Vanguard proposes flexible way to determine retirement paycheck

(MoneyWatch) Want to learn about a simple method you can use to turn your retirement savings into a reliable retirement paycheck? For most people, this is one of the most critical -- and challenging -- retirement planning tasks. To help with this sometimes confusing mission, in a recent research paper, Vanguard proposed a dynamic, flexible method that do-it-yourselfers can easily implement.

Vanguard's approach is a variation on the systematic withdrawal method of drawing down retirement savings, where you invest your savings and then withdraw investment earnings plus a portion of principal in a way that's intended to make your savings last for life. (Of course there's no guarantee you won't outlive your retirement savings -- you might live a long time and/or experience poor investment returns.)

The first common method of systematic withdrawals that Vanguard reviewed in its research paper is the four percent rule, where you withdraw an annual amount from your savings equal to four percent of your retirement savings when you retire. Each year thereafter, you give yourself a raise equal to inflation. Vanguard's paper calls this spending method "dollar amount grown by inflation."

The problem with the strict application of the four percent rule is that it's inflexible -- you ignore investment gains or losses that occur since you retired. If you experience gains, on the one hand, you forgo the chance to increase your retirement income. On the other hand, if you experience significant losses, you run the risk of exhausting your retirement savings.

To address these problems with the four percent rule, you could determine the amount of your retirement paycheck using an endowment method, the second variation on systematic withdrawals reviewed in Vanguard's paper. In this case, your annual retirement paycheck would equal four percent of your total assets remaining at the beginning of each year. By using these guidelines, you'll adjust your retirement income up or down to reflect the investment gains or losses that have occurred since you retired. Vanguard refers to this as the "percentage of portfolio" approach.

One advantage of this second approach is that you'll never exhaust your retirement savings, since you're always withdrawing just a small percentage of remaining assets each year so the portfolio can never be depleted. Also, your retirement paycheck will increase if you experience investment gains. One challenge with this approach, however, is that the amount of income can be highly volatile, depending on investment performance, which can make your year-to-year financial planning very difficult.

Vanguard's approach is a modification of the endowment method -- they call it the "percentage of portfolio with ceiling and floor." With this method, you still determine your annual retirement income as four percent of assets at the beginning of each year, but the amount you'll withdraw is subject to a ceiling and a floor.

The ceiling restricts the increase in the amount of your retirement paycheck so it won't be more than five percent higher than the previous year's paycheck. This way, if you experience significant investment gains, you hold back a portion of these gains in reserve in case you experience losses later down the road.

The floor guarantees that you won't reduce your income by more than 2-1/2 percent below the previous year's retirement paycheck. This protects you from a potentially disruptive reduction in your retirement paycheck if you experience significant investment losses.

Let's look at an example to see how it works.

  • Suppose you decide to use $300,000 in retirement savings to generate a paycheck using the Vanguard method. In the first year, your annual retirement paycheck would equal $12,000 (.04 times $300,000).
  • Then suppose at the beginning of the second year, your retirement savings equals $310,000, reflecting the withdrawals you made during the first year plus your investment earnings. The amount of your annual paycheck before adjusting for the ceiling and floor would be $12,400 (.04 times $310,000). But your ceiling is $12,600 (last year's paycheck of $12,000 times 1.05) and your floor is $11,700 ($12,000 times .975). In this example, the floor and ceiling guidelines don't kick in, since $12,400 is between the two amounts.
  • Now suppose at the beginning of the third year, your retirement savings is $330,000, reflecting the withdrawals you made during the second year and even better investment returns. The amount of your annual paycheck before adjusting for the ceiling and floor would be $13,200 (.04 times $330,000). The ceiling is $13,020 (last year's paycheck of $12,400 times 1.05), and the floor is $12,090 ($12,400 times .975). In this case, the ceiling limits the increase in the annual retirement paycheck to just $13,020.
  • OK, let's look at one more hypothetical year. Suppose you had a bad investment year, and at the beginning of the fourth year, your retirement savings equals $280,000, after the withdrawals you made during the third year and your investment losses. The amount of your annual paycheck before adjustment for the ceiling and floor would be $11,200 (.04 times $280,000). The ceiling is $13,671 (last year's paycheck of $13,020 times 1.05), and the floor is $12,695 ($13,020 times .975). In this case, the floor limits the decrease in the annual retirement paycheck to $12,695. Note that your annual withdrawal is still above the withdrawal amounts in the first two years.

The Vanguard paper contains a number of financial analyses that show that its dynamic method of determining a retirement paycheck is a good compromise between a strict application of the four percent rule and the endowment method. Compared to the four percent rule, using the Vanguard dynamic method offers a much lower risk of outliving your money if you live a long time and/or experience poor investment returns, yet you get an increase in your paycheck if you experience good investment returns. Compared to the endowment method, the amount of your retirement paycheck will fluctuate much less, allowing for easier planning of your short-term spending.

The Vanguard paper modeled a portfolio that was invested 50 percent in stocks and 50 percent in bonds, with no assumption for investment expenses. This brings up an important point: The Vanguard dynamic method works best with low-cost index funds. Do-it-yourselfers could implement this simple approach on their own, using Vanguard funds or other low-cost mutual funds.

The Vanguard paper contains more details of its new suggested withdrawal approach if you're interested in this method, such as variations that use different floors and ceilings and withdrawal percentages other than the four percent that's described in this post.

Keep in mind that the Vanguard method is just one application of systematic withdrawals and that annuities are another category of generating retirement income that will guarantee your retirement paycheck will last for the rest of your life, no matter how long you live. You might achieve similar results to the Vanguard method by devoting a portion of your savings to a fixed immediate annuity that will generate a retirement paycheck for you, and then using the simple endowment method with the remainder of your savings.

Because of the importance of this task -- determining your retirement paycheck for the rest of your life -- it's well worth taking the time to learn about the method ormethods that will work best for you.

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    Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck and Recession-Proof Your Retirement Years.

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