By Scott Burns
Q. You confused me recently in a column about safe rates of withdrawal. I am 68 years old and 80 percent invested in CDs. My CDs are currently paying between 5 percent and 5.5 percent. If I withdraw only 4 percent or 5 percent from my investments, I will have more money when I die than I have now.
It seems to me that I should withdraw all of my interest each year
as well as about 4 percent of my principal, or about 9 percent total.
If I buy an immediate life-only annuity, it will pay me 9.2 percent for the rest of my life--- something I cannot outlive. So why do many financial advisers only
recommend only 4 percent to 5 percent?
---G.W., by email
A. It's confusing, isn't it? It's particularly
confusing when you can earn more in current interest. The distinction, however,
is that the 4 to 5 percent safe withdrawal rate is calculated under the
assumption that you will increase the
annual dollars withdrawn to compensate for inflation. As a result, you'll
have constant purchasing power throughout your life. You won't get that from a
CD.
The same calculations estimate the value of your assets at death.
They estimate the safe withdrawal rate based on the idea that the worst case is
that you might die with less money, but you would not die broke. So your assets
at death will be greater than zero.
Your CDs don't allow for that. If you
reserved 3 percent for inflation, you'd have only 2 to 2.5 percent annually to
spend--- and this assumes the CDs are in a tax-deferred account. If you spend
the full payment, your purchasing power will diminish as you age, but you will
have assets at death equal to what you now have (except the dollars will have
much less purchasing power).
It's the same with a life annuity. It
will provide you with the same monthly check until you die. But the purchasing power of that check will
decline each year with inflation. If you got a quote on an inflation-adjusted
life annuity, the annual payment (as a percent of original investment) would be well under 9
percent, and a portion of the excess over 4 to 5 percent would be considered
return of principal. Your assets at death would be zero.
All three paths--- portfolio with safe
withdrawal rate, life annuity or inflation-adjusted life annuity--- are
different ways of coping with having an income in retirement and the possible
spending down of assets. It's not a trivial problem.
You should know, by the way, that there is a very vocal group on
the Internet that believes the 4 to 5 percent withdrawal rate rule is far too
high most of the time.
They believe, following research
originally done by Steve Leuthold and renewed later by Rob Arnott, that future
stock returns depend on the price to earnings ratio of stocks at the time you
start. Retire in a high P/E period--- like 1972 or 1999--- and the odds of
portfolio survival decline because future returns are likely to be poor. Retire
in a low P/E period--- like 1981--- and the odds of portfolio survival soar
because future returns are likely to be high.
I regularly suggest a 4 to 5 percent
withdrawal rate because it's still a good rule of thumb for all but the most
extreme periods of over- and undervaluation.
The only truly safe withdrawal rate that will guarantee that you die with an
amount of purchasing power--- not dollars--- equal to what you retired with is
the premium over inflation paid on a portfolio of Treasury Inflation Protected
Securities. That's about 2.4 percent.
It's also a bit lean for all but the
very wealthy. So it all comes down to taking some amount of risk to earn a
higher return. The only alternative is to convert some of your assets into a
life annuity. Then an insurance company takes the risk.
On the web:
Thursday, August
29, 2007: Will the Real Safe Withdrawal Rate Please Stand Up?
Column Collection
on "The Spender's Portfolio and Portfolio Survival"
