Retirement Planning Horizons and IRS Required Minimum Distributions (RMDs)

The planning horizon for the 4% rule is 30 years, but how long will your retirement last? One of the key difficulties of planning a retirement income strategy is that this question is difficult to answer. We may know our life expectancy, but that is just an average and there is a great deal of variability around that average. There are two general approaches to deal with this uncertainty: planning for specific retirement durations and making plans which specifically incorporate mortality data into the calculations. Today I'll discuss the first of these approaches.

Planning for a Fixed Retirement Duration

The idea behind planning for a specific retirement duration is to choose a sufficiently long time horizon that one is unlikely to outlive, and to then plan based on that. In 1994, Bill Bengen thought that 30 years was a reasonable planning horizon for 65 year olds. The planning age in this case is 95. Others use 100 or 105 as planning ages. To repeat a fundamental point which is sometimes overlooked, the 4% rule applies specifically to a 30-year horizon. Those who are either younger or older than 65 may need to plan for more or less than 30 years. And even 65 year olds may wish to plan for different retirement durations depending on how conservative they wish to be with their choice. A 65 year old planning to live to 100 or 105 would need to plan for a 35 or 40 year horizon.

The retirement duration is important because longer time horizons will guide optimal retirement income solutions toward:

• Lower withdrawal rates
• Higher stock allocations
• Greater reliance on guaranteed income retirement products
• An implied end date for building a bond ladder (and perhaps forgetting about the possibility of living even longer)

Writing in Harold Evensky and Deena Katz’s Retirement Income Redesigned, Bob Curtis made a convincing case for fixed horizons. He argued that longevity is not a “probability problem” but a “possibility problem,” adding, “What possible sense does it make to tell your client that she can spend more money now because you’re assuming in some of the Monte Carlo iterations that she’ll die early? How does a person die ‘some of the time?”

Good question. But at the same time, does it really make sense to lower one’s spending now, because you are specifically planning to spend just as much when you are 105 as when you are 65, despite the less than 1% chance of living to 105?

Because the risk (and this risk varies from person to person depending on how much value they would get from additional spending) of planning for an overly long retirement is that you cut spending and miss out on enjoying your hard-earned wealth. It is conservative to plan for a longer horizon, because it means you will need to spend less and may end up leaving a larger than planned bequest. This risk is missing from traditional safe withdrawal rate studies which focus only on minimizing failure. On the other hand, the risk with planning for a shorter horizon is that you may overspend and end up outliving your wealth.

We can see further about the role of retirement duration on sustainable withdrawal rates in Figure 4.2. Using the historical data since 1926 and all of the baseline assumptions, including a 50/50 allocation to large-capitalization stocks and intermediate-term government bonds, this figure shows William Bengen’s SAFEMAX withdrawal rate for retirement horizons between 5 and 40 years. We saw before that the SAFEMAX for a 30-year retirement is 4.04%. This figure illustrates a curve in which the SAFEMAX declines, but at a decreasing rate, as the retirement duration increases.

 

Visualizing the data in Figure 4.2 is helpful, and Table 4.2A shows the specific numbers for a variety of asset allocations and retirement lengths. The figure also shows the withdrawal rates implied by the Required Minimum Distribution rates set by the IRS for tax-deferred retirement accounts. Those requirements apply after age 70.5, but those with inherited IRAs may have to withdraw at earlier ages as well using these rules. The purpose for adding the RMD withdrawal rates to this table are to provide a comparison between historical SAFEMAXs for different time horizons and the RMDs. These are lined up in such a way as to imply a planning age of 100.

Table 4.2A Varying SAFEMAXs by Retirement Duration and Asset Allocation Inflation Adjustments for Withdrawals, No Fees Using SBBI Data, 1926-2011, S&P 500 and Intermediate-Term Government Bonds
Retirement Duration	100% Stocks	75% Stocks	50% Stocks	25% Stocks	0% Stocks	1/Life Expectancy	Age
1	100	100	100	100	100	15	99
2	38.52	41.83	44.41	45.53	46.09	14.08	98
3	23.54	25.87	27.94	28.79	29.13	13.16	97
4	16.13	19.11	20.70	21.05	21.25	12.35	96
5	12.85	15.58	16.83	16.87	16.87	11.63	95
6	10.90	12.91	13.97	14.13	13.86	10.99	94
7	9.42	10.97	11.87	12.17	11.67	10.42	93
8	8.61	9.55	10.30	10.74	10.09	9.80	92
9	7.89	8.56	9.14	9.62	8.91	9.26	91
10	7.10	7.68	8.17	8.55	7.94	8.77	90
11	6.54	7.07	7.50	7.84	7.09	8.33	89
12	6.14	6.61	6.99	7.28	6.37	7.87	88
13	5.78	6.22	6.57	6.82	5.78	7.46	87
14	5.53	5.94	6.26	6.39	5.31	7.09	86
15	5.34	5.72	6.01	5.99	4.92	6.76	85
16	5.09	5.51	5.78	5.68	4.58	6.45	84
17	4.89	5.27	5.56	5.41	4.27	6.14	83
18	4.74	5.08	5.35	5.17	4.02	5.85	82
19	4.59	4.93	5.19	4.95	3.79	5.59	81
20	4.43	4.79	4.99	4.76	3.57	5.35	80
21	4.29	4.67	4.83	4.59	3.40	5.13	79
22	4.17	4.57	4.71	4.44	3.25	4.93	78
23	4.09	4.47	4.58	4.31	3.11	4.72	77
24	4.02	4.39	4.48	4.18	2.99	4.55	76
25	3.96	4.31	4.39	4.07	2.87	4.37	75
26	3.90	4.23	4.30	3.98	2.77	4.20	74
27	3.86	4.17	4.23	3.88	2.67	4.05	73
28	3.84	4.11	4.16	3.79	2.58	3.91	72
29	3.81	4.06	4.10	3.71	2.49	3.77	71
30	3.78	4.00	4.04	3.63	2.41	3.65	70
31	3.76	3.96	4.00	3.55	2.34	3.60	69
32	3.74	3.93	3.95	3.48	2.27	3.50	68
33	3.72	3.90	3.92	3.41	2.21	3.40	67
34	3.71	3.88	3.89	3.35	2.15	3.31	66
35	3.69	3.86	3.86	3.29	2.09	3.23	65
36	3.68	3.84	3.83	3.22	2.04	3.14	64
37	3.67	3.82	3.81	3.15	1.99	3.06	63
38	3.66	3.79	3.78	3.10	1.94	2.99	62
39	3.64	3.77	3.75	3.04	1.89	2.91	61
40	3.63	3.75	3.73	2.99	1.84	2.84	60
http://www.irs.gov/pub/irs-pdf/p590.pdf

Figure 4.3 plots the SAFEMAXs for different retirement durations calibrated to a planning age of 100, as well as the IRS required minimum distribution rates. These curves are relatively close together, though do notice that the RMDs become more conservative as one approaches age 100. This makes sense, since as one approaches their planning age, it becomes increasingly likely that one will live beyond the age. Using the RMD rules to set withdrawal rates for each year of retirement does present a viable alternative to using constant inflation-adjusted withdrawal amounts.