By FPA past president Dan Moisand, CFP®
Last Updated: December 21, 2009
Why is it that with many rules of thumb, far more people know of the rule than what the rule may or may not mean to their unique circumstances?
In 1993, FPA member William P. Bengen, CFP®, a financial planner in El Cajon, Calif., attempted to find an answer to the question one of his clients asked him, "how much can I spend without fear of running out of money?" His findings were published as "Determining Withdrawal Rates Using Historical Data," in the October 1994 issue of the Journal of Financial Planning. The paper has had such influence, the Journal honored it as one of the best in the publication's first 25-years and its conclusion has become a widely cited rule of thumb.
Bengen concluded that "a first-year withdrawal of four percent …, followed by inflation-adjusted withdrawals in subsequent years, should be safe." Many subsequent works place a safe withdrawal rate between four and four and a half percent. Bengen's three follow-up pieces explore different aspects of the problem. His book, "Conserving Client Portfolios During Retirement," expands the basic premise by incorporating how other variables affect the equation through a "layer cake" approach. Depending on the layers employed, the safe rate can be close to five percent.
The Journal of Financial Planning's Call for Papers competition introduced us to FPA member Jonathon T. Guyton's thoughts on withdrawal rates in his winning paper, "Decision Rules and Portfolio Management for Retirees: Is the 'Safe' Initial Withdrawal Rate Too Safe?" (0ctober 2004 issue). Guyton, a CERTIFIED FINANCIAL PLANNER™ (CFP®) professional and principal of Cornerstone Wealth Advisors, Inc., noticed people simply did not robotically increase their spending each year as is assumed in many studies. He came up with some "decision rules" and back tested those rules. His initial withdrawal rate was closer to six percent of the portfolio value.
More recently FPA member Michael Kitces, CFP®, publisher of The Kitces Report, examined the issue from a different angle, examining the effect market valuations have on the withdrawal rate problem. In its simplest form, when market valuations are low, future returns tend to be higher and therefore can support a higher withdrawal rate and when valuations are high valuations, lower withdrawal rates are indicated.
While these studies and others give us more insight into the plausibility of a withdrawal plan, not all variables can be modeled well. The mathematics is only marginally helpful in making decisions in real time. With today's 24/7 media thrusting gobs of information at you, "set it and forget it" will not be an option.
What happens if the withdrawal rate goes above the "safe" rate? A better question is, what will you do when the rate goes above the safe rate? Higher than desired withdrawal rates are indeed a "when" proposition. There are two ways a withdrawal rate increases: either the withdrawal amount is increased or the asset base upon which the rate is calculated decreases. You may be able to control your spending but asset base decreases are unavoidable. Either your stocks will sink as they have historically in just over 30 percent of one-year periods or, if you invest soley in fixed holdings, the asset base will be eroded by inflation, taxes and withdrawals.
The answer to the what-to-do question, according to virtually every study I have seen, is not to go to cash, or become a market timer or a trader. All of the studies maintain long-term positions in diversified holdings of stock. Most assume that the reaction to a down market is buying more stock through rebalancing. Mutual fund cash flows and studies of investor behavior show clearly that is not what most people wish to do, especially when the market drop is severe like the panic we saw in 2008-2009. People wish to sell when prices are down and buy when prices are up. That is exactly backwards, but many cannot get over the fear that things will get worse before they get better.
One of the most pervasive errors in financial planning is looking to the portfolio management function for all the answers. Wall Street furthers this fallacy in its marketing. Want a beach house? No sweat, just make some portfolio adjustments.
Good portfolio management is important but effective financial planning assumes markets will be volatile. I suggest a better approach to operating in panic mode when crisis strikes is to have rehearsed ahead of time what will be done and write it down. Don't just address the buy high, sell low error. Focus on the things you can control like your spending, savings rate, how long you will work, and what a bequest to your heirs will be to name but a few.
At some point in life, everyone will face financial challenges. In such times people will tighten their belts. If you know exactly how you would make changes ahead of time, actually doing so is less traumatic, even if you do not like it particularly. Conversely thinking ahead can help you be more prudent when times are particularly good. This is the essence of planning.
Change is inevitable. Even plans that look good because they are well within the rules of thumb have a high probability of requiring change even in just the first few years.
Rules of thumb can provide some sensible framing but what is more important is what is unique to your household. They say rules are meant to be broken and these rules of thumb are no exception. Find a financial planner.
FPA past president, Dan Moisand, CFP®, has been featured as one of the America's top independent financial advisors by Financial Planning, Financial Advisor, Investment Advisor, Investment News, Journal of Financial Planning, Accounting Today, Research, Wealth Manager, and Worth magazines. He practices in Melbourne, Fla.