Beware conventional wisdom when planning for retirement

If you read a lot about retirement you have no doubt come across established thinking that asks you to follow the so-called 4% rule and to choose a Social Security start date after conducting a break-even analysis.

These well-recognized strategies may have problems. Let’s take a closer look.

Deciding to draw down retirement assets using the 4% rule

Most people have heard that withdrawing 4% of your portfolio each year of retirement (adjusted for inflation) is an excellent way to make sure you don’t run out of money before you die. Ironically, this withdrawal rate was revised by its creator shortly after it was published to be not 4%, but 4.5%, when a more realistic mix of stock and bond investments is used. Nonetheless, people insist on using 4% (or less if you look at some recent research) as the number as though it was handed down from Mount Sinai on a stone tablet.

The reality is the 4% rule (e.g., draw down 4% of your $1 million this year and then draw $40,000 plus inflation next year) may be asking you to unduly restrict spending. What people who blindly follow this established strategy may not know is that research shows that 96% of the time the 4% rule is used people will die with all of their retirement assets intact. The 4% rule of thumb is a good one, and for ultra-risk-averse people it may serve its purpose. But for many the goal is to spend down retirement assets and not run out of money; as opposed to spend retirement assets to not run out of money.

In other words, many do not want to keep their fortunes locked away in a vault so they never run out of money. Instead they want to maximize spending without putting themselves in a position to have inadequate resources in the latter part of retirement. For many, using the ultraconservative 4% methodology just won’t meet this goal. There is no shame in dying with your portfolio balance significantly south of where you started retirement. Let’s be realistic, no one is suggesting you take 10% annual withdrawals…but it is important to note that most established endowments, which have the goal of permanently maintaining principal, allow for a 5% distribution a year.

So what is the alternative? In many cases you can increase the amount distributed if you are willing to take some common sense precautions. Several strategies can be used to balance the risk of not outliving your money with the risk of unnecessarily underspending in retirement.

For example, partial annuitization with single premium immediate annuities, or using a higher rate of withdrawal (e.g., 5.5%) but adjusting it in down s, or dividing assets into time-segmented classes can help overcome the well-known wisdom that may force you to live more frugally than necessary.

A little prudence, some small adjustments, and a different perspective on what you hope to achieve makes adapting the 4% rule a workable solution to providing some extra cash flow.

Deciding when to claim Social Security using a break-even analysis

Many planners recommend a net-present-value calculation to determine when to claim Social Security. Essentially the net-present-value approach compares the net-present-value of X dollars for Y months (early start for Social Security) to the net-present-value of X-plus dollars for Y-minus months (later start). Software then calculates a break-even age. If the person is expected to die before that age, then he or she should claim Social Security early. If a person is expected to outlive that age, then he or she should claim Social Security later. For example, a calculation using conventional wisdom may say if you will live to age 80 or beyond wait to claim Social Security, otherwise claim early. However, this recognized understanding ignores the “insurance value” of waiting to collect Social Security; it also ignores the increased survivor benefits associated with waiting, and it also ignores the fact that a deferral decision is like purchasing a larger (and cost of living adjusted) deferred annuity for each month of delay with no fees that is backed by the full faith and credit of the federal government.

For those who have no concerns about outliving their income, the break-even age analysis is an acceptable way to choose a claiming age. However, for those in need of insurance protection against living too long, retirement income security should be their primary concern. Many in this group cannot afford the luxury of trying to maximize wealth by timing the system (much like investors cannot afford the luxury of timing the market to maximize their rate of return). Most need as much longevity insurance protection as they can get.

Buying longevity insurance from Social Security should not be considered a bad decision even if the individual happens to die early, much like buying homeowners insurance is not a “bad deal” even if you never make a claim.

There is no doubt that reasonable people will argue the insurance protection is a bad investment. They will point to the fact that if the single individual delays until age 70 and dies before that age, they left 8 years of contributions on the table. However, I would argue this is not an investment decision. It is a financial planning decision, and well-established financial planning principles mandate insurance protection against potential catastrophic risks like not having the income to pay for food, shelter, or care; especially for a frail elderly person who needs the lifelong protection provided by guaranteed income.

We also need to acknowledge that many researchers have shown that later claiming (age 70) has the ability to lower the risk of running out of money later in retirement. It seems the idea of claiming early using a break-even approach is predicated on not passing up free money. However, there are two sides to the “free money” issue.

Many people focus on lost years with no payments while they wait month after month to collect at age 70. However, they ignore the larger payments (another type of free money) that results from delayed claiming. Once again common sense may dictate that choosing a Social Security start date should not be about gaming the system; but about procuring financial security for a lifetime.

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