Retirement Planning Gone Awry

Once retirement hits, the choices are no less challenging. As noted in my April column, the academic experts are essentially unanimous in seeing some form of guaranteed lifetime income stream (such as an income annuity) as the best retirement vehicle for most people. But we also know that most people will not follow this advice. The academic world is often befuddled by the unwillingness of so many to do what is so clearly in their best interest, calling this unwillingness “the annuity puzzle.” Multiple possible reasons have been proposed, most focusing upon psychology and framing, but the puzzle remains.

That leaves most people needing to take retirement income out of current assets, with most advisors defaulting to the rule of thumb known as “the 4 percent rule” for making such distributions. However, recent research discloses that this rule of thumb is far more hazardous than commonly understood. Wade Pfau, a professor at the National Graduate Institute for Policy Studies in Japan, has demonstrated that the experience of international markets suggests a withdrawal rate far lower than 4 percent, and that a 4 percent real withdrawal rate is based upon “irrational optimism.” Indeed, data from countries such as Spain, Belgium and France suggest that even a 3 percent withdrawal rate is highly problematic. Pfau has also shown that Americans who retired around the turn of the century are often in real danger. Indeed, for 2008 retirees, Pfau estimates a maximum sustainable withdrawal rate of only 1.46 percent.

Engineer and CFP Jim Otar’s new book, Unveiling the Retirement Myth, tries to account for “sequence risk” in distribution planning. This risk occurs when retirement portfolios suffer significant drawdowns early in the distribution period. Otar looks at market history in great detail and ends up recommending surprisingly low but prudent annual retirement withdrawal percentages ­— usually no more than 3 percent. For most retirees, Otar finds that asset allocation is simply not enough to overcome a bad sequence of returns early on. Indeed, since “luck” (most often related to return sequences and inflation) plays such an important role in the success of any retirement plan including regular withdrawals, Otar cautions that “the remedy is not in what you can do with your portfolio, but what you can do with your assets. Insurance products, specifically annuities, become a natural choice.” Shakespeare famously wrote that “the fault…is not in our stars, but in ourselves.” Our failure to save enough and Otar’s analysis shows that, at least with respect to retirement planning, it’s both.

Pfau suggests that retirees would be well advised to consider the market value (and not just price) of a retirement portfolio when determining a withdrawal rate. He has shown that the amount of wealth remaining 10 years into retirement accounts for up to 80 percent of the variation in final outcome measures after 30 years.

Therefore, retirees who are unlucky and retire into a down market and who have not provided adequate guaranteed income will need to try to readjust their spending downward and consider returning to work. In his view, since current dividend yields are low, earnings valuations are near historical highs, and nominal bond yields are low, current retirees should assume lower portfolio returns than normal for the near-to-intermediate term and should lower their withdrawal expectations accordingly to try to avoid plan failure. His recent paper entitled Predicting Sustainable Retirement Withdrawal Rates Using Valuation and Yield Measures gives a solid framework for how to do that.

Of course, past performance is not indicative of future results, so we can hope for better results than the data portend. Yet hope based upon what Pfau sees as “irrational optimism” is anything but a sound strategy.

None of this is good news. But behavioral economics does perhaps help a bit. It is well established that people experience loss much more strongly than gain. Uncertainty hurts the worst of all. Through recent research advancements, retirees who have taken imprudent withdrawals or have suffered significant drawdowns early in retirement can at least get a handle on how precarious their situation is and move ahead with making the necessary adjustments to their lifestyles and changes in their plans. Knowing you’re in trouble doesn’t feel as bad as merely fearing you’re in trouble. There is some small consolation in that.