On April 7, Scott Burns wrote an excellent column (How Much Will You Leave on the Table?) in the Dallas Morning News following up on an article co-authored by me along with Michael Finke and Duncan Williams of Texas Tech University, wich was published the March 2012 Journal of Financial Planning and entitled, Spending Flexibility and Safe Withdrawal Rates. This article continued an earlier line of inquiry by Finke and Williams from the Fall 2011 issue of the Retirement Management Journal, and it won the RMJ’s Academic Thought Leadership Award.
Scott Burns had earlier brought the Trinity study into widespread prominence. Michael Kitces also took a look at our article at his blog, ("Utility Functions in Financial Planning - A New Framework For Decision Making?"), and Doug Nordman scooped them both with an excellent description of an earlier draft which he wrote last November ("Is the 4% withdrawal rate really safe?").
Scott's column prompted this comment at my blog entry about the article:
Thanks for your colleagues and you for this research. As someone in the real world who will be retiring in the very near future I appreciate practical research and advice. I understand the need for theory but how does that get applied? Maybe Scott Burns over simplifies these ideas but people in the real world want to know how to apply something to their specific situation.
Thanks Matt Bly
It's a good question.
And it's an important one, because in particular as Doug Nordman describes, most of my earlier withdrawal rate research focuses on the concerns that I had and that I continue to have about the sustainability of the 4% withdrawal rate rule for retirees in recent years.
I understand that co-author Duncan Williams is working further to address this question with his research, but let me just provide some of my own comments for now about it.
The way I see it, the original purpose of Bill Bengen's research (that link will bring you up to speed on this issue) was to ask a very basic and important question: what is the highest withdrawal rate that can reasonably be used without running out of funds?
But a lot of subsequent research which should have been branching out became too stuck on this narrow question and ignored the fact that retires may have access to more income sources from outside their personal savings. I think an extreme version of this narrow focus can be seen in Rory Terry's research article from the May 2003 Journal of Financial Planning when he wrote:
This question clearly depends on the definition of an acceptable probability of failure and a definition of “acceptable” is certainly client specific. My opinion is that most investors would find failure rates in the five percent-and-higher ranges described in Ameriks, Bengen and Pye, for example, to be unacceptable. I believe that most investors would find even a one percent probability of failure to be excessively high when dealing with irreplaceable assets and considering the extreme costs of failure. (my emphasis)
For a lot of retirees, running out of wealth may not be as catastrophic as he makes it sound. There's also Social Security. For some people, there are employer pensions. Some people may have a fixed income annuity. Some people may have made arrangements with their children that the parents will use a more aggressive stock allocation in order to try and provide a larger inheritance with the understanding that this also increases the risk of depleting wealth in bad market conditions such that there is a small chance the children will need to help their parents out. And so on.
The problem with arbitrarily choosing an acceptable failure rate, as traditional safe withdrawal rate research would ask you to do, is that it leaves aside the issue that you may ultimately give up a lot of potential spending power by using a low enough withdrawal rate to satisfy a low acceptable failure rate.
I don't think Scott Burns oversimplified our article. There is more math and theory in the article, but ultimately that was to formalize the concept and demonstrate the tradeoffs with clear examples of well-defined retiree preferences. I'm glad in particular that he emphasized our "percentage of retirement spent without wealth" measures as a contrast to traditional failure rate measures.
I think for the time being, the way to apply this theory in practice is to just keep some of these concepts in mind as you formulate your retirement income strategy:
Wade Pfau, Ph.D., CFA, is an associate professor of economics at the National Graduate Institute for Policy Studies (GRIPS) in Tokyo, Japan, and the curriculum director for the Retirement Management AnalystSM designation program. He maintains a blog about retirement planning research at wpfau.blogspot.com