Thursday, October 4, 2012

Planning for Retirement

This morning's New York Times carried an excellent column on retirement planning.  If you are at all interested in this subject, I would urge you to click on the link below.

One of the most important subjects the column addresses is the appropriate withdrawal rate for retirement accounts.

This is one of the most favorite topics among my clients who are either retired or nearing retirement, particularly in an environment with ultra-low interest rates.

Here's an interesting question/answer excerpt from the column, authored by financial planner Doug Wheat, a CFP associated with a firm named Family Wealth Management:

Q. I have read that the rule of thumb is to withdraw 4 percent or 1/25 of your retirement funds each year. My guess is that this “rule” was developed when interest rates on “safe” investments (CDs, certain bonds, etc.) would support this level of withdrawal. However, with interest rates near zero (at least for now), it seems only equities have the chance to earn a sufficient return to support the 4 percent rule, but equities are risky for retirees. What is your advice on how to invest retirement funds, and is the 4 percent rule still applicable? —HonuCarl, Los Angeles.
A. The notion of a 4 percent safe withdrawal rate emanates from a 1998 academic study often referred to as the “Trinity Study.” In the study the authors from Trinity University provide historical evidence that if you begin withdrawing 4 percent of your accumulated savings your first year of retirement and increase that amount each year by the rate of inflation, you have little danger of running out of money over a 30-year period if it is invested in a balanced portfolio of stocks and bonds. For example, if you have $1 million at retirement, you can withdraw $40,000 the first year. Assuming the inflation rate is 3 percent, the second year of retirement you can withdraw $41,200. This strategy is appealing because it provides a steady cash flow while the value of your portfolio may be fluctuating. Updated studies through 2011 indicate that since 1926 there were no 30-year periods where you would have run out of money using this strategy (although if you retired in 1966 you would have come awfully close). 

I went on the internet to look up the "Trinity Study" that Mr. Wheat refers to in his column.

The authors of the study (Philip Cooley, Carl Hubbard and Daniel Walz) looked at portfolios that contained at least 75% stocks, and as Mr. Wheat indicates, retirees could provide 4% to 5% inflation-adjusted withdrawals without running out of money over any longer time period.

The problem I have these days, however, is that many people are reluctant to have at least 75% of their retirement accounts invested in stocks.  The pain of 2008-09 is still too fresh in investors' minds, and despite bond yields that are below the rate of inflation most still want a significant allocation to bonds.

However, history would suggest that the real risk to retirement planning is becoming too conservative, not too aggressive.