The Apparent Paradox of Retiring Twins – Is it True?

Twins_Grace_and_Kate_Hoare_1876Under the retirement paradigm using the 4% rule, there appears to be a paradox as to the timing of one’s retirement. Let’s look at identical twins born the same year (so they’re the same age now), with the same amount of savings at Time Zero (see graph 1 below). Their allocations are identical – so any market effects will also have an identical effect on their portfolios.

Twin A retires and her first year income under the 4% rule would be $40,000 ($3,333/mo) the first year, and then subsequently increased for inflation (3% used in this example) each year until some spending reduction rule kicks in (e.g., Guyton/Klinger decision rules).

Twin B retires one year later. However, the markets have declined and the net effect is that her portfolio balance is now just over $900,000, down ~ 10%, from the year before. Under the rote application of the 4% rule, her initial first year income  would be $36,000 ($3,000/mo).

It appears Twin A is better off having “timed” her retirement during a good year. Hence, the paradox. Does when you retire really affect only those who retire that year?

 

GRAPH 1 Time Zero Year 1 (Age 65) Year 2 (Age 66) Year 3 (Age 67) Year 4
Twin A 1,000,000
40,000 41,200 42,436 etc.
Twin B 1,000,000 900000
36,000 37,080 etc.

 

In truth, Twin B is actually better off in the long run because she is not overspending; she’s spending $36,000 while her Twin is spending $41,200. Twin A has not only experienced the same portfolio value decline, because they’re identically invested, but also worse by taking an additional amount from the portfolio for the spending needs that year. The impact of spending too much is on the portfolio value each year … think of that as number of shares. During a down market, Twin A is selling more shares to net $41,200 as compared to the number of shares Twin B needs to sell to net $36,000 (over simplified explanation, but makes the point). When one runs out of shares, that’s when she runs out of money. Cash doesn’t grow after it has been converted from share value to cash – and eventually gets spent down – especially considering the effect of inflation on the loss of purchasing power.

Let us take a look at a bit more sophisticated approach to retirement income that adjusts the withdrawal rate based on longevity tables – in this case the Annuity 2000 Table. I’ve described this actuarially based approach in a few of my blogs before. Here’s a general description of how it may work in practice. Some practitioners imagine the income adjustments to be much larger than may be experienced. This perception is discussed more below.

Let us say our Twin A retires at age 65. Fifty percent of her cohorts are expected to outlive age 89 (24 years). Under that time frame she may withdraw 5.22% or $52,200 with a 10% chance she may need to adjust her spending down sometime this year (75% Bonds/25% Equity // 4.4% Avg return with 6.5% standard deviation – the greater the allocation to equity, the greater the potential decline/increase in portfolio value).#

 

Yr# Outlive% Years Left Yr# POA Withdraw%
Female Age 65 89 1 50% 24 1 10.00% 5.22%

 

As Twin A’s portfolio value declined (along with that of her Twin B), Twin A is getting small signals, based on an increasing Possibility of Adjustment (PoA) value as follows:

 

Portfolio   Value WR%: * PoA  Age 65
$1,000,000 5.22% 10.00%  $  4,350
$956,044 5.46% 15.00%  $  4,159 Sustainable
$928,826 5.62% 20.00%  $  4,040 Dist. $$ per
$904,679 5.77% 25.00%  $  3,935 month.

 

Thus, when Twin A’s portfolio value reaches approximately $904,000, she should consider reducing her spending to approximately $3,935/month (by $415/month from $4,350) to better preserve her portfolio value for future years. The Possibility of Adjustment (PoA) percentages represent corresponding portfolio values that relate to how sensitive she may be to adjusting spending. Adjusting sooner retains portfolio value that is not spent – but may lead to adjustments more often if economic and/or market conditions continue downward. Waiting to adjust may avoid an adjustment if portfolio values don’t reach a lower decision point. However, should they reach that point, then a larger spending adjustment would be needed to reset the PoA back to 10% (and subsequently resetting all the values based on the new spending and portfolio values being placed at the top of the graph, and new values being recalculated to fill in all the lower PoA’s).

Now, 1 year later, Twin B retires. They are both age 66 with 23 years of remaining expected longevity. During this annual review, the withdrawal rate may be increased (because there is less time remaining) to 5.38%. Recall the portfolio balance is now approximately $904,000, so both twins may now prudently plan on starting the year spending approximately $4,053 / month (5.38% * 904,000 divided by 12).

 

Yr# Outlive% Years Left Yr# POA Withdraw%
Female Age 66 89 1 50% 23 1 10.00% 5.38%

 

Twin A may evaluate her spending. She may have reduced her spending to $3,935 / month, or some value just above that. She should reset her expectations to approximately $4,053 (5.38% * $904,000) – depending on the sense of what may be happening in the markets – might she need to reduce spending another year? Twin B is now retiring at age 66. Her spending should be the same – approximately $4,053/month.

 

Portfolio   Value WR%: * PoA  Age 66
$904,000 5.38% 10.00%  $  4,053
$866,934 5.61% 15.00%  $  3,887 Sustainable
$841,436 5.78% 20.00%  $  3,772 Dist. $$ per
$821,537 5.92% 25.00%  $  3,683 month.

 

You see, Possibility of Adjustment (PoA) is a useful signal as to how much, or little, the stress of spending may be putting on a portfolio balance throughout the year. PoA is simply the percentage of simulations that fail to reach the end of the time period. If more simulations fail – that’s clearly a signal to do something. Reducing the strain through adjusting the spending is the most effective method (market timing doesn’t work).

Yes, Twin A started with expectations based on having $1,000,000. However, the markets did not cooperate. Rather than continue to spend at a higher rate than prudently suggested. You can see now that indeed Twin A was the one more unfortunate than Twin B in that Twin A’s expectations about prudent spending may not have been managed, such that she may have been prepared to reduce spending just a bit. Twin B entered retirement with a lower balance to begin with and, as such, probably had a different spending expectation that her twin sister. Going forward, both may make small adjustments to spending based on their exposure to various market dimensions as well as how those markets do in the unknown future.

On the other hand, all of the above discussion was in case values went down. Higher spending would be possible if portfolio values went up – for example, as they did in 2013 following March 2009. In that case, the decisions would be about removing the “excess” portfolio value needed to support monthly living expenses and using that for example, to replace the aging car, needed home repairs, or rebuild reserves that may have been spent during the last market swoon – all possible examples of deferred spending.

Some advisers interpret using a 10% (or any other value) for the PoA means constant adjustment in spending during the present year … i.e., as portfolio values go up or down, spending is adjusted constantly up or down as well, to keep PoA constant. However, a more practical application is to use the PoA value as a reference point, and then only adjust spending should a decision point be reached. In the above example, two thirds of the time the portfolio value is 6.5% from the mean return. I put the example beyond that by using a 10% decline to illustrate how adjustments may work the other one third of the time. Therefore, most of the time (2/3rd’s) an adjustment to spending would probably not be needed until the annual review to reset the decision points based on the age and portfolio values for that new year.

Of course, I’m not just talking about twins. It’s a metaphor for anybody the same age. As to portfolio values, the monthly income may be proportional – for example $450,000 would be 4.5 * $1,000,000. However, the values above are derived from specific risk and return characteristics as well as specific ages while assuming the 50% longevity percentile. In other words, specifics of each case must be evaluated separately. This is no longer a rule of thumb approach to retirement income planning. As medicine has moved from the 19th into the 21st centuries, I’m suggesting here that income planning has also moved into the 21st century.

So you see, by changing the paradigm to recognize that all boats rise and fall with the tides of the markets, one can get a better sense of exposure to the risk of outliving your money. There is no paradox; simply a need for a method to measure what we are observing. I believe using the percentage of failing simulations is a good measure to evaluate and monitor how fast money should be metered out in retirement.

 

Note, this is income filling the gap in her Standard of Individual Living over and above Social Security (and Pension if she has one). The point being, that not all her income is subject to market forces – only the part that she has invested to fill the gap in need.

 

Added points you may be thinking:

For those thinking that market declines may be insured against … here’s a great blog post saying not so fast.

Should you just buy an immediate annuity and essentially make it into your own pension? Here’s a blog on that too. Depends on how old you are.

And pensions are often not fully funded either.

My point with the above points? Risk is inherent in life and money. Putting it in a black box doesn’t make it go away. It simply makes it harder to recognize what the risk is, where it comes from, and its’ effect on you. We can’t get off the blue marble called Earth and get away from living within the global economy, global markets and their ripple effect in the modern age (just as nobody could escape those effects in any past era either). So … by managing expectations, you may be more adaptable with subtle changes along the way.

#Values come from data for indexed funds I use with clients. Readers should use their data, represented from their own actual allocation and data characteristics, and not try to use data that does not represent their situation. I offer example data here for illustration of an example purposes at two specific ages and only female longevity.

Research supporting the above. And see disclosures.

First use photo source.

 

 

 

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3 Responses to The Apparent Paradox of Retiring Twins – Is it True?

  1. Larry Frank, Sr. February 7, 2014 at 8:17 am #

    Here’s a blog on what I call emergency procedures – as a retired Air Force pilot, we went into the simulator often to practice things we didn’t want to see in real life … it is not pleasant but necessary to know what to do ahead of time.

    http://blog.betterfinancialeducation.com/behavior-corner/emergency-procedures/

  2. Larry Frank, Sr. February 7, 2014 at 10:04 am #

    The above annual or monthly values are gross values since fees and taxes would change based on your specific situation.

  3. Larry Frank, Sr. February 12, 2014 at 9:37 am #

    A couple of articles I have that explain the process above that is based on annual reviews that adjust longevity expectations each year as well as using current portfolio balances:

    http://blog.betterfinancialeducation.com/sustainable-retirement/bear-market-retiree-income/

    http://blog.betterfinancialeducation.com/sustainable-retirement/two-retirement-questions/

    http://blog.betterfinancialeducation.com/sustainable-retirement/the-old-4-rule-for-retirement-its-gone/

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