Retirement Income Drawdown Part 3: Social Security & Constant Spending Strategies

Constant Spending

Part 3: Social Security & Constant Spending Strategies

Hello folks! Thanks for stopping by The Green Swan! Today is Part 3 in my thoughts and commentary on Retirement Income Scenario Matrices (RISMAT) as authored by Nobel Laureate William Sharpe.

Going through all 729 pages has been a good exercise for me. While a lot of it is devoted to the modeling aspect and coding for MATLAB, there are loads of other takeaways that help me get my arms around my own retirement drawdown strategy.

In Part 1 I went through my introduction to the series and longevity which is a key variable in retirement investment drawdown strategies.

Part 2 took a look at Dr. Sharpe’s thoughts on inflation and market returns.

And here today I will take what we’ve learned so far and delve into various income strategies.

Social Security

Dr. Sharpe’s thoughts on social security were very interesting. The chapter started out by building the foundation of knowledge with the programs history, how it is funded, how benefits are calculated including the “bend points”, etc. While the first part of the chapter was technical and detailed, it was helpful for me to understand the fundamentals.

One part that I found fascinating was the discussion on whether the system was truly progressive (benefiting the poor proportionately more than the rich) or regressive (benefiting the rich more than the poor). Given the design of the bend points and how you earn benefits, the system was designed to be progressive.

However; an important nuance that makes the difference much smaller is that retirees who earned a higher income are likely to live longer than folks with lower incomes and thereby receive benefits for a longer period of time. An article was written on the subject in the New York Times by Neil Irwin (April 24, 2016). The conclusion was that folks in the top 1% of earners who claim benefits at 66 and lives on average to 87 receive an “internal rate of return” from social security of 1.07% while someone making just $30,000 per year die on average at age 78 and obtains just a 0.92% return.

Another important point though that wasn’t factored into the above analysis is the potential income tax incurred on said benefits. While the rules are complex, it is important to keep this in mind. In 2016, the computation of “combined income” = adjusted gross income (AGI) + non-taxable interest + half of your social security benefits. Depending on your combined income, 50% or 85% of your benefits could be taxed as outlined below (quoted from the Social Security Administration):

Constant Spending

So considering the added tax maybe social security isn’t so regressive after all…

Social Security is…complex? Yes, most certainly. Confusing? No doubt. But there are free online tools. Dr. Sharpe himself was a founder of one such tool known as the Financial Engines Social Security Planner although he is no longer involved with the company.

It doesn’t take more than 5 minutes or so and you can get a pretty little output chart like Lucy and mine below. I did say that our lifespan is expected to be longer than average based on the longevity studies discussed previously. As such, the recommendation for us is to wait until age 70 to begin claiming benefits to max lifetime benefits.

Constant Spending

Will we actually get a benefit though? I’m starting to think we might. I’ve never considered Social Security in my retirement plan for sake of being conservative. It is hard to rely on something that is so underfunded since we are so many years (decades…) away from actually claiming on the system.

Dr. Sharpe talks quite a bit about sustainability and given the popularity of the system it is hard to imagine it going away completely. Just imagine the backlash on Congress if they let it fail and “push granny off the cliff”. One simple solution he mentioned was to issue more Treasury bonds and fund the Social Security Administration that way. Of course future taxpayers would have to service the interest and principal so it wouldn’t solve the problem, just simply defer it further down the road. That is the D.C. specialty after all so it may not be so far fetched.

Who knows what will happen though. Dr. Sharpe does consider it likely that contributions must be increased as well as benefits being cut to help sustain the program. The 2016 Trustees Report concludes that shortfall could be eliminated an increase in payroll taxes of 2.2% or with cost reductions equivalent to about 24%. While Dr. Sharpe mentions these figures are likely overly optimistic, it does put it into context how the system could be fixed.

While Lucy and I have been contributing for over a decade and don’t plan on many more years of doing so with our planned early retirement, we’d be most impacted by a potential cut.

I think cutting our expected benefit by a third (33%) would be conservative. Based on the Financial Engine output above, that would mean my annual benefit of $43,200 would be $28,900 and Lucy’s benefit of $37,500 would be near $25,100 for a total of approximately $54,000 / year. That is still quite a meaningful figure and would provide a great safety net to our planning! And I believe this would be inflation adjusted by the time we actually begin claiming benefits, but feel free to correct me in the comments below.

But will it be taxed? Based on our early retirement investment drawdown strategy, I don’t think the social security benefit will be subject to tax. By the time we reach 70 and would begin claiming benefits, our taxable brokerage account will likely be depleted and we’ll be living on our Roth IRA (to which we plan to roll our 401ks into via the Roth Conversion Ladder). As we all know, Roth IRA assets aren’t taxable. Unless we have some other sort of income flowing to us, Social Security benefits should be free and clear.

Last thing I’ll mention regarding this chapter is that Dr. Sharpe does talk quite a bit about the funding status of not only Social Security (which isn’t good), but also on state and local government pensions (also horribly underfunded) and lastly on corporate pension plans (which are in decent shape). These systems aren’t of personal consideration for me, but if you are then feel free to give Dr. Sharpe’s Chapter 14 a read. It is an insightful read.

Constant Spending (The 4% Rule)

If you are part of the Financial Independence / Retire Early (FIRE) crowd than the 4% rule is not new to you. This is the safe withdrawal rate, along with the 3% or 3.5% derivative and more conservative “rules” that provide the basis for determining financial independence and the touted safe point to retire early and have everlasting wealth.

Dr. Sharpe again provided a great historical perspective about the coming of the 4% Rule along with other constant spending rules. One that I hadn’t heard of before was published in a Business Week article in the Fall of 2016 titled “Living on 4 Percent – or Less” in which Evan Inglis (an actuary at Nuveen Asset Management). He offered the alternative rule to “divide your age by 20 – couples should use the younger partner’s age – to get the percentage you can safely spend.” That doesn’t bode well for early retirees!! That would be a sub-2% withdrawal rate for Lucy and I which seems just a bit too conservative.

Dr. Sharpe also pointed out the retirement nest egg calculator as a planning resource which I wasn’t previously aware of. I have primarily resorted to FIREcalc or cFIREsim.

The Analysis

Throughout the book, Dr. Sharpe has revolved the analysis around his protagonists Bob and Sue, a typical retired couple in their 60s. I don’t blame him for making such a vanilla choice of protagonists, not as many folks could relate to an early retiree couple in their mid-30s…although wouldn’t that have been perfect :).

The case revolves around their particulars though, including longevity with a max of 50 years. To give you a snapshot, Dr. Sharpe starts with the assumption of a market portfolio which holds equal relative proportion of all available marketable securities (which I discussed initially in the part 2 market returns post) along with a 4% payout ratio.

After running it through his simulators and discounting values back to the present, the conclusion is that 16.9% of the total value ends up going to their estate. Said differently, considerable money is left on the table. Running the program with different payouts shows a likely range of corresponding results:

Constant Spending

Stating the obvious, the lower the payout ratio (safe withdrawal rate) the happier are the heirs of Bob and Sue. And the heirs’ gain is Bob and Sue’s loss.

My personal view is that I’d rather my last check bounce. I hope to put my kiddos on good solid ground in other ways so that they are contributing members of society and not in need of an inheritance. But at the same time, I don’t want to risk running out of money. So I plan to be conservative and utilize a 3.5% safe withdrawal rate or less to ensure a stable retirement. If there is some left over at the end, so be it and good for my heirs.

The Problem

Dr. Sharpe is not a fan of constant spending strategies, but when I read the reasons why I am not surprised. They really aren’t a perfect plan for practical use for withdrawals. I do think constant spending plans are really useful to help frame up the approximate size of retirement portfolio for a safe retirement though.

Dr. Sharpe’s problem derives from the fact that advocates call for constant spending going forward with little or no regard for variations in portfolio values. The 4% Rule (and variants) finance constant, non-volatile spending plans using risky, volatile investment strategies. Dr. Sharpe appears to be recognizing sequence of return risk with his comments. And ultimately he criticizes such rules for inefficiencies in over-payments and wasteful spending since many retirees prefer cheaper spending plans.

Personally, I don’t get too caught up in his points of criticism. Especially for early retirees that may have really long retirement horizons, there is no way around the inefficiencies in any contemplated plan unless you risk running out of money. I’m an advocate for conservative plans and am ok with leaving a significant estate. There could be worse outcomes for working an extra year or two to ensure a safe and secure retirement.

The Potential Solution: Constant Spending plus Social Security

As I’ve come to realize Social Security could be there for me in some form or fashion, I may end up resorting to this strategy. The point being that most folks are not solely reliant on discretionary savings for retirement income and do have some sort of fail-safe, be it a pension plan of some sort or Social Security. Combining the two solutions as sources of retirement income provides outcomes that need not conclude in starvation if discretionary savings are depleted.

For the sake of efficiency and not resorting to a potential large estate, Dr. Sharpe seems to be advocating for less cushion and conservativism than I would. He goes on to note that in the context of other sources of income, constant spending policies aren’t as unattractive as when considered in isolation.

Not surprisingly then, Dr. Sharpe is not a fan of constant spending strategies and instead advocates for a different approach with variations in spending patterns. He discussed alternative strategies in future chapters and, given the length of this post, I will resort to discussing them in next weeks part 4 and final installment on RISMAT.

A quick view of one of his potential solutions: spending a portion of savings over a given number of years and using the remainder of savings to purchase an insured income stream such as an annuity product.

Stay tuned for next week’s post to wrap up Dr. Sharpe’s RISMAT book with proportional spending, lockboxes and ratchet spending strategies.

Thanks for taking a look!

The Green Swan

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12 Comments

  1. JW –

    Just caught up on the series, missed part 2 when it was posted. Ah the last two weeks have been a bit crazy due to work and enjoyable due to summer festivities!

    The new information on Social Security was quite interesting to me, as I hadn’t thought about the benefit of retiring early being that you don’t pay on it as much throughout those years, and still receive the benefits later in life.

    Also – Joshua Kennon is a huge fan of TIPs, so it was interesting to see that you were not. Could you elaborate more on why?

    Thanks for sharing man – hope all is well!

    1. Hard to believe summer is almost over, huh? Seems like it only just began but glad you’ve been able to enjoy it.

      I’m not a huge fan of tips for much of the same reasons I’m not a fan of other government securities or corporate bonds and that is primarily because of their suboptimal returns.

      My view is nothing can beat stocks so as long as I have some extra cushion and can stomach the volatility then I’ll just stay 100% in them.

      My view on tips isn’t overly thought out so I’d be curious to read up on Joshua Kennon’s view. Perhaps I’m missing something.

      Thanks for the great comment!

  2. Hi GS, I’d recommend using the PoF XLS from his SS Bend Points post to calculate your SS projections. The SSA site is notoriously bad for projecting your benefits with the assumption that you continue to work.

    If you use the PoF calculator and input your SS earnings to date, it will calculate your AIME which is then used in a standard formula to calculate monthly benefit at your standard retirement age. You can then work out age 70 (late) or age 62 (early) from there. Since AIME is averaged over 35 years (420 months) of SS contributions, AIME for a very early retiree is going to be low unless of course you have a specialist physician salary and have been able to maximally contribute to SS in a short working life…..

    1. Hmm great points, Mr Pie. I didn’t realize that and given Dr Sharpe is not focused on early retirees in his book I’m not surprised that point didn’t come up. Very value-added comment!

      Sounds like that can be a very material adjustment to the SSA estimates so I’ll be sure to check out PoFs xls.

      Thanks!

  3. I’ve incorporated Social Security in my plans, but it’s really a buffer and not a very material part.

    I would say that those figures for present value to estate are highly dependent on sequence of returns. I’m starting to think that is the key metric to analyze, and average return provides a useful guide, but is actually no help when you are actually executing your spendown strategy.

    Great to see a shout out to actuaries with the Age/20 rule! That is such a great example of the divergence between actuarial thought and standard FI thinking. I have his paper sitting on my desk and I am planning to write a post on this huge discrepancy.

    1. Great comment, AoF! I agree with having social security serve as a buffer and if we collect on it, it’ll serve mostly as a means of passing more wealth onto heirs which I’ll feel good about.

      Agree as well with your point on sequence of return risk. Focusing on that is helpful because it’s a worst case scenario type of thing, and then secondarily what contingencies you have in place to shore up your finances if needed.

      I look forward to your post, feel free to come back and link to it once it’s published!

      Thanks!

  4. Nice job explaining this complicated material, JW.

    Even though we’ll get SS, we haven’t accounted for it. The biggest fly in the ointment is healthcare costs (as you know we’ll). I honestly fear about health insurance is going to perpetuate the one more year syndrome for younger retirees with long life horizons.

    Whatever happens, I don’t believe it will become less complicated in my lifetime. And at some point, Medicare age will rise and may align with the SS FRA (full retirement age). I hope to see more bloggers writing about medical tourism. Frugal Vagabond has some excellent posts about his experience in going to Thailand for dental work.

    Sorry for going off on a tangent but I think we all need to be creative in coming up with flexible strategies for dealing with healthcare costs and slaying the fear dragon.

    1. I totally agree, Mrs Groovy. Medical tourism is still a pretty new concept for me too. I’m a little skeptical of it and whether the treatment quality is up to snuff, etc. I’m guessing it may be and that I just suffer from bias there, but who knows? Maybe this ” industry” will continue to develop.

      Thanks for the comment!

  5. It was only a few years ago that I read some posts about how SS is designed to give roughly the same payout depending on when you decide to take it. In other words if you take it early, you collect less but, also collect longer, if you wait, you collect more each pay but it’s several years until the break even point. If you assume that is true, which I do now, the SS decision for me comes down to if you are working or not at 62.

    When I get to FIRE, I still plan on doing some type of work stuff. It will be less than what I do now, and it will be on my schedule etc. The point being, if I’m 62 and working my 15-20 hours a week but I built some business that still pulls in an income that is considerable, then I will likely wait. If I do not, and I “need” my SS then I take it at 62. When I say need, I don’t mean I wouldn’t have other money to draw from because I will. But why would I take from money my heirs would get instead of taking my SS early? That seems very silly to me. Waiting until 70 to try to beat the system (by living longer), only makes sense to me if I still have high income (between 62-70) such that I am not using any of my retirement funds yet. I see this unlikely since I am 45 and I already have the FIRE itch.

    1. Great points, Chris, and I appreciate you sharing that. I’ve never looked too much into SS myself to understand the design, etc, but that makes sense.

      My parents are nearing that age though and they plan to retire next year. I know they’ve looked into it extensively and for curiosity sake I’ve been meaning to pull their ear on that.

      I like your plan though… Might as well leave as much as possible for heroes in that situation!

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