For Release: September 4, 2008

DENVER, Colo.… It's well accepted in the financial planning literature that retirees should limit their initial annual withdrawal to roughly 4 percent of their portfolio's value, adjusted annually for inflation. But what if that 4 percent isn't sufficient to maintain their pre-retirement standard of living? They'll likely have to reduce their standard of living—but perhaps not as much or as soon as they might think, finds an article in the September 2008 issue of the Journal of Financial Planning, published monthly by the Financial Planning Association^® (FPA^®).

"For a variety of reasons, including forced early retirement or health problems, or perhaps poor investment returns, workers often retire without having saved enough for the commonly recommended 4 percent 'sustainable' withdrawal rate from their portfolio to provide sufficient income to meet their living expenses," writes Gordon B. Pye, Ph.D., in "When Should Retirees Retrench? Later Than You Think."

Pye, a financial consultant and planner in New York City, uses the example of a retiree who is 65 and starts withdrawing Social Security. Her expenses are $60,000 a year, but her Social Security payment plus a 4 percent withdrawal from her portfolio provides only $44,000 that first year. Typical advice would be for her to find some way to slash her expenses to $44,000—a difficult task.

But Pye finds that this retiree can stick to her $60,000-a-year budget initially and postpone a painful reduction of her standard of living, at least for a while, even though it means her initial portfolio withdrawal will equal 7.5 percent of the account's value. The "retrenchment" is deferred to a time when future events indicate how much retrenchment is necessary. For example, if her portfolio performs above expectations and her life is short, she may need to reduce her standard of living little, if any, in the coming years.

To determine whether, when, and how much a retiree may need to retrench, Pye has developed a "Retrenchment Rule." The rule is derived from a discount rate that discounts the future investment withdrawals for each year in the future that the withdrawals are received. The sum of these discounted withdrawals is their present value, and the interest rate used for discounting increases with factors that reduce the future value of those withdrawals, such as a shortened life span or deteriorating health.

Suppose the retiree needs an 8 percent withdrawal to cover living expenses and he uses a 6 percent discount rate over 45 years of withdrawals. Then the present value of the withdrawals would exceed the present value of the portfolio and the retiree would need to retrench at that point. Pye ran a series of simulations to assess various discount rates and found that a discount rate of 8 percent turns out to be the most reasonable for most scenarios.

More surprisingly, Pye's study finds that while some amount of retrenchment will likely be necessary for many retirees, it often doesn't have to begin immediately. He writes, "In fact, initial retrenchment often has the effect of lowering the standard of living during the early years of retirement without alleviating the reduced standard of living that would have occurred if retrenchment had been delayed."

In Pye's case example, the 65-year-old retiree would benefit from reducing her standard of living and withdrawing 4 percent initially only if she lives a very long time and her investment returns perform poorly.

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