At retirement, individuals stop working and no longer get employment earnings, and enter a phase of their lives, where they rely on the assets they have accumulated, to supply money for their spending needs for the rest of their lives. Retirement spend-down, or withdrawal rate,[1][2][3][4][5] is the strategy a retiree follows to spend, decumulate or withdraw assets during retirement.
Retirement planning aims to prepare individuals for retirement spend-down, because the different spend-down approaches available to retirees depend on the decisions they make during their working years. Actuaries and financial planners are experts on this topic.
Importance
More than 10,000 Post-World War II baby boomers will reach age 65 in the United States every day between 2014 and 2027.[6] This represents the majority of the more than 78 million Americans born between 1946 and 1964. As of 2014, 74% of these people are expected to be alive in 2030, which highlights that most of them will live for many years beyond retirement.[7] By the year 2000, 1 in every 14 people was age 65 or older. By the year 2050, more than 1 in 6 people are projected to be at least 65 years old.[8] The following statistics emphasize the importance of a well-planned retirement spend-down strategy for these people:
87% of workers do not feel very confident about having enough money to retire comfortably.[9]
80% of retirees do not feel very confident about maintaining financial security throughout their remaining lifetime.[10]
49% of workers over age 55 have less than $50,000 of savings.[11]
25% of workers have not saved at all for retirement.[9]
35% of workers are not currently saving for retirement.[9]
56% of workers have not tried to calculate their income needs in retirement.[9]
Individuals each have their own retirement aspirations, but all retirees face longevity risk – the risk of outliving their assets. This can spell financial disaster. Avoiding this risk is therefore a baseline goal that any successful retirement spend-down strategy addresses. Generally, longevity risk is greatest for low and middle income individuals.
The probabilities of a 65-year-old living to various ages are:[12]
Probability
Male
Female
75%
78
81
50%
85
88
25%
91
93
Longevity risk is largely underestimated. Most retirees do not expect to live beyond age 85, let alone into their 90s. A 2007 study of recently retired individuals asked them to rank the following risks in order of the level of concern they present:[13]
A portion of retirement income often comes from savings, sometimes referred to as a nest egg. Analyzing one's savings involves a number of variables:
how savings are invested (e.g., cash, stocks, bonds, real estate), and how this changes over time
inflation during retirement
how quickly savings are spent – the withdrawal rate
Often, an investor will change some of their investment types as one ages. A common strategy to replace more risky investments with less risky investments as one gets older. A "risky" investment is an investment that has a higher potential return but also a higher potential loss. A "conservative" investment is an investment with a low potential return but a lower potential loss. A number of approaches exist to assist with choosing the correct risk level, for example, target date funds.
A common rule of thumb for withdrawal rate is 4%, based on 20th century American investment returns, and first articulated in Bengen (1994).[14] Bengen later stated the 4% guideline was intended as a "worst case scenario" for retirees in United States, using a hypothetical example of someone who retired in 1968 at a stock market peak before a protracted bear market and high inflation through the 1970s. In that scenario, a 4% withdrawal rate allowed the investor's funds to last 30 years. Historically, Bengen says closer to 7% is an average safe withdrawal rate and at other times withdrawal rates up to 13% have been feasible.[15]
A 4% withdrawal rate is also one conclusion of the Trinity study (1998). This particular rule and approach have been heavily criticized,[citation needed] as have the methods of both sources, with critics arguing that withdrawal rates should vary with investment style (which they do in Bengen) and returns, and that this ignores the risk of emergencies and rising expenses (e.g., medical or long-term care). Others question the suitability of matching relatively fixed expenses with risky investment assets.[citation needed]
New dynamic adjustment methods for retirement withdrawal rates have been developed after Bengen's 4% withdrawal rate was proposed: constant inflation-adjusted spending, Bengen's floor-and-ceiling rule, and Guyton and Klinger's decision rules.[16][17] More complex withdrawal strategies have also been created.[18]
To decide a withdrawal rate, history shows the maximum sustainable inflation-adjusted withdrawal rate over rolling 30-year periods for three hypothetical stock and bond portfolios from 1926 to 2014. Stocks are represented by the S&P 500 Index, bonds by an index of five-year U.S. Treasury bonds. During the best 30-year period withdrawal rates of 10% annually could be used with a 100% success rate. The worst 30-year period had a maximum withdrawal rate of 3.5%. A 4% withdrawal rate survived most 30 year periods. The higher the stock allocation the higher rate of success. A portfolio of 75% stocks is more volatile but had higher maximum withdrawal rates. Starting with a withdrawal rate near 4% and a minimum 50% equity allocation in retirement gave a higher probability of success in historical 30 year periods.[19]
The above withdrawal strategies, sometimes referred to as strategic withdrawal plans or structured withdrawal plans, focus only on spend-down of invested assets and do not typically coordinate with retirement income from other sources, such as Social Security, pensions, and annuities. Under the actuarial approach described below for equating total personal assets with total spending liabilities to develop a sustainable spending budget, the amount to be withdrawn from invested assets each year is equal to the amount to be spent during the year (the spending budget) reduced by income from other sources for the year.[20]
Sources of retirement income
Individuals may receive retirement income from a variety of sources:
Each has unique risk, eligibility, tax, timing, form of payment, and distribution considerations that should be integrated into a retirement spend-down strategy.
Modeling retirement spend-down: traditional approach
Traditional retirement spend-down approaches generally take the form of a gap analysis. Essentially, these tools collect a variety of input variables from an individual and use them to project the likelihood that the individual will meet specified retirement goals. They model the shortfall or surplus between the individual's retirement income and expected spending needs to identify whether the individual has adequate resources to retire at a particular age. Depending on their sophistication, they may be stochastic (often incorporating Monte Carlo simulation) or deterministic.
There are three primary approaches utilized to estimate an individual's spending needs in retirement:
Income replacement ratios: financial experts generally suggest that individuals need at least 70% of their pre-retirement income to maintain their standard of living.[21] This approach is criticized from the standpoint that expenses, such as those related to health care, are not stable over time.
Consumption smoothing: under this approach individuals develop a target expenditure pattern, generally far before retirement, that is intended to remain level throughout their lives. Proponents argue that individuals often spend conservatively earlier in their lives and could increase their overall utility and living standard by smoothing their consumption.[22]
Direct expense modeling: with the help of financial experts, individuals attempt to estimate future expenses directly, using projections of inflation, health care costs, and other variables to provide a framework for the analysis.
Adverse impact of market downturn and lower interest rates
Market volatility can have a significant impact on both a worker's retirement preparedness and a retiree's retirement spend-down strategy. American workers lost an estimated $2 trillion in retirement savings during the 2007–2008 financial crisis.[23] 54% of workers lost confidence in their ability to retire comfortably due to the direct impact of the market turmoil on their retirement savings.[9]
Asset allocation contributed significantly to these issues. Basic investment principles recommend that individuals reduce their equity investment exposure as they approach retirement. Studies show, however, that 43% of 401(k) participants had equity exposure in excess of 70% at the beginning of 2008.[24]
World Pensions Council (WPC)financial economists have argued that durably low interest rates in most G20 countries will have an adverse impact on the underfunding condition of pension funds as "without returns that outstrip inflation, pension investors face the real value of their savings declining rather than ratcheting up over the next few years" [25]
From 1982 until 2011, most Western economies experienced a period of low inflation combined with relatively high returns on investments across all asset classes including government bonds. This brought a certain sense of complacency amongst some pension actuarial consultants and regulators, making it seem reasonable to use optimistic economic assumptions to calculate the present value of future pension liabilities.
The potentially long-lasting collapse in returns on government bonds is taking place against the backdrop of a protracted fall in returns for other core-assets such as blue chipcompanies'stocks, and, more importantly, a silent demographic shock. Factoring in the corresponding longevity risk, pension premiums could be raised significantly while disposable incomes stagnate and employees work longer years before retiring.[25]
Coping with retirement spend-down challenges
Longevity risk becomes more of a concern for individuals when their retirement savings are depleted by asset losses. Following the market downturn of 2008–09, 61% of working baby boomers are concerned about outliving their retirement assets.[26] Traditional spend-down approaches generally recommend three ways they can attempt to address this risk:
Save more (spend less)
Invest more aggressively
Lower their standard of living
Saving more and investing more aggressively are difficult strategies for many individuals to implement due to constraints imposed by current expenses or an aversion to increased risk. Most individuals also are averse to lowering their standard of living. The closer individuals are to retirement, the more drastic these measures must be for them to have a significant impact on the individuals' retirement savings or spend-down strategies.
Postponing retirement
Individuals tend to have significantly more control over their retirement ages than they do over their savings rates, asset returns, or expenses. As a result, postponing retirement can be an attractive option for individuals looking to enhance their retirement preparedness or recover from investment losses. The relative impact that delaying retirement can have on an individual's retirement spend-down is dependent upon specific circumstances, but research has shown that delaying retirement from age 62 to age 66 can increase an average worker's retirement income by 33%.[27]
Postponing retirement minimizes the probability of running out of retirement savings in several ways:
Additional returns are earned on savings that otherwise would be paid out as retirement income
Additional savings are accumulated from a longer wage-earning period
The post-retirement period is shortened
Other sources of retirement income increase in value (Social Security, defined contribution plans, defined benefit pension plans)
Studies show that nearly half of all workers expect to delay their retirement because they have accumulated fewer retirement assets than they had planned.[23] Much of this is attributable to the market downturn of 2008–2009. Various unforeseen circumstances cause nearly half of all workers to retire earlier than they intend.[9] In many cases, these individuals intend to work part-time during retirement. Again, however, statistics show that this is far less common than intentions would suggest.[9]
Modeling retirement spend-down: alternative approach
The appeal of retirement age flexibility is the focal point of an actuarial approach to retirement spend-down that has spawned in response to the surge of baby boomers approaching retirement.
The approach is based on personal asset/liability matching process and present values to determine current year and future year spending budget data points. This self-adjusting actuarial process is very similar to the process employed by pension actuaries to help pension plan sponsors determine current and future years’ annual contribution requirements.[20]
Similarity to individual asset/liability modeling
Most approaches to retirement spend-down can be likened to individual asset/liability modeling. Regardless of the strategy employed, they seek to ensure that individuals' assets available for retirement are sufficient to fund their post-retirement liabilities and expenses. This is elaborated in dedicated portfolio theory.
Retirement is the withdrawal from one's position or occupation or from one's active working life. A person may also semi-retire by reducing work hours or workload.
In the United States, a 401(k) plan is an employer-sponsored, defined-contribution, personal pension (savings) account, as defined in subsection 401(k) of the U.S. Internal Revenue Code. Periodic employee contributions come directly out of their paychecks, and may be matched by the employer. This pre-tax option is what makes 401(k) plans attractive to employees, and many employers offer this option to their (full-time) workers. 401(k) payable is a general ledger account that contains the amount of 401(k) plan pension payments that an employer has an obligation to remit to a pension plan administrator. This account is classified as a payroll liability, since the amount owed should be paid within one year.
A pension is a fund into which amounts are paid regularly during an individual's working career, and from which periodic payments are made to support the person's retirement from work. A pension may be:
A pension fund, also known as a superannuation fund in some countries, is any program, fund, or scheme which provides retirement income.
Personal finance is the financial management that an individual or a family unit performs to budget, save, and spend monetary resources in a controlled manner, taking into account various financial risks and future life events.
An individual retirement account (IRA) in the United States is a form of pension provided by many financial institutions that provides tax advantages for retirement savings. It is a trust that holds investment assets purchased with a taxpayer's earned income for the taxpayer's eventual benefit in old age. An individual retirement account is a type of individual retirement arrangement as described in IRS Publication 590, Individual Retirement Arrangements (IRAs). Other arrangements include individual retirement annuities and employer-established benefit trusts.
Tax advantage refers to the economic bonus which applies to certain accounts or investments that are, by statute, tax-reduced, tax-deferred, or tax-free. Examples of tax-advantaged accounts and investments include retirement plans, education savings accounts, medical savings accounts, and government bonds. Governments establish tax advantages to encourage private individuals to contribute money when it is considered to be in the public interest.
In finance, interest rate immunization is a portfolio management strategy designed to take advantage of the offsetting effects of interest rate risk and reinvestment risk.
A defined contribution (DC) plan is a type of retirement plan in which the employer, employee or both make contributions on a regular basis. Individual accounts are set up for participants and benefits are based on the amounts credited to these accounts plus any investment earnings on the money in the account. In defined contribution plans, future benefits fluctuate on the basis of investment earnings. The most common type of defined contribution plan is a savings and thrift plan. Under this type of plan, the employee contributes a predetermined portion of his or her earnings to an individual account, all or part of which is matched by the employer.
Dissaving is negative saving. If spending is greater than disposable income, dissaving is taking place. This spending is financed by already accumulated savings, such as money in a savings account, or it can be borrowed. Household dissaving therefore corresponds to an absolute decrease in their financial investments.
Liability-driven investment policies and asset management decisions are those largely determined by the sum of current and future liabilities attached to the investor, be it a household or an institution. As it purports to associate constantly both sides of the balance sheet in the investment process, it has been called a "holistic" investment methodology.
A life annuity is an annuity, or series of payments at fixed intervals, paid while the purchaser is alive. The majority of life annuities are insurance products sold or issued by life insurance companies however substantial case law indicates that annuity products are not necessarily insurance products.
Retirement planning, in a financial context, refers to the allocation of savings or revenue for retirement. The goal of retirement planning is to achieve financial independence.
William P. Bengen is a retired financial adviser who first articulated the 4% withdrawal rate as a rule of thumb for withdrawal rates from retirement savings; it is eponymously known as the "Bengen rule". The rule was later further popularized by the Trinity study (1998), based on the same data and similar analysis. Bengen later called this rate the SAFEMAX rate, for "the maximum 'safe' historical withdrawal rate", and later revised it to 4.5% if tax-free and 4.1% for taxable. In low-inflation economic environments the rate may even be higher.
Asset location (AL) is a term used in personal finance to refer to how investors distribute their investments across savings vehicles including taxable accounts, tax-exempt accounts, tax-deferred accounts, trust accounts, variable life insurance policies, foundations, and onshore vs. offshore accounts.
In finance, investment advising, and retirement planning, the Trinity study is an informal name used to refer to an influential 1998 paper by three professors of finance at Trinity University. It is one of a category of studies that attempt to determine "safe withdrawal rates" from retirement portfolios that contain stocks and thus grow irregularly over time.
Financial independence is a state where an individual or household has accumulated sufficient financial resources to cover its living expenses without having to depend on active employment or work to earn money in order to maintain its current lifestyle. These financial resources can be in the form of investment or personal use assets, passive income, income generated from side jobs, inheritance, pension and retirement income sources, and varied other sources.
Pensions in Canada can be public, private, and collective, or come from individual savings.
Dedicated portfolio theory, in finance, deals with the characteristics and features of a portfolio built to generate a predictable stream of future cash inflows. This is achieved by purchasing bonds and/or other fixed income securities that can and usually are held to maturity to generate this predictable stream from the coupon interest and/or the repayment of the face value of each bond when it matures. The goal is for the stream of cash inflows to exactly match the timing of a predictable stream of cash outflows due to future liabilities. For this reason it is sometimes called cash matching, or liability-driven investing. Determining the least expensive collection of bonds in the right quantities with the right maturities to match the cash flows is an analytical challenge that requires some degree of mathematical sophistication. College level textbooks typically cover the idea of “dedicated portfolios” or “dedicated bond portfolios” in their chapters devoted to the uses of fixed income securities.
The FIREmovement is a lifestyle/investment plan with the goal of gaining financial independence and retiring early through savings. The model became particularly popular among millennials in the 2010s, gaining traction through online communities via information shared in blogs, podcasts, and online discussion forums.
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