How to Revise Your Retirement Plan

Despite the rally in stocks and other risky assets since March 9, many portfolios are still damaged from the events of the last few years. For those who are retired or near retirement, one step you have to take after such an event is to re-evaluate your retirement plan, especially your spending. Specifically you have to check the rate at which you plan to withdraw money from your retirement portfolio and decide if it needs to be adjusted to reduce the risk of running out of money.

Financial planners spend a lot of time contemplating the safe or sustainable withdrawal rate. This is the percentage of the portfolio you can withdraw the first year, increase the dollar amount by inflation each subsequent year, and have a high probability the portfolio will at least 30 years. The biggest risk to a retirement portfolio is a bear market or a long-term flat market in the early years of retirement. The second biggest risk is to withdraw money at an unsustainable rate.

Numerous studies indicate that to be safe, the first year withdrawal rate should be between 3% and 4% of the portfolio. The most commonly-cited sustainable rate is 3.6%. This assumes you invest at least 50% of the portfolio in stocks or assets that earn similar returns. If you invest a lower percentage in growth assets, the sustainable withdrawal rate is lower.

If you are fortunate enough to retire at the beginning of a bull market, a higher withdrawal rate is safe. But you won't know until after a few years of retirement the type of market that coincided with the beginning of your retirement.

Whatever withdrawal rate you choose the first year, the rate needs to be re-evaluated periodically. Even the 3.6% withdrawal rate does not allow a portfolio to last 30 years 100% of the time. There still is a risk of running out of money.

When portfolio returns are disappointing, you need to re-evaluate the plan to be sure you aren’t on track to run out of money. Bear markets are followed by bull markets, eventually. The key is to be sure the combination of the bear market and your spending does not bring the portfolio balance so low the subsequent bull market gains are not enough to sustain the portfolio through retirement.

If you retired a few years ago and still have a portfolio that is worth more than your starting portfolio, you probably are in good shape. The research shows you should be able to continue your planned withdrawal schedule with a very low probability of outliving your money. You might want to reduce spending a bit for the next few years to be on the safe side, but drastic measures are not needed unless there is another significant downward leg to for your portfolio.

What if you now have less money than when you first retired? In that case, you need to consider changes. We will review some potential changes shortly. First, let's look at more objective benchmarks of your spending rate.

One way to evaluate your spending rate is to assume an immediate single-premium lifetime annuity is purchased with your entire retirement portfolio. Is the annual payout from that annuity similar to the amount you are withdrawing now? If you are withdrawing significantly more than the annuity payment, you likely will have a problem sustaining the withdrawal rate unless investment returns increase. Insurance companies spend a lot of resources calculating life expectancies and determining how much they can pay a person and still make a profit. If your withdrawals are significantly higher than what the insurers are paying, then you are assuming a significantly higher investment return or shorter life expectancy than the insurers. Keep in mind if you have a spouse you intend to provide for, the portfolio likely will have to last longer than for a single life annuity. Check annuity payout rates at web sites such as

Another objective warning sign is a withdrawal rate approaching 10%. Surveys continue to show that many people think they safely can withdraw 8% to 10% annually. Research does not back that up, except in strong bull markets.

Here’s another quantitative measure.

One study found a strong correlation between the safe withdrawal rate for the next 30 years and the current price/earnings ratio of the S&P 500. The higher the P/E ratio, the lower the safe withdrawal rate is for the next 30 years. P/E ratios tend to be high at bull market peaks, followed by years of below-average returns.

A simple rule is that when the P/E ratio is above the historic average, the safe withdrawal rate is on the low side. When the P/E ratio is low, withdrawal rates can be higher. When the P/E ratio is below 12, a withdrawal rate of 6% or more generally is safe. At extreme bear market bottoms, a rate of 10% can be sustained going forward. Right now, the P/E ratio is around the historic average and not near historic lows.

If your portfolio has declined and you are concerned how long it will last at the current spending rate, there are steps you should consider. One or more of these steps should put you back on the right track.

Ÿ Drop the inflation bump. The studies of the safe withdrawal rate all assume that after the first year the amount taken from the portfolio each year increases with inflation. A simple step is to stop the inflation increase for a while. With consumer prices falling, that makes sense anyway.

Ÿ Use a market-based formula. Instead of a formula that steadily increases spending, have spending rise and fall with the portfolio, though not by as much. One simple formula is to set your withdrawal rate, but apply it to the average account value at the end of each of the last five years.

Another option is what I call the Yale Endowment formula. Each year 70% of the distribution is the initial spending amount plus inflation. The other 30% is a fixed percentage of the portfolio's value. More details of the formula are in my book The New Rules of Retirement.

These formulas smooth distributions. They have the disadvantage of automatically reducing spending when the portfolio declines, but that makes the portfolio last longer. They also have the advantages of increasing spending as investment returns improve, and the cuts are not as drastic as the portfolio’s changes.

Ÿ The safety fund system. Another approach I have recommended is to create a safety fund at the start of retirement. You put an amount equal to the estimated spending for two to five years in safe investments such as money market funds and certificates of deposit. The rest of your portfolio is invested for the long-term. You take money from the safety fund to pay expenses. At the end of the year you rebalance the long-term portfolio by replenishing the safety fund.

The advantage of the safety fund approach is that you do not feel pressured to sell investments after a steep decline, because you know there is enough money in safe assets to get through the two to five year period. Those who do not have large enough portfolios to create a safety fund should consider purchasing an immediate annuity with a portion of their portfolios. Because of low interest rates now is not an optimum time to put a lot of money in an immediate annuity, but as rates rise it is a good long-term strategy.

Ÿ Change allocations and strategies. Retirees whose past investment strategies have let them down should consider changes. Some portfolios were too heavily weighted to equities instead of being diversified (though there were few asset classes that did not lose money in 2008). Other investors could benefit by shifting from buy-and-hold to the more active strategies of our Managed Portfolios.

Most retirees are able to vary spending. They can postpone travel, spend less on restaurants and entertainment, and replace cars and other items less often. Spending adjustments are the best way to get a retirement portfolio and spending back on track.

When secular bear markets strike early in retirement and put the longevity of your portfolio at risk, adjustments are needed. First, adjust spending. You can reduce it for only a year or two or consider making a permanent change to the spending formula. Second, reconsider your investment policy. Do not give up on growth or risk or take too much risk, but be sure your strategy fits today’s markets.



Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site He also is author of the books The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Posted 09-03-2009 1:25 PM by Bob Carlson