Some recent articles in InvestmentNews and SmartMoney, among other publications, have questioned the viability of the “4% rule,” which suggests that a long-term maximum withdrawal of 4% from a client's savings each year in retirement is a prudent rule of thumb.
Introduced by noted financial planner Bill Bengen almost 20 years ago, this percentage has long been considered safe.
More recent recommendations range anywhere from 7% (The Retirement Management Journal) to 1.8% (Journal of Financial Planning) — quite a big difference.
Although 4% of savings may be a good starting point, the reality is that any annual savings withdrawal depends on many factors, both “external,” e.g., the state of the market, interest rates and inflation, and “internal,” e.g., your client's lifestyle, spending habits and tax status. In other words, determining a safe amount to extract from savings each year should be a very tailored and dynamic process.
LIFE ISN'T STATIC
The notion of a fixed withdrawal percentage throughout retirement — though neat and convenient — isn't at all practical. Typically, the formula for withdrawing a set amount of assets each year is based on fixed assumptions such as how long your client's retirement will last, health status and expected investment return.
These straight-line calculations aren't always realistic and don't account for all the variables that affect a person's finances in retirement. Life isn't static — each year's expenses and priorities won't be the same.
An article appearing in the April issue of the Journal of Financial Planning, “Tax-Efficient Retirement Withdrawal Planning Using a Comprehensive Tax Model,” discussed another aspect of retirement withdrawals: strategically drawing down funds in a tax-efficient manner.
The article provided further evidence that withdrawal calculations in retirement can be complicated. Careful thought must be given to “what assets, from which accounts, and when,” in addition to how much to draw down.
From a tax efficiency perspective (highest ending balance, not tax minimization), where to pull the assets from first depends on numerous factors that differ from client to client: overall wealth, how much Social Security he or she receives, amount of itemized deductions, where the assets are located, etc.
Again, there are different approaches to retirement withdrawals and unique circumstances surrounding each client. A “set it and forget it” mentality just doesn't work.
When helping their clients plan for retirement, financial advisers should consider a no-nonsense, analytical approach.
With your guidance, clients should develop a cash flow projection for their retirement years to assess what they anticipate their lifestyle will be and whether these plans match up well with their projected assets. Overall, there are many factors to bake into the plan.
Running Monte Carlo simulations within the client's cash flow projections to help estimate the probability of financial well-being based on a set of variables is critical. These should include tax rates, market fluctuations, investment management fees, the client's risk tolerance, asset allocation, projected life span, health care costs, etc., as well as all sources of income (including pensions, if applicable).
This cash flow analysis can help your clients determine how likely they are to outlive their assets — which is great news in terms of their longevity but kryptonite as far as retirement planning goes. Withdrawing too much too early in retirement ultimately could leave them with a goose egg rather than a nest egg — another reason why a fixed withdrawal percentage doesn't work.
Running out of money isn't an option.
Realistically assessing how much your client is spending now and plans to spend in retirement is key to a successful plan. It is also a good idea for you to review the plan with your client a year or two after retirement and readdress each internal and external category.
An adviser should update the plan at least every two years during a client's retirement. As a general rule, I counsel my clients to save as much as they can while they are working and to curb excessive spending.
If your clients are spending $150,000 a year but save only $17,000 a year in their 401(k), they are relying on one heck of return on that $17,000 to allow them to continue spending $150,000 in retirement.NEVER TOO EARLY
Also, when your clients are 60 isn't a good time for you to start talking to them about retirement planning. It is never too early to devise a cash flow projection and a savings withdrawal plan that makes sense.
Although it is beneficial to have a benchmark with which to start planning, the reality is that any annual withdrawal is going to be different for each person, depending on his or her particular situation and objectives, as well as market conditions, and likely will vary over time.
Our role as advisers is to outline our clients' options, perform analyses and determine what course of action is likely to be best — and to update all that on a regular basis.
Abigail Rosen is a financial adviser with Brinton Eaton Wealth Advisors.
