard of living or consider delaying retirement. In other words, you may have to live on less or keep working.
There are a number of resources available on the Internet that provide tips for cutting expenses after retirement. The goal is to try to attain the same desired standard of living at a lower cost. However, there are times when “luxuries” have to be eliminated, but the problem becomes what is a luxury to one may be a necessity to another. Since the prospect of running out of money in retirement is so grim, it’s important that you have a realistic outlook in regard to post-retirement budgeting.
If your nest egg won’t support even the most austere post-retirement budget, you may have to continue working. You may prefer to continue to work for your same employer, if feasible. If not, you’ll need to find employment elsewhere. Delaying retirement and continuing to work have several advantages for those with insufficient retirement savings:
The primary negatives associated with working past normal retirement age (usually age 65) are that your health may not allow you to do so, or that delayed retirement is not desired. Many people want to retire while they are still healthy enough to enjoy traveling, being around their grandkids, or other post-retirement activities. Delaying retirement until age 70 or later increases the chances of having health issues that might affect post-retirement plans, but this disadvantage may be unavoidable for many Baby Boomers who have not saved enough for retirement.
A compromise may be to retire from a full-time job and work only part-time, assuming that this level of employment can produce sufficient income for you to be able to avoid drawing down on your nest egg. You would still get most of the advantages of delaying retirement, but also have some free time for travel, etc. Sometimes your current full-time employer may even be the source of a part-time position.
There are also other ways to supplement retirement income for those who have not saved enough before retiring. One way to do so is a “reverse mortgage” in which you may be able to receive a regular monthly payment on your home as long as you live, plus still be able to stay in your home. Gary wrote about these instruments in his August 29, 2006 E-Letter, and I’m sure you’ve seen the many ads on TV promoting these programs.
While there are a lot of issues to consider, a reverse mortgage may provide needed additional income. However, beware of people promoting reverse mortgages in order to generate cash to invest in a program they are offering. While not all such programs are scams, there are a number that are, and news stories about abuses of reverse mortgages are growing in number. As always, seek out a qualified professional to help guide you through the reverse mortgage maze.
A final way to generate some extra cash may be to sell an unneeded life insurance policy in a transaction known as a “life settlement.” In such a transaction, you are paid a discounted amount for a life insurance policy you own and no longer need. The buyer continues to pay the premium, and collects the death benefit when your eventual demise occurs.
While some consider this a rather morbid business, it is a legitimate option, and it can mean extra cash in your pocket should you have life insurance coverage that you no longer need. However, the key is that the coverage is no longer needed. It’s always best to review your needs and current life insurance situation with an insurance or financial professional before entering into a life settlement transaction.
In future Retirement Focus issues, I’ll discuss both reverse mortgages and life settlements in more detail. For now, suffice it to say that they are two potential options available to anyone who qualifies and needs to supplement retirement income.
Conclusion – Putting It All Together
As you have been able to see from this series of articles, there are a number of ways to handle distributions of your retirement plan assets. While each has been dealt with separately, retirees often use a combination of approaches, or sometimes move from one to another as their financial situation changes during retirement.
I’m sure you have also observed that a discussion of many of these options actually generates additional questions that will be handled in later Retirement Focus issues. Unfortunately, this adds to the complexity of the decision-making process, but it’s important to do your homework on the front-end of retirement rather than paying the price of making an uninformed decision much later when you are far too old to have other options available to you.
Continual monitoring is also an important part of any withdrawal strategy. Retirement income is not a “set it and forget it” operation, it must be monitored at least annually to make sure you are still on track. It’s better to make adjustments early on, rather than waiting until it’s too late.
Throughout the discussion of payout alternatives, one of the major variables has been the rate of return you might be able to expect on your investments during retirement. Now that you know the various options available to you, it’s time to delve into the investment side of the equation. We’ll do that in the next Retirement Focus issue.
Finally, I would greatly appreciate your comments and suggestions for these Retirement Focus articles. Those of you who are in, or approaching, retirement are on the front lines, and you may be able to point me to issues and options that I don’t run across in my research. So, please let me hear from you at firstname.lastname@example.org.
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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.