Retirement Strategies – Spending Safely

Today’s post is about a report from Stanford on Retirement Strategies.

Retirement Strategies

Today we’re going to look at a report from Stanford University that analysed 292 retirement strategies, to work out which one was best.

• The report actually came out in November 2017, but it only recently came to my attention.

The purpose of the report was to identify the best strategy for middle-income workers as they move into retirement.

• The strategy needed to be fairly straightforward so that investors could implement it for themselves.

Steve Vernon, one of the report’s authors, said:

Left to their own devices, retirees tend to fall into two camps when deciding how to deploy their retirement savings:

1. Cautious retirees conserve their savings, minimizing withdrawals or treating savings as an emergency fund.

2. Carefree retirees “wing it” and use their savings like a checking account, spending on current living expenses without a plan to make their savings last for life. Often, they spend too rapidly at an unsustainable rate.

Both groups can do better. The first group could benefit from a strategy that allows them to spend more in retirement and still feel safe. The second group should spend their savings more wisely, so they won’t outlive their money.

Middle income workers were defined as those with a net worth of more than $100K but less than $1M (£710K as I write).

• The authors think that this group might represent more than half of US workers aged 55 and over.

With a safe withdrawal rate (SWR) of 3.3%, a $1M portfolio would produce an income of £23.5K here in the UK, which many people would find adequate.

• So the report should be of some relevance to readers of this blog.

Of course, since it’s a US study, there will need to be some interpretation in order for the process to be applicable to UK private investors, particularly around taxation.

• But even if it proves impossible to adapt the winnings strategy to the UK, there should be some useful insights along the way.

The researchers called the winning strategy “spending safely” or the SS / RMD strategy – depending on the audience they are addressing.

Competing goals

The report acknowledges that any retirement income plan involves tradeoffs between potentially competing goals:

1. Maximizing lifetime income
2. Access to savings (liquidity)
3. Bequests
4. Simplicity of implementation
5. Low costs
6. Minimizing taxes
7. Protecting against common risks:
   • Longevity
   • Inflation
   • Variability of investment returns
   • Death of spouse
   • Cognitive decline
   • Fraud
   • Political / regulatory issues

The process

The report look at three hypothetical retirees

1. Retiree #1: Single female age 65 with $250,000 in savings
2. Retiree #2: Married couple, both age 65, with $400,000 in savings
3. Retiree #3: Married couple, both age 65, with $1,000,000 in savings

The retirement strategies analysed included:

• Investing assets with various systematic withdrawal plans (SWPs), including endowment methods with annual withdrawal percentages of 3%, 5%, and 7%, and the IRS required minimum distribution (RMD)
• Purchasing various types of annuities, including single premium immediate annuities (SPIAs), guaranteed lifetime withdrawal benefits (GLWBs), and fixed index annuities (FIAs), and
• Using savings to delay starting Social Security income.

The study used the following process:

• Stochastic forecasts of income and accessible wealth (liquidity) throughout retirement
• An efficient frontier that trades off between expected income and liquidity
• Patterns of retirement income during retirement (volatility and inflation protection)

Prevailing economic conditions (low interest rates), annuity prices and tax law from early 2017 were used.

Stochastic investment returns were used, with the following real arithmetic mean annual rates:

• Equities: 5.1%
• Bonds: 0.3%
• Inflation: 2.1%

The efficient frontier analysis was used to reduce the 292 strategies down to 21 that were examined in more detail.

• Dashboards were produced for these 21 strategies.

Performance factors

The researchers found that several factor drove returns from pension pots:

1. Asset allocation decisions – the mix of stocks and bonds
2. Investment timing decisions, including selling stocks when the market is down
3. Fees

Guaranteed income

The study looked at six main sources of income in retirement:

1. Social Security (the State Pension)
2. DC pension plans (401ks)
3. IRAs (roughly ISAs)
4. Working longer
5. Annuities
6. Home equity

The study seems to assume a “guaranteed” element to a retirement portfolio.

• For most people this will include the State Pension and perhaps some DB pensions

But the study also looks at annuities, including indexed annuities (poor value at present) and reverse mortgages (only to be used as a last resort).

The idea is to cover basic living needs from the guaranteed portion of the portfolio so that you can afford to take the risk of investing the remainder in high-growth but volatile equities.

• Note that many retirement funds (eg. target date funds) own much less than 100% of equities.

The study looked at a range of withdrawal rates, but we can disregard anything above 4% pa as it is almost guaranteed to deplete your pot.

• In the US, required withdrawal rates rise with age.

Defer the state pension

One of the features of the “spending safely” strategy is deferring Social Security (effectively the state pension).

• Social Security contributes more than half of retirement income for middle-income workers in the US.

The researchers like Social Security for four reasons:

1. it lasts your whole lifetime
2. it’s inflation-linked
3. returns are independent of capital markets
4. its partially tax-free

This last point isn’t true of the UK state pension.

Another point to consider is that the UK state pension is the lowest in the developed world, at only 29% of average incomes.

• As such it will be of most importance to poorer retirees.
• If we assume a target retirement income of say £25K pa, the state pension will provide less than a third of that.

The report suggests deferring social security until age 70, and working part time until then to cover living expenses.

• Those with $300K to $400K (or more) in savings could stop work at 65 and draw on their savings until age 70.

We looked more directly at the effects of deferring the UK State Pension back in December 2017.

• There used to be a good deal on this, but it has recently been removed.

Now you get a 1% increase for every nine weeks that you defer, which is a 5.8% increase per year.

• The increase used to be 10.4% pa until April 2016.

Given the new rate of increases and current life expectancy, deferral is likely to lose you a little money.

• So we can ignore this part of the spending safely strategy.

Minimum distributions

The IRS in the US forces retirees to take “required minimum distributions” (RMDS) from their IRAs and 401(k)s from the age of 70 1/2.

• The 401(k) is like a SIPP, and the (Roth) IRA is like an ISA (except that you can’t access it until age 59 1/2).
• The RMD is then taxable as income.

The RMD is calculated by spreading your pension funds across your expected “distribution period” – the time left until your death.

• So at age 70 the distribution period is 27.4 years, which means that your RMD is 3.6%.

To me, this is already a not very safe withdrawal rate.

• The report’s author say that although the RMS was designed to maximise tax capture from retirement accounts, it works fine as a spend-down strategy.

As you age, the distribution period shrinks, but by less than one year for each year that you survive.

• Note that the RMD will vary the nominal size of withdrawals according to your investment returns, since it is percentage based.

The spending safely strategy suggests that you stick to the minimum RMDs.

Withdrawals are not mandatory here in the UK, but you need to take money to live on.

• So UK pensioners will have to make some assumptions about investment growth and life expectancy in order to work out how much they can afford to withdraw each year.

It would be possible to mimic the RMD by looking at your life expectancy, but the most readily available number is the mean age of death.

• A large proportion of people will live longer than that, so you need to take out less money than that number implies.

We really need access to the 95% death level on the survival curve.

• The ONS statistics don’t seem to provide this.

So the only way forward appears to be to use the US figures, which won’t be correct since life expectancy in the UK is higher.

• Perhaps we could add the difference in life expectancies to the IS RMD.

It should also be noted that the RMD tables begin at age 70, and most people in the UK will want to take money from their DC pensions much earlier (perhaps at 55).

Perhaps we could extrapolate the distribution periods down to age 55.

• I’ll look at this in a future post.

My plan

After looking at each of the key elements (SS and RMD) the SS/RMD strategy doesn’t appear to apply at all here in the UK.

• What we are left with are the central concepts of a guaranteed base level and a gradually accelerating withdrawal from a mostly-equities pot.

To these I would add the need for a cash buffer of four to five years of living expenses, so that you don’t need to sell stocks during a market downturn.

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I wrote about my own drawdown strategy as part of a chain of blog posts in July 2017.

My guaranteed portion of the portfolio comprises two State Pensions (for me and my partner) and an equivalent amount of DB income (spread across four pensions).

• We also have a lot of money tied up in property (since we live in London).

The rest of our net worth is in a multi-asset portfolio, with close to two thirds in stocks and close to a third in cash (I think we’re near a market high).

None of the above says exactly how much to take out each year.

• That’s because I don’t really know at the moment.

I’ve taken out a couple of years of money from my SIPP, but I’ve used the higher tax threshold to work out how much to drawdown each year.

In the near future I’ll be trying to determine what is the optimal amount for me and my partner to withdraw each year from our SIPPs.

• It’s more complicated than it sounds, and I’ll have a separate article on that in the near future.

The plan will probably include moving cash back down to around half it’s present level, and moving it inside the SIPPs (to slow their growth and minimise problems with the LTA in the future).

• I need to keep around five years of living expenses in cash to avoid having to sell stocks when markets are low.

Until next time.

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