The Price Your Clients Pay for Using Safe Withdrawal Rates
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Safe-withdrawal rates (SWRs) are perhaps the most extensively studied topic in financial planning literature. But applying a single SWR-driven methodology to all clients neglects their unique and individual needs. A better approach is for advisors to assist clients in defining their ideal and acceptable goals and the relative priorities among them. Then they can demonstrate through Monte Carlo simulation the likelihood of the recommended plan becoming over- or under-funded relative to those goals.
Much of the interest in SWRs has been driven by the aging and retirement-oriented demographics of the clients financial advisors serve. Advisors need some credible yet simple rules of thumb they can use to instill confidence and comfort in a decision that for the client is emotionally very scary and nearly irreversible: how to finance one’s retirement.
The notion of a SWR is simple. What can you “safely” withdraw in assets each year, adjusted for inflation over the course of your retirement, without leaving you with too high of a risk of running out of money before you pass?
William Bengen’s seminal 1994 article about the historical evaluation of a 4% withdrawal rate set the stage for this debate. Since then, many others have joined the discussion with various perspectives. Some claim there is a “new retirement” where people still work when they retire. Some have addressed the emotional fears retirees face by focusing on the risks, mainly of outliving one’s money, but sometimes advisors focus on these risks without considering lifestyle consequences or the size of the risk they are insuring against. Some advocate setting asset allocations based on one’s career being considered as an “asset.” Others have gained visibility by pointing out common-sense things that should be included in the calculation of sources of income (but excluded from the withdrawal rate calculation) to meet retirement spending needs like pensions, Social Security and even reverse mortgages. David Zolt suggested investors could have a significantly higher withdrawal rate (49% to 53% higher) if they forego inflation adjustments in years where returns are lower than the targeted returns along with other rules about asset allocation.
Embracing fears - Balancing reason and emotion
Put yourself in the place of a client who is contemplating retirement. On one hand there is an aspirational vision of pursuing those things in life you value, or regret having neglected. Be it golf, travel, fishing, or time with children or grandchildren, there is a pleasant aspirational vision of making the most of your life. On the other hand, there is also the fear that the income that has enabled your lifestyle will need to be replaced by assets for an unknowable amount of time. These conflicting emotions can provoke apprehension among retirees.
The fear side of the emotional equation includes the irreversible nature of retirement (considering the difficulty of getting rehired years later), visions of terrible capital markets that might leave you destitute, health-care costs that could surprise you at any time, and the potential expense for elder care like nursing homes or assisted living. No one is indifferent about the image these scary pictures paint. These risks are both real and emotionally taxing.
Financial services product manufacturers are aware of these emotions and have designed products to appeal to them. Many advisors use products like annuities, long-term care insurance or supplemental health insurance to allay specific fears clients express.
To deal with the fear of return-sequence risk, advisors bring other solutions to the table like a financial plan built through Monte Carlo simulations that provide a high degree of confidence. Advisors may also use the “buckets of money” approach, where near-term spending is funded through very low-risk (essentially cash-like) investments, while longer-term assets are deployed for growth to avoid needing to realize losses in the near term for spending.
Finally, there is the fear of inflation that can be appeased by the use of TIPS, various asset-allocation approaches using inflation hedges or inflation-adjusted riders on annuities.
Advisors are entrusted with the profound responsibility of guiding clients through the lifestyle they will have in their golden years that represents a lifetime of sacrifices to accumulate their wealth. It is critical that we listen to and understand these common fears. It is equally critical that we address them not just emotionally, but to help them understand the very real cost of insuring these emotions and risks. Our advice must balance the emotional understanding of the risks they (or we) fear while objectively assessing the consequences of such choices.
The beginning of Monte Carlo simulations
When online probability analysis tools for professionals started to appear back in 1999, some industry leaders were intrigued by the impact of return-sequence risk. Some were even in shock from the results. It was common for such tools to produce results that showed the client running out of money at age 76 with a trial in a simulation that had a 12% return, while another trial in the same simulation with a 9% return might provide money lasting through age 95 with a sizeable estate.
At the time, financial plans were generally built around conservative return assumptions for the underlying asset classes with zero variation in the year-to-year returns. This was unrealistic – even Treasury bill returns have a non-zero standard deviation. With it uncommon at the time to have tools to evaluate this, few practicing advisors were aware of the impact of sequencing risk. The bear market that began in 2000 highlighted the need to use tools that consider that portfolios can go both up and down, and the adoption of such tools increased.
Many of the first tools claimed that many financial plans would “fail,” even if the client experienced the assumed return, because of sequencing risks. The complexity of stress-testing plans a thousand times or more was simplified in reports and presented as a “success” and “failure” rate, terms that are still commonly used today.