The Value of Budgetary Flexibility

Here’s a question for you:

Which of the following has the greatest impact on your standard of living in retirement?
A. Employing a wise asset allocation.
B. Having a wise investment advisor.
C. Having a wise tax advisor.
D. Having flexibility in your budget.

If you said, “E. All of the above,” shame on you. You’re not being responsive to the question. I said greatest impact. Of course they’re all important, but you have to pick one.

My educated guess is that the answer is D. Flexibility in your budget. Someday I hope to do a study confirming the relative importance of those factors, but for now it remains an educated guess. Consider the following tale.

Rita Rigid and Zelda Zen are twin sisters. Both are about to retire with $2,000,000 of assets (in a traditional IRA). Both use the same financial advisor. Both want a standard of living that’s as luxurious as possible, consistent with prudence—neither wants to run out of money. The sisters are alike in every way, except for one key difference. While Rita Rigid wants to live on a budget that doesn’t fluctuate from year to year, except for increasing with inflation, Zelda Zen believes she can stand some ups and downs in her annual spending.

Here is the advice they get after consulting with their financial advisor. Rita is advised to plan on spending $70,000 per year, increased annually by inflation, plus necessary income taxes. That’s 3.5% of her starting assets. Zelda is advised to spend $110,000 plus necessary income taxes. Every year, Zelda's budget is to be 5.5% of her remaining assets, but no less than $60,000 and no more than $130,000 (with those brackets increased for inflation each year). Zelda is told to expect her future budget to be both unknown and erratic, to fluctuate significantly between the $60,000 and $130,000 brackets. But the central tendency of her expected annual budget will be about $96,000 (plus taxes).

Depending on which number you look at (Zelda’s $110,000 starting budget or her $96,000 expected budget), Zelda’s standard of living is either 57% or 37% greater than Rita’s. That entire difference arises from her willingness to be flexible in her annual spending. Of course Zelda might experience an unlucky investment environment in the future, and her spending will be less than Rita’s; but she has expressed a willingness to accept that. And it is precisely that willingness that enables her to prudently spend more than Rita.

These figures come from an article I wrote that will appear in a professional journal later this year (CCH Journal of Retirement Planning). They were not just pulled out of a hat, but were based on a rigorous study of how Rita’s and Zelda’s investments might be expected to behave in uncertain markets. Rita prudently deals with that uncertainty by reducing her spending to a conservative amount so that she has a low likelihood of running out of money. Her desire for budgetary certainty demands that conservatism. Zelda prudently deals with uncertainty by anticipating that her spending will fluctuate—within the limits she has set—as the unknowable future unfolds.

Either approach is legitimate. But it’s eye-opening to see that Zelda’s budgetary flexibility is worth a whopping 37%-57% of her standard of living. It’s positively Zen-like. The less you must spend, the more you can spend.

3% is Depressingly Small

In a comment to April 27’s post, David points out how depressingly small 3% is. It simply ain’t that much. If that’s all your savings can generate, it doesn’t sound like you’re in for a luxurious retirement. That’s the main reason I don’t care for the 4% Plan (or 3% Plan or 3.5% Plan). It’s too darn miserly.

First, let me recap. When you retire, you need a plan for determining how much of your assets you’re going to spend each year. The goal is to spend as luxuriously as possible, without imprudently risking running out of money before your ticket is punched. That’s your “Retirement Spending Plan.”

One such plan, often written about in the financial press, is the 4% Plan. Add up your assets on the day you retire, multiply by 4%, and that’s your allowance for the year. Then the following year, increase the dollar amount of your allowance by inflation. And so on, and so on. As pointed out in April 27's post, 4% is the “right” percentage for assets in a tax-favored retirement account. But then if it’s a traditional IRA or other pre-tax account, income taxes will shave your after-tax spending (the part you can actually enjoy) down to 3%. (Not so with Roth accounts.) And maybe the “right” percentage for taxable accounts is 3.5% rather than 4%. Either way, these numbers—and therefore your allowance—simply aren’t that big. They do depress one, don’t they.

What are you buying by limiting your first year withdrawal to a miserly 4%? Two things. One is the security that you will not likely run out of spending money during your lifetime. That aspect of retirement security is, in my view, well worth the price.

But you’re buying something else for which you are paying dearly; too dearly in my view. That is the ability not to have to ratchet down your lifestyle in years when the financial markets are unkind. (And in the course of a typical retirement, there will be such years.) The 4% Plan allows you, to a degree, to ignore short-term losses and simply keep spending according to plan. But if you have some fat in your lifestyle—expenses you can cut back if need be—you can use that flexibility to buy a more luxurious lifestyle. You just have to be willing to have your annual allowance float with the ups and downs of the financial markets, and therefore your retirement assets. Then you can increase that 4% to something closer to 6%. That’s a 50% pay increase! Moreover, that 6% can gradually get bigger and bigger as your life expectancy decreases. Life is grand!

But you can’t have it both ways. If you increase your payout percentage you have to give up on the certainty of a fixed allowance. You have to be willing to cut back on your discretionary expenses when Mr. Dow Jones tells you to. And 2008 taught us that Mr. Dow Jones can be very cruel indeed. Cutting back is easier said than done.

More on the 6% Plan in future posts.

The 4% Plan vs. 3% Plan vs. 3.5% Plan

A number of prior posts have mentioned the 4% Plan. That’s one of a few schemes for rationally spending down your assets once you have retired and switched from saving to consuming. But whether 4% is the “right” number will depend on many factors. One of them is the type of savings buckets in which your assets dwell.

First, what is the 4% Plan? Under the 4% Plan, you add up your investment assets on the day after your retirement party, multiply by 4%, and that’s your budget for the year. Then every year you increase the dollar amount by the prior year’s inflation, and you've got yourself a new budget. I’m not crazy about the 4% Plan, but at least it’s a plan, and it's simple enough.

Of course, nothing’s simple. Because taxes matter, and one of the important variables we have glossed over is this: In which of the three main types of savings buckets do your assets sit? Are they in a pre-tax retirement account like a traditional Individual Retirement Account? Or a newfangled Roth account? Or a taxable investment account? (Chances are they are in some combination of the three, but for the sake of discussion, let’s pretend they are all in one or another.)

Here’s why the answer matters. The number 4% was arrived at by financial professionals to result in a distribution amount that is as big as possible, while still maintaining a high likelihood that you will not run out of assets during your lifetime (or the joint lifetimes of you and your spouse). The professionals who arrived at that figure assumed your assets were invested in a traditional tax-favored retirement account, like a 401(k) account or IRA.

So let’s follow that through. Let’s say on your retirement day you have $1,000,000 saved in a traditional IRA. You figure 4% is $40,000, so that (plus future inflation) is your budget. But what about taxes? You haven’t paid taxes yet! If, for example, your overall marginal income rate is 25%, then $10,000 goes to pay your taxes, and you are left to live on $30,000. You can’t eat taxes. 4%, it turns out, is the rate at which you can deplete the account; not necessarily what you get to spend. That looks more like 3%.

Now let’s change the facts. Say you have the same $1,000,000, but it’s not in a traditional IRA; instead it’s in a Roth IRA. Your sustainable distribution is the same 4%, or $40,000, but now all income taxes have already been paid, so you get to spend the whole $40,000 on yourself. With a Roth savings bucket, 4% is truly 4%.

One more scenario. Assume the $1,000,000 is in a taxable investment account. You’ve already paid income taxes on that $1,000,000 so you get to spend your entire distribution on yourself. But it should be a bit less than 4% in this case. I’m not sure how much less, but I think probably around 3.5%, or $35,000 in the example. Why do you have to shave the 4% down? Because the professionals who came up with the 4% number assumed you were investing your $1,000,000 in some sort of tax-exempt environment, like an IRA, in which you would not have to pay income tax on your investment earnings (although you would have to pay income tax on your distributions, as we saw two paragraphs above). So if your investment returns (not your distributions) have to be shaved by income taxes, it stands to reason that your long run sustainable distribution percentage will have to be shaved as well. Perhaps down to 3.5%. For a description of the factors that go into this particular haircut, see February 3’s post.

As I said, in reality your retirement savings will likely be housed in all three types of savings buckets, so your own spending percentage will be some blend of the three numbers.

Oh, by the way, your own percentage will also vary depending upon your asset allocation plan. But that discussion is for another day.

Longevity Risk and Market Risk

Yesterday’s post made a point about saving up a sufficient amount to meet your retirement needs. And the point was this: that in a world of many uncertainties, the uncertainty of how the financial markets will treat all of us exceeds the uncertainty of how long your particular lifespan will be.

And today’s point is this: So what! You have to live with both uncertainties. You don’t get to choose one or the other.

There is a silver lining of sorts: The financial risk of an extra-long life is presumably independent of the risk of an extra-crummy market environment. (Then again, maybe they’re not independent. Maybe suffering through a bad market environment makes you want to die. I know it’s making me pretty sick.)

Assuming they are unrelated, your true financial risk is that you will suffer through both bad situations simultaneously. This point was made by Messrs. Blanchett and Blanchett in the article discussed in January 14’s post. (I shouldn’t refer to long life as bad. Long life is generally a good thing. It’s just the financial aspect of it that’s bad.)

How does this affect Goldilocks from yesterday’s post? If she saves enough to meet her projected needs for an average life expectancy in an average market environment, she actually has about a 75% chance of not running out of money while still alive. That’s not too bad. (Caveat: These percentages incorrectly use the historical performance of the financial markets to measure the likelihood of future success. It's wrong to do that, but I do it anyway. Like eating potato chips.)

Unfortunately, Goldilocks gains only diminishing returns in her level of certainty as she increases her savings. For example, building up her retirement savings by an additional 30% gets her from a 75% up to about an 88% chance of not outliving her life retirement savings.

Don’t you just hate uncertainty?

Longevity Risk vs. Market Risk

Words matter. The words that are used to describe something color—even distort—how we think about that thing, and can easily mislead us.

I read an article about a retired person’s risk of running out of money before she runs out of pulse. Financial professionals call that “longevity risk.” What I don’t like about those words is the connotation that running out of savings during retirement is somehow your fault. You chose to live too long, you selfish Baby Boomer. It’s not something that happened to you, it’s something you brought on your own damn self. Or maybe it’s your parents’ fault for bequeathing you such sturdy genes. Where’s George Carlin when we need him?

But the risk of living too long is minor compared to the risk of living through a crummy market environment. And the market environment is not something you brought on yourself, like healthy living; it’s something that’s thrust upon you (and all your classmates) by the accident of when you reached retirement age. 1926? A great year to retire. 1969? Terrible.

In what way is market risk greater than longevity risk? Here’s a little fairy tale.

Goldilocks has turned 65 and is about to retire. She needs for her savings to generate $50,000 per year, plus inflation. She has saved up $649,271, which, it turns out, is just right if she lives an average female life expectancy (which at age 65 is 20 years) and retires in an average market environment.

But wait! Goldilocks is smarter than that. Despite the bear thing, which happened when she was very young, so it doesn’t count. She realizes she might live longer than average. So to be cautious, she magically increases her savings to $849,006. (This is a fairy tale, so she can do that.) That’s the amount she’ll need if she lives to age 98, which only 5% of 65-year-old women are expected to do. (These projections came from a table of life expectancy statistics on the Social Security website.) So by increasing her savings by $200,000 she is 95% sure not to get stung by longevity risk.

But wait! What about market risk? Goldilocks prudently plans to invest her savings 50% in stocks and 50% in bonds. What if the upcoming future for stock returns, bond returns and inflation is worse than the historical average? It turns out that market risk is much scarier than longevity risk. Goldilocks studies 83 20-year periods from 1926 through 2008 and sees that during 10 of them—more than 15% of the time—her extra $200,000 of extra savings would have been an insufficient cushion; she would have run out of bucks before the end of her average 20 year life expectancy.

Goldilocks's extra $200,000 of savings bought her 95% certainty of avoiding longevity risk, but only 85% certainty of dodging market risk.

It turns out that market risk—the one that’s shared by you and everyone who got the gold watch in the same year—is bigger than longevity risk—the one that’s unique to you. And 2008 turned out to herald a very inauspicious start for the current crop of graduating retirees. Can you just picture a whole cohort of 65-year olds, eyes glazed over, all wandering around Miami Beach at 4:30, all looking for the same early bird special?

The Grandchild’s Inherited Retirement Account

Yesterday’s post discussed the likelihood of leaving your children an inheritance—in particular an inherited retirement account of some kind.

As long as inheritance is likely, you might consider skipping your children and leaving some or all of your unspent retirement account to your grandchildren, especially if your kids are doing well enough on their own.

There’s three reasons this might be a particularly good idea. First, your grandchildren may still be facing their high-cost years and can better use the money. You know: college education, their first house, the cost of raising their own kids. Second, being younger, they may not yet have reached their peak earning years, and might therefore be in a lower income tax bracket—a consideration in the case of a traditional IRA which throws off lots of taxable income. Third, their younger age means they are allowed a longer period over which to stretch out distributions.

Here’s an example. Let’s say the facts are almost the same as in yesterday’s post: Three brothers each with a $100,000 account—a taxable investment account, a traditional IRA and a Roth IRA. But their named beneficiaries, instead of being their children, are their granddaughters (Patty, Maxine, and Laverne) . And they are age 25, with a life expectancy-based distribution period of 58.2 years. Here is the inflation-adjusted annual after-tax distribution each of the girls projects:

Patty (taxable account): $3,821 per year
Maxine (traditional IRA): $3,727 per year
Laverne (Roth IRA): $5,325 per year

But if instead the girls take only required minimum distributions, and reinvest the proceeds, here is what they project they can accumulate over a 59-year distribution period:

Patty (taxable account): $3,827,572
Maxine (traditional IRA): $4,671,516
Laverne (Roth IRA): $6,673,594

Myth has it that Einstein thought compound interest to be one of the miracles of the universe. And that was before the advent of IRA’s.

The Unintentional Inherited Retirement Account

Chances are pretty good your kids are going to inherit a retirement account from you. “No way!” you say, “I’m spending that on me!” “Way!” I reply.

As previously pointed out in prior posts, your inability to predict the future—how long you will live, what your investments will earn, what financial emergencies will befall you—will lead you to avoid draining your savings buckets dry. Like it or not, inheritance is a by-product of uncertainty.

And if you engage in clever spigot planning in an effort to boost your own retirement spending—as I am sure you will—chances are pretty good the last bucket standing will be a tax-favored retirement account of some kind—either a traditional retirement account or a Roth retirement account, or perhaps some of both.

To put an even finer point on this prediction, chances are pretty good your retirement account (or accounts) will be IRA’s rather than 401(k) or other employer plan accounts. Why? Because somewhere along the way, after you have left employment, you will have rolled over your employer plan accounts into IRA’s, due to the greater control you can exercise over them compared to the potential restrictions of employer plans (as pointed out in February 18’s post).

So your kids are probably in for an inherited IRA despite your best efforts to die broke. What’s it worth to them?

Here’s a little thought experiment. Picture three different brothers, Huey, Dewey and Louie. Each dies with a $100,000 account left to his sole 45-year old daughter, Patty, Maxine and Laverne, respectively. The only difference is that Patty’s inheritance is in an ordinary taxable investment account; Maxine’s is in a traditional IRA, and Laverne’s is in a Roth IRA. These are all different animals, so they are worth something different to the girls. How can we compare their values? Here’s one way. Since the IRS assigns a 45-year old beneficiary a 39-year distribution period, as described in yesterday’s post, we can ask how much of an after-tax inflation-adjusted stream of payments might the different savings buckets be projected to provide the girls over a 39-year period. Using reasonable assumptions, here’s what the girls project:
Patty (taxable account): $4,582 per year
Maxine (traditional IRA): $4,154 per year
Laverne (Roth IRA): $5,934 per year

The results are not terribly surprising. Laverne’s Roth IRA gives her the largest payout (by a wide margin), since she benefits from both a tax-exempt savings bucket and tax-free distributions. Patty comes in second with her taxable investment account; she has to pay tax on her investment earnings, but not on any distributions from the bucket. And Maxine comes in third with her traditional IRA; she benefits from a tax-exempt savings bucket, but the tax she has to pay on distributions outweighs that benefit.

But now let’s look at it another way. What if the girls have other sources of spending, and instead choose to let the inherited money continue to be reinvested? In other words, they’re savers rather than spenders. Maxine and Laverne take IRA distributions only in the minimum amount required by law, and then reinvest the after-tax amount remaining in a taxable investment account. By the end of 39 years, the IRA’s will have been completely distributed into taxable investment accounts just like Patty’s. Then the amount of after-tax dollars the girls project they can accumulate over 39 years will be as follows:
Patty (taxable account): $1,151,334
Maxine (traditional IRA): $1,156,783
Laverne (Roth IRA): $1,652,547

In a surprise reversal, over 39 years Maxine’s $100,000 IRA turns into a taxable account worth (a bit) more than Patty’s $100,000 taxable account. The benefit of the traditional IRA’s tax-exemption, combined with the slow stretching out of distributions, ends up overcoming the detriment of having to pay income tax on the distributions. It’s a miracle!

Either way, your kids’ unintentional inheritance can give them a leg up on their own retirement planning. Rest in peace.

Spigot Planning

If you’re retired, chances are you should be engaged in spigot planning. Say, what!? What is spigot planning?

Chances are you have built up retirement savings in different types of savings buckets. Perhaps you have assets housed in ordinary taxable accounts, in traditional (pre-tax) tax-favored retirement accounts, and in Roth retirement accounts. Spigot planning is the art of determining which buckets to tap to meet your annual spending goal, i.e., which spigot to turn on or off. Through clever spigot planning, you can possibly increase your long-term standard of living.

Here’s one way to approach the task. Let me set the stage. You’re retired. Say you’ve got three savings buckets: a taxable investment account, a traditional IRA, and a Roth IRA. You’ve gone through the process described in Saturday’s post, and you’ve adopted a long-term spending plan of some kind. Let’s say your plan calls for you to spend 6% of your assets this year. Start by pretending you will tap each of your buckets in proportion to their value. Then look at alternatives to see if one of them improves your long-term lot. Should you delay taking Roth distributions, and spend more of your taxable assets? Or vice versa?

Of course there are many factors to consider. And one of the most important is the tax consequences. In general, it is beneficial to delay distributions from Roth and traditional tax-favored retirement accounts for as long as the law (and your resources) allow. But going too far down that road might bunch up your taxable income in later years and put some of those distributions into a too-high tax bracket. It’s certainly not easy weighing that long-term cost against the long-term benefit of tax deferral.

Here’s a way you might be able to get the best of both worlds. Let’s say you plan to open up the taxable spigot full force, and take all of your spending this year from your taxable account. That’s good, in that it maximizes the tax deferral benefit of your two tax-favored retirement accounts. But it’s bad, in that it will put you in an extra-low tax bracket this year, at the cost of putting you in an extra-high bracket in later years. What to do, what to do? Eureka! I’ve got it! Use some of this year’s low tax bracket to convert some of your traditional IRA to a Roth IRA—just enough to get you to the top of your extra-low tax bracket. Then you can tap some of that newly bulked-up Roth IRA in a later year—tax-free—to avoid kicking yourself into a higher bracket. Voila! You retain (actually improve) the benefit of tax deferral and avoid creating a future high tax bracket.

When playing with spigot planning, be sure not to make the mistake of spending too much. After all, one of the primary goals of your spending plan is to equalize spending by the Present You and the Future You; more accurately, to equalize after-tax spending. So when you turn down the traditional IRA spigot, and yurn up the taxable account spigot, you’re building in a bigger tax bite into future years’ spending, which needs to be taken into account.

And one last thing:
Happy 200th birthday, Charles Darwin!

Overview of the Retirement Spending Process

Let’s say you’re just about to retire. They’ve thrown you the party, given you the watch, and you’re out the door. You’ve got, say, $1,000,000 saved up. Now what?

(If you’re still in your working years, please don’t tune out. You need to have an idea of what the process will be once you get to retirement. That will then allow you to set a savings target for yourself.)

Now you’ve got to determine—and meet—your standard of living out of your accumulated savings. You’ve got to give yourself an allowance. You’re passed the planning stage; you can no longer determine how much to save out of your salary, because you’ve cut that lifeline. Your only degree of freedom is to bow to reality, and determine how much of a lifestyle to treat yourself to based solely on your available resources. You’re like a teenager who has to get by on the allowance Mom and Dad give you, but you’re also Mom and Dad determining what that allowance is. How do you determine that allowance?

Here’s an overview of the seven main steps in the process of determining your allowance.
Step One. Think about, and make a rough guess at, your personal poverty level, as discussed in January 17’s post. It will help to have a rough sense of this as you go through the remaining steps.
Step Two. Adopt a spending plan, i.e., the methodology you will go through every year to convert your wealth into an annual allowance. For example, in January 13’s post I described one I don’t particularly care for. I will describe others in future posts.
Step Three. Adopt an investment plan, i.e., a suitable allocation of your retirement assets among major asset classes (you know, stocks, bonds, cash). Your investment plan may very well involve a projected change in asset allocation as your projected days on earth shrinks over time. Lots more on this subject in future posts.
Step Four. Adopt appropriate assumptions for all those unknowns. You know, investment returns, inflation, your life expectancy, and the like.
Step Five. Now run those assumptions through your spending plan and investment plan, and out pops your allowance!
Step Six. Now figure out how to get by on your allowance.
Step Seven. Every year, repeat Steps Four, Five and Six.

That’s just an overview. There’s a lot of thought and decision-making that has to go into these steps. In fact, I get tired just thinking about it. I gotta go lie down. More to come in future posts. Lots more.

A Tale of Two Multipliers

In a comment to Wednesday’s post, Anonymous made a very good point. He or she said that it’s hard to adjust your standard of living. Indeed it is. Very hard. Which is what people like about a spending plan that will very likely not require them to have to do so.

Which is why it is a good idea to have a sense of where your personal poverty level lies (as recommended in yesterday’s post). Because it’s your personal poverty level that pretty much defines the spending you can’t realistically drop below. Think of it as the level at which you join the Nation of Whiners. Above that level, and you could adjust, as unpleasant as that might be. So when you’re working, and trying to determine a retirement savings target, you should actually have two targets in mind. One is based on the Present You’s current spending level, and one is based on your rough estimate of your personal poverty level. You can afford to use a realistic approach toward saving up the first target. But you should be very cautious—even pessimistic—about saving up the second target.

Here’s an example. Remember Ernie from Friday’s post. He had figured that he needed his future retirement savings to provide him with an income of $47,950. Adding projected Social Security would give him a retirement income of $65,950, which is comparable to his current lifestyle (which you may recall was $86,350, before adjustments). To translate that $47,950 into a savings target, he multiplied it by a reasonable multiplier, one that is likely to give him a sufficient war chest; he chose 17. His tentative target was $815,150 (= 2517 x $47,950).

But Ernie really needs to take a second step. He can afford to be reasonable about saving for his current standard of living, but he has to be unreasonably conservative about saving for his personal poverty level. He simply couldn’t stand entering the Nation of Whiners, and he’s willing to take any reasonable steps to avoid going there. So Ernie searches his soul. He asks himself how low his spending can drop below $86,350 without being too painful. After some thought, Ernie figures he could adjust his spending by $10,000, down to $76,350. That would mean, after Social Security and other adjustments, his retirement savings would have to provide him with $37,950 (= $47,950 - $10,000) to support his bottom line lifestyle. So he has to be unreasonably cautious about saving up that amount.

How do your translate that caution into a savings target? By using an unrealistically conservative multiplier; 25 instead of 17. So his alternative target is $948,750 (= $37,950 x 25). He has to save up the greater of the two target amounts, $815,150 or $948,750. Bummer.

It’s worthwhile to remember what these two different multipliers represent. The cavalier multiplier (17) gets you to a retirement level that is likely to be similar to your current lifestyle, but which may require the Future You to be flexible about making those difficult spending adjustment if things don’t go as expected. The conservative multiplier (25) gets you to a retirement level that is damn likely to never drop below your personal poverty level.

There are a lot of implied decisions behind these two multipliers, and your multipliers may well be different. But that’s a subject for another day.

What Else Is Wrong with 4%?

In yesterday’s post I opined as to what I fundamentally disliked about the 4% Plan for determining your retirement allowance. Now here’s another thing. Four percent may well be the wrong number.

First, a recap. The 4% Plan is a spending plan you might adopt as you embark on your retirement. You spend 4% of your retirement assets, and then increase that annually with cost of living adjustments. The fundamental flaw in this plan is that for many people it gives up too much of an affordable lifestyle in exchange for more certainty as to your allowance from year to year.

But there’s another problem. It appears that 4% is too small a percentage! In a lapidary article appearing in the Journal of Financial Planning, David Blanchett and Brian Blanchett point out a flaw in the literature that has been hiding in plain sight. Perhaps your initial spending percentage should be 5%. It very much depends on your age and your tolerance for uncertainty.

Their argument goes something like this. The financial planners who zeroed in on 4% basically did two separate analyses to get there. First, they analyzed how long a retirement fund ought to last. To be conservative, they chose a long period, e.g., one that no more than 15% of 65 year old couples would survive (30 years). Then they analyzed, for a given investment strategy (60% equities, 40% bonds), what withdrawal rate (4%) would result in a high probability (95%-96%) of lasting the entire period. But the flaw in that reasoning, as pointed out by the authors, is that for the 4% withdrawal rate to fail during the couple’s lifetimes, two unlikely events would have to occur simultaneously: a really long life and a really bad investment period.

So the authors refigured the probability of both events occurring, and concluded that a 4% withdrawal rate does not carry a 4%-5% risk of failure, but rather a 0.7% risk of failure, i.e., running out of money before running out of heartbeat. To ratchet up to a 4%-5% risk of failure, the initial withdrawal rate should be 5%, a 25% increase in spending from your retirement assets. That’s a pretty substantial leap in lifestyle: Outback Steaks instead of McDonalds; the Caribbean instead of Rockaway Beach; whatever.

Of course 99% confidence is better than 95% confidence. But at what price? Is the incremental certainty worth the cost? Only you can make that judgment. But the important thing is that the underlying trade-offs not be hidden from you.

So maybe the 4% Plan should be the 5% Plan. As I said in yesterday’s post, I don’t care for the 4% Plan. And for the same reasons I don’t care for the 5% Plan. I think many people are better off giving up the quasi-certainty of either approach and getting a (likely, but variable) higher standard of living in exchange.

What do you think? If you had $1 million, would you rather have a mostly unvarying $50,000 standard of living, or a varying $60,000 standard of living?

What’s Wrong with 4%?

When the Personal Financial Planning column of your newspaper’s business section does an article about spending your assets in retirement, it will invariably mention the “4% Plan.” I don’t particularly care for the 4% Plan. Here’s why.

First, what is it? The 4% Plan is one plan for spending your accumulated assets in retirement. When you are done working and about to embark on your retirement, you add up all your retirement assets—your IRA’s, 401(k) accounts, savings accounts and the like—and multiply the total by 4%. That’s your allowance for the next twelve months. Then, after a year has passed, you increase your allowance by the prior twelve months' rate of inflation, and that becomes your next year’s allowance. And so on until both you and your spouse have passed on.

The 4% Plan has a lot to be said for it. It’s simple. It gives you certainty as to your standard of living from one year to the next. If you invest your assets wisely, you have a high probability that your assets will not be depleted before you pass on. And it's a plan. All good.

But it has a built-in flaw. Because it’s designed to carry a high probability that you will not outlast your assets, that necessarily means there’s a high probability that your retirement assets will build up and up and up. And then as you move into your seventies, eighties, and nineties, you likely will have more than enough to afford a meaningful increase in your allowance. Your nineties are a hell of a time for a raise. Where was that raise in your sixties when you could have put it to better use?

The flaw in the 4% Plan is that it fails to adjust to the reality of your changing assets. When it comes to your allowance, there’s a trade-off between certainty and size. And size matters. It essentially defines your standard of living. If you can accept fluctuations in your annual spending, your initial allowance can prudently be greater than 4%. Maybe 6% (but that’s a subject for another post). The more flexibility you have to turn your back on a portion of your spending if circumstances warrant, the greater the amount of spending you can prudently allow yourself. Another way to put that is: the less you must spend, the more you may spend. It’s Zen-like, isn’t it.