Since 1995, the approach to retirement income planning has revolved around determining a sustainable withdrawal rate on the retirement portfolio and then working backwards to figure out how much the retiree needs to save. Today we explore a more sustainable and predictable alternative known as the "Safe Savings Rate", as researched by Dr. Wade Pfau, Professor of Retirement Income at the American College, CFA, PhD in Economics from Princeton.
The traditional approach to planning retirement income looks like this:
Step 1: After accounting for all of the sources of retirement income a client has access to – including Social Security, Defined Benefit Plans, etc., - estimate how much in expenses a retiree will be responsible for. Figure out how much of the client's current income must be replaced in order to cover their left over expenses. This figure is known as the “Replacement Rate” of the pre-retiree’s salary.
Step 2: Decide on a withdrawal rate that can be used to fill the income needed to be replaced based on what has worked historically and what you feel comfortable with.
Step 3: Determine the wealth accumulation that much be achieved by the client by the time of retirement.
Step 4: Figure out how much a client needs to save in order to reach that accumulation goal.
Perhaps a better way to plan for retirement income looks like:
Step 1: This step is the same as above.
Step 2: Determine a savings rate that can sufficiently fund a client’s desired income expenditures based on historical data and what you feel comfortable with.
This proposition comes from a study done by Wade Pfau and published in the Journal of Financial Planning in 2010 which recommended using a “Safe Savings Rate” rather than a “safe withdrawal rate”.
The History of Safe Withdrawal Rates
In 1995, Dr. William Bengen published in the Journal of Financial Planning the first research on sustainable withdrawal rates. Using 65 years worth of data between 1926 and 1991, Bengen concluded that even in the worst 30 year period for portfolio decumulation, someone could take 4% of withdrawals from their portfolio every year, adjusted for inflation, and never run out of money. This is known as “The 4% Rule”.
Ever since, economists and actuaries have strived find ways to safely increase the 4% withdrawal rate.
The Problems with using a Safe Withdrawal Rate Strategy
Accumulation and Decumulation Cannot be Separated
One of the issues with the methods of determining the maximum sustainable withdrawal rate based on Bengen’s research is that the accumulation and decumulation phases of someone’s lifetime are isolated. We need to be able to have a more comprehensive way to look at a client’s life cycle in terms of their financial planning. Perhaps if Bengen had more than 65 years of data, he would’ve been able to find a retirement income planning strategy that incorporated both the savings and spending phases of someone’s life.
Volatility in Withdrawal Rates
Another problem with finding the maximum sustainable withdrawal rate is the variance in how that might look for client retiring even one year apart. There can be a lot of volatility in withdrawal rates, depending on the state of the markets at the time the withdrawals begin.
For example, following a prolonged bull market, a sustainable withdrawal rate is going to be much lower than that following a prolonged bear market. While the “sustainable safe withdrawal rate” has historically been 4%, that number may actually range between 2 – 10%, depending on when you retire. There are serious consequences for either having too high of a withdrawal rate and running out of money or compromising necessities to meet a smaller withdrawal rate when you could’ve actually been using more.
Withdrawal Rates are Hyper Sensitive to Timing
Allow me to introduce the Safe Withdrawal Rate Paradox:
Let’s say two people have 1,000,000 at beginning of 2008. Person A starts withdrawals in the beginning of the year. They can take 40,000 as a safe withdrawal rate following the 4% rule.
Both take a 40% hit by the end of 2008, so each of them has $600,000. Person B starts taking income at the end of that same year with 600,000 and they can only take $24k annual income using the 4% rule.
The safe withdrawal rate is extremely sensitive to the precise amount of a client’s portfolio at the time they decide to “flip the switch”.
It is Difficult to Meet a Wealth Accumulation Target
The numbers can get pretty big when you work backwards to find a wealth accumulation target you need to retire. Let's look at the Rule of 72 – if we assume 7% return every year on a portfolio, your porfolio will double every 10 years even if you don’t add any money. In a 40 year time period, your money should double four times. If the market is flat for the last 10 years before your retirement and you don’t see your portfolio double, you only have half of “The Number” you need.
… Especially in the 5 Year Window Before Retirement
It is very difficult to predict even five years before retirement where you’re going to end up. The relationship between wealth accumulation 5 years before retirement and retirement is very weak. Regardless of whether you’re behind the target, on point, or ahead of schedule, there’s no saying where you'll be in relation to your wealth accumulation goal.
For example, those retiring in 1921 had a very similar wealth accumulation track to those people that retired in 2001 BUT their final accumulation amount was much different. The 1921 retiree accumulated less than 4 times the earnings while the 2001 accumulated more than 12 times their earnings and the difference all occurred in the final five years.
4% Rule is Outdated
Another issue on the 4% rule is that, although there are some indications that this number may be a low, there are many indications is that far too high. Bengen was only able to analyze a withdrawal rate that worked for retirees through early 1980’s. The clients retiring in the early 2000’s are particularly at risk. This may be the first age group where the 4% rule doesn’t work.
It is now 24 years since the publication of William Bengen’s safe withdrawal rate research. In 2018, we know that there is a better way.
A Superior Alternative: Safe Savings Rates
Allow me to introduce to you the “Safe Savings Rate” as described by Wade Pfau, , in an article in the Journal of Financial Planning in 2010 called “Safe Savings Rates: A New Approach to Retirement Planning over the Life Cycle".
This study proves that someone saving at a “Safe Savings Rate” will be able to finance their intended retirement expenditures regardless of a specific nest egg amount or sustainable withdrawal rate.
How does it work?
When Wade Pfau was working to find "Safe Savings Rates", he tested the scenarios for someone:
- With a consistent 60/40 portfolio blend of equities/bonds
- Saving a fixed rate of their salary for 30 years
- Annually adjusting for inflation
- Looking to save for a 50% replacement rate of their pre retirement income
- Aiming to finance their intended retirement expenditures instead of building a portfolio that will work with a certain withdrawal rate
And found that a safe savings rate allows planners and clients to:
- Withdraw the amount needed to meet spending needs regardless of wealth at retirement age or the withdrawal rate
- Link together the saving and withdrawal phases using a more comprehensive approach
- Eliminate the volatility of withdrawal rates
- Minimize the sensitivity of a retirement portfolio to market conditions
- Stop questioning sustainable withdrawal rates
- Feel relief in not having to meet a specific target goal
- Resolve the Safe Withdrawal Rate Paradox
- Effectively use a lower and truly more sustainable withdrawal rate in today’s economic environment
What do the numbers look like?
Based on a worst case scenario, the following Savings Rates in a 60 year life cycle using data through 1871 would have allowed a client to meet their retirement spending needs:
You may be thinking –
Ok so this is great information, but its only applicable if you’re working with a young client who is just starting to save. The "Safe Savings Rate" can also be used for clients within 10 years of their retirement. For someone:
- Age 55
- Retiring at 65
- Looking to fund a retirement expenditure goal
- Using 50% replacement rate of their income
Worst case scenario is 52% "Safe Savings Rate" for the next 10 years. This is an extremely high and unrealistic savings rate, but is a good indicator for this client and their advisor that they should postpone their retirement.
For more data on what "Safe Savings Rates" work for people well into their careers, check our Wade Pfau's article in the Journal of Financial Planning called Getting On Track for a Sustainable Retirement: A Reality Check on Savings and Work.
The conclusions from "Safe Saving's Rate" Research:
- There is not a rule of thumb with “Safe Savings Sates”, unlike the 4% rule, but we can create guidelines
- The length of the savings period matters much more than the length of the retirement period
- The longer you save for retirement, the better chance you’ll have at meeting your retirement expenditure goals
- In this approach, withdrawal rates and accumulation goals can be an afterthought
- Savings plans must be adhered to regardless of whether you’re “behind” or “ahead”
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