Figuring Retirement Savings Spend-down rate

By Jay MacDonald • Bankrate.com

As retirement looms, our focus naturally shifts from acquiring the assets required to maintain our lifestyle once we turn off the income spigot to budgeting ourselves accordingly in retirement so our funds won't expire before we do.

If you've given any thought to post-retirement spending strategies, you may have heard the term "spend-down rate" bandied about by a financial adviser or investment Web site. The term refers to how much of your portfolio you might safely tap on an annual basis without unduly jeopardizing your nest egg.

The so-called "4 percent solution" is the most traditional approach. It starts with a 4 percent dip into your portfolio in the year you retire, then increases annually only by the rate of inflation. If your portfolio totals $800,000, your first-year withdrawal would be $32,000 (4 percent of $800,000); year two would be $32,960 ($32,000 plus inflation), given an inflation rate of 3 percent.

Challenging traditional thinking
But over the past couple years, the "4 percent solution" has come under attack by economists and financial advisers alike who regard it as little more than a thinly veiled scare tactic to sell nervous baby boomers more investment products.

Simply put, you may actually be saving too much -- and needlessly paying off the Mercedes of a financial professional who earns fees for managing that money.

In an article published in the Journal of Financial Planning in June 2005, Ty Bernicke, a certified financial planner in Eau Claire, Wis., threw down the gauntlet. Bernicke pointed out that data from the Bureau of Labor Statistics Consumer Expenditure Survey clearly shows that as retirees age, household expenditures actually decline in every consumer category except health care.

"Most people have heard, as a rule of thumb, that for their initial starting withdrawal rate from their portfolio, they have to stay around the 3 to 4 percent mark," says Bernicke. "It's my opinion that a person could actually start off closer to 5 or 6 percent, assuming that they're not going to be ratcheting up their income for inflation every year, which, guess what, statistics show they're not going to do anyway."

Using his own "reality retirement planning" method, which alters only the spending component to bring it in line with actual BLS survey results, Bernicke calculated the annual post-retirement spending needs for a 55-year-old couple beginning at $60,000 a year. In addition to income, the couple has $800,000 in a 401(k) earning 8 percent annually.

Under traditional retirement planning, which factors in an additional 3 percent in spending each year for inflation, the couple would need $125,626 at age 80, at which point their 401(k) would be completely depleted. Under his reality retirement method however, the couple's spending would be a mere $58,625 at age 80 and the balance in their relatively untapped 401(k) would be $1.8 million.

Quite a difference. In fact, Bernicke says the couple would have had to work another seven years or reduce their initial annual draw by $12,000, putting a severe crimp in their lifestyle, to make up for what traditional planning figured to be their "shortfall."
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What's wrong with over-saving?
Laurence Kotlikoff, professor of economics at Boston University, says Bernicke's objection is only one of a host of factors that financial institutions routinely ignore in their online retirement calculators. He is equally willing to reject another industry rule of thumb, the "replacement rate," which typically recommends that you'll need to stockpile 75 percent to 86 percent of your final-year's income for every year you spend in retirement.

"Any of these rules of thumb are really rules of 'dumb,'" he says. "These Web sites are in general inducing people to over-save. I think the SEC should be investigating these major companies and their Web sites. I think it's a form of financial malpractice."

Kotlikoff admittedly has a horse in this race. As president of Economic Security Planning Inc., he spent 13 years developing his own retirement planning software, ESPlanner, available to download for $149. ESPlanner's approach does away with setting future spending targets altogether, and instead focuses on determining your highest sustainable living standard while factoring in such life changes as income, family composition, special expenditures, bequests, downsizing and year-by-year actual federal and state taxes.

In short, it thin-slices your financial picture to calculate what Kotlikoff says is a more realistic spending model, one that ebbs and flows as your wants and needs change.

Gone is that particularly vexing rule of thumb, guesstimating your date of death (the financial industry has traditionally suggested you add two years to the number of years your parent of the same sex lived; controversy surrounds this advice like a dust storm).

"A lot of these Web sites are focused on your life expectancy. That's completely inappropriate. It should be based on your maximum age of life," Kotlikoff says.

OK, so maybe most retirement calculators are more chainsaw than scalpel. At a time when the average American's savings rate has dropped into negative numbers, shouldn't we encourage people to err on the safe side and save more? What's wrong with over-saving anyway?

"What wrong with it is, you could die," says Kotlikoff. "You may want to party big-time from age 78 to 100, but you may die at 62. As fiduciaries for our current as well as our future selves, we have to make sure we don't squander our youth rather than our money."

Kotlikoff estimates that the financial industry's helpful calculators not only fudge your future needs a little; they miss the mark by a mile. In comparing his ESPlanner calculations with the online calculators of three major financial institutions, he found that Fidelity was 36.4 percent higher, Vanguard was 53.1 percent higher and TIAA-CREF was 78 percent higher.

"These calculators out there are incredibly primitive and dangerous," he says. "Nobody should be handing out financial advice on a casual basis, and that's what is going on systematically throughout the industry because the industry is interested in selling product, not giving advice. Th"A dynamic process"
The financial industry has met the accusations with a mixture of patience and bewilderment. After all, how can anyone question how much Americans are saving when all indications are that Americans are not saving nearly enough to carry them down the back nine?
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Fran Kinniry, principal of Vanguard's investment counseling and research group, says the naysayers are ignoring some inconvenient truths.

"We've done quite a few research situations on this. Most of their assumptions underestimate the historical volatility of markets. If you want to use average rates of return for markets, then potentially the calculators are too high, but if you typically think about markets being cyclical, it's very difficult to say that investors are saving too much," he says.

Think of it as a game of musical chairs: if the markets are with you in retirement, you get to keep your chair; if they should cycle downward however, you may lose it. Literally.

In fact, Chad Peterson, spokesperson for TIAA-CREF, says traditional targets may be a little low.

"Extensive research and empirical evidence gained through our nearly 90 years of helping millions build financial security in retirement suggest people should aim to replace approximately 80 percent of their pre-retirement income when they stop working. Some experts believe that this 80 percent replacement estimate may even be on the low side, given the potentially higher costs of medical and long-term nursing care projected for the future and increased individual longevity," he says.

Jenny Engle, spokesperson for Fidelity Investments, says that while Fidelity's online tools default to an 85 percent pre-retirement income savings rate, the key is to keep using them to adjust both pre-retirement savings and post-retirement spending.

"We've taken what we believe is a realistic, if somewhat conservative, approach to building our tools," she says. "These tools help them really develop quite a robust income plan; they can modify it, use different scenarios and alter the withdrawal rate that they might consider using based on their budget and the type of lifestyle they want to live. This is really a dynamic process."

Engle says a little controversy in the staid retirement planning industry might be a good thing.

"Our research shows very clearly that the majority of people are not saving enough for retirement," she says. "We think it's a healthy discussion and the more people are thinking about this and focused on it, the better off people will be and the more prepared for retirement they're likely to be."

But Kinnery cautions against the temptation to shortchange your nest egg.

"The number one way we think about it is to ask one simple question: What are the consequences of over-saving verses under-saving? I would argue to save as much as you can while you are young, and if you experience good markets, you can always cut back (saving) when you're still in the work force later, when you're 50 or 55. But it's so much harder to play catch-up later because you lose the compounding impact, that it's clear to us that the consequences of over-saving verses under-saving are not even on the same plane."They're overdoing it with a lot of people."

Will boomers go bust?
Some suggest that the recent assault on traditional retirement-planning assumptions is itself a thinly veiled rationalization for baby boomers to continue their wanton spending ways. After all, who wouldn't like to hear that their nest is sufficiently feathered and it's OK to buy that plasma TV?
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But Bernicke says don't confuse the spend-down debate with a license to consume. "Nobody is advising against saving," he says. "The issue is spending AFTER retirement."

How to find your perfect post-retirement spending zone? Kotlikoff says the key is to input more (not less) of your data and have it crunched by a disinterested party (i.e., not affiliated with a financial company) whose calculations are free of the rules of thumb of interested parties (i.e., financial institutions). Bankrate's retirement calculator is one place to start.

"This stuff is rocket science, and it's time for people to realize that it's not just fun and games here. You can't dumb it down," Kotlikoff says. "It's a little like trying to target to the moon; if you're off a little bit in the calculation of the trajectory and you don't have any self-correcting mechanism, you're going to miss it. If you miss it by a small deviation, one degree, that can leave you thousands of miles away.

"If you target for the wrong retirement spending, you make a 10 percent mistake, you're making it for 40 years if you live to be 100. A 10 percent mistake times 40 is a big number."

Software programs such as ESPlanner and the similarly priced Financial Engines emphasize their roots in economic theory and intentionally distance themselves from the financial products market.

Kotlikoff predicts financial planners in the future will be required to have economics degrees.

Bernicke says seeking objective advice from a living, breathing -- and reliable -- financial planner is even better if you hope to spend happily ever after.

"We're starting to talk about it and be more reasonable about it, as opposed to getting our information directly from the very financial institutions that stand to benefit the most from telling us that we need too much. It's sort of like asking Philip Morris if you should take up smoking. Why would we ever go to an investment company to get objective advice on how much we need to save? How much do they stand to benefit by telling us we need to save, on average, 40 percent more than we actually need? Their revenue goes up by the billions."

Jay MacDonald is a contributing editor based in Texas.