The RMD Strategy for Retirement Income Withdrawals ...

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The RMD Strategy for Retirement Income Withdrawals (Preliminary Version)

Floyd Vest, Oct. 2014

We will explore the possibility of basing retirement income withdrawals on the Internal Revenue Service (IRS) rules for Required minimum distributions (RMDs) which is used for 401k and IRA retirement plans. See other articles in this course such as "The 4% Rule for Retirement Withdrawals." We investigate this strategy by going to the internet, and going to Search, AARP RMD Calculator, and click on the site. In order to follow this discussion, the student should be looking at this AARP Required Mandatory Distribution Calculator. Since the Calculator had $100,000 balance at age 70, and Estimated rate of return of 4%, we used these figures. For Spouse beneficiary age, we put in Age 70 for simplification. Then we clicked Calculate and got a bar graph of Projected required minimum distributions (RMDs) from Age 70 to Age 100 and a graph of Projected account balance from Age 70 to Age 100. We printed this out. We clicked on View Report to see the report in tabular form, and printed it.

The tabular report gave for each of Age 70 to Age 100, the IRS Uniform Life Expectancy, the Required Minimum Distributions, and the remaining Balance in the IRA, 401k account. One way to interpret the table is to calculate the IRS RMD percentage withdrawal which is one divided by the Uniform life expectancy. Thus for Age 70, the percentage withdrawal is 1 = .0364964 = 3.64964%. Actually the IRS Publication 590 says to

27.4 determine Required minimum distribution, divide the Account balance on Dec. 31 of previous year by 27.4 . We will use as an approximation, the percentage withdrawal, for purposes of comparison with other retirement withdrawal strategies such as the 4% Rule.

For the 4% Rule, for living expenses for the first year, one withdraws 4% of all retirement funds at age 65. Each subsequent year the withdrawal is increased at the then current rate of inflation. The 4% Rule is the most common recommended rule but there are other rules which have better efficiency as judged by certain methodology and standards.

We will build Table 1 comparing percentage withdrawals by the 4% Rule and the RMD Rule as follows. We will use an inflation rate of 3.2% which is a long term average.

Table 1- Percentage Withdrawals

Age

70 75 80

85 90 95

RMD Rule 3.6% 4.4% 5.3% 6.76% 8.8% 11.6%

4% Rule 4.69% 5.50% 6.45% 7.55% 8.84% 10.75%

We notice from Table 1 that the RMD Rule is more conservative than the 4% Rule in that it starts at Age 70 with a smaller percentage withdrawal than for the 4% Rule. The 4% Rule has been studied historically and has a small chance of running out of money in 30 years and a significant chance of leaving a large amount of money on the table on the target date.

One advantage of the RMD strategy is that it is sensitive to remaining longevity, and it is easy to follow. Wei Sun and Anthony Webb (See the References.) give a withdrawal percentage for Age 65 of 3.13% from a longevity table. The RMD strategy allows in Table 1 about the

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same percentage withdrawal as the 4% Rule beginning at Age 90 and increasing. Both strategies are sensitive to investment returns since if the balance is less, the withdrawal is less.

Wei Sun and Anthony Webb compared four withdrawal strategies by a Strategy Equivalent Wealth (SEW) factor where an Optimal rating is one. The RMD strategy ranked third in efficiency. (See the References.)

They developed a Modified RMD strategy and compared five strategies. It ranked the most efficient. This strategy involved the RMD percentage withdrawal plus withdrawal of investment earnings for the year, in dividends and interest. It seems that the strategy would be recommended for the earlier years, or years when the RMD percentage doesn't supply adequate funds for living expenses. This Modified RMD strategy had a near optimal score by the SEW factor.

These RMD Calculators at AARP and Fidelity give most of the information we need to investigate the RMD withdrawal strategy. Imagine what it would take to write your own spreadsheets. We learned about them from an article by Scott Burns. (See the References.) Since many people, for many reasons, begin retirement at Age 70, an RMD table beginning at Age 70 is timely. For retiring at Age 65, some people could make their own adjustments to the RMD Table. In his work with the calculator, Scott used a long term average return of 6%. The student can supply their own numbers for rate of return and inflation. (See the Exercises and References.)

What rate of return on the retirement fund should you assume? The AARP calculator put in an example of 4%. The calculator tells us that the return for S&P 500 Index for the 10 years ending Dec. 31, 2013, was 7.3% including reinvestment of dividends. From Jan. 1970 to the end of 2013, the average total return was 10.6%. It is interesting that highest yearly return was 61% (June 1982 to June 1983), and the lowest was -43% (March 2008 to March 2009). It is recommended that during retirement, funds be invested in a balance account of stocks and bonds and gradually reducing the exposure to stocks as the target date approaches. You can do this for yourself by using low cost, low taxes, index funds. Then there is the question of, for tax purposes, what kind of investments belong inside the IRA and belong outside the IRA.

What Life expectancy does a couple have? We present Table 2 giving two Life expectancy tables which can be used in retirement planning. It gives the life expectancy for one or both of a couple, for different ages, assuming that the spouse is ten years younger.

Table 2, Life expectancy

Age

65 70 75 80 86 90 95

IRS Uniform Life expectancy

31.9 27.4 22.9 18.7 14.8 11.4 8.6

5% Life expectancy

37 33 27.7 22.2 16.9 11 5.5

(See Blanchett for the 5% Life expectancy.) Interpret these tables.

Here is Longivity Table 3 from a different point of view. It gives the probability of living to a certain age, once they reach Age 65.

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Table 3, Longivity Table (TIAA-CREF Participant, Nov. 1990)

Age

65

85 90 95

100% 58% 38% 19%

Then there are tables in other articles in this course which give the chances that one or both of a couple will live to a certain age. Interpret the above tables.

Side Bar Notes:

P/E's (Price to Earnings Ratios) vary with prices of the S&P 500 Index of Stocks and events which punish the market. From Dec. 1988 to June 2014, the Shiller P/E varied from 12.9 to 45.5. The Shiller P/E is based on the previous ten years. The higher the Shiller P/E the lower the average returns including dividends for the next five years. Also, the maximum downside risk increases. In 1990, the Shiller was up to 45.1 which Morningstar said is ridiculously high. Over 1988 to 2014, the average was 21.9. Since 1988, the Shiller has increased at a nominal rate of 5.6% per year, 2.8% real rate, with CPI Inflation at 2.7%. On a graph from 1988 to 2014, roughly when the market is down the Shiller is down. When the Shiller is down, both stock prices and the Shiller rise (Morningstar, Stock Investor, Aug. 2014).

Success of investment types. From 1976 to 1999 inclusive, for stocks, Small Value led for nine years, was bottom for four year. The results are similar for Mid Value, Large Value, Small Growth, and Large Growth. All but one beat the S&P 500 which for 24 years grew $10,000 to $387,000 but Small Value stocks to $602,000. What index represents Small Value? Calculate the rate of return. (Mutual Funds, June 2000, page 50)

Triple tax free bonds and bond funds. For many states and cities with income tax, as well as federal income tax, triple-tax-free bonds and funds are owned by investors who are invested in the bonds issued by the residence city and its agencies (Mutual Funds, May 1998).

The RMD strategy coupled with an immediate inflation-adjusted annuity produced stable cash flows that grew faster than those of other rules of thumb (A 2010 Vanguard Group paper).

Retiree taxes. Kiplinger''s retiree tax map (tools/retiree map) is a state by state guide that can help to determine the most tax friendly states.

Online Social Security statements. Go to mystatement. You see your benefits statement, it provides estimates for retirement, disability and survivor benefits.

Laddering immediate annuities. For 1980 to 2006, a stock and bond portfolio ended up with $489,346, while one with laddered annuities ended with $735,292. ( A MassMutual study, Kiplinger's Retirement Report, Aug. 2014) Perhaps this period was carefully chosen. Consider current Single-Premium Immediate Annuity Monthly Payout Factor, Male age 65, Highest $5.83, Average $5.52. Explain what this means. For a 65 year old man, what is the average total payout? What do they mean by "ended up with"? You might find this study on the internet. It certainly will be quoted by salesmen.

"When fees cost more than taxes": (Scott Burns, Denton Record Chronicle, Sept. 21, 2014). Many people saving for retirement invest in tax deferred Large Cap Variable Annuity

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funds for which the average expense ratio is 1.86%. For balanced Variable Annuity funds the average expense ratio is 2.09%. Assuming a 6% return, 2.09% is 34.8% of a 6% return. For money invested in a taxable S&P 500 index fund, taxes are at most 15% of the return. So, here we have fee costs which are more than taxes. For the index fund, the expense ratio is only 0.17%. But maybe you can choose a fund which out performs the index. The probability of beating the index can be only 9.7% on average. (See the article in this course, "Investing in Tax Deferred Variable Annuities," Fall 2012.)

The bucket strategy for retirement withdrawals recommends that you keep one years living expenses in a low volatility investment, and use it in years when the market loses money, so you won't have to sell shares when their price is low to acquire needed funds.

Stock Superstars. Historically, there is a collection of well- known superstar stock investors. If you study financial mathematics, you will learn their names, investment style, and their performance. In this article, we feature John Neff with whom the author invested for years. During his 30-plus years at the helm of the Vanguard Windsor fund, he produced an average annual return, that beat the market by 3% each and every year. What does "beat by 3% mean"? AAII claims that for the last 12 years ending in 12/31/13, the S&P 500 had a 107.1% gain and the John Neff style gained 392.2%. Use your mathematics to investigate these figures (AAII, 2014). Was this 12 year figure arrived at by back testing?

Anthony Webb, author of "Retirement Withdrawals: Can You Base Them on RMD?" which is quoted in this article, is a research assistant at the Center for Retirement Research, at Boston College. At the end of their article is a blog discussion of readers' concerns. You might be interested in reading and answering their questions and reading the supplied answers in the blog. Go to the website for the Center for Retirement Research and read the interesting and informative research articles. See the References for the study from which their article was drawn and an explanation of their SEW factor, and answers to other questions about their article.

Save $58,000 on a target date fund. Assume you are 40, aiming to retire at age 66, and considering putting $100,000 in a well-known target date fund for 2040 with .78% expense ratio. Consider a homemade portfolio of ETFs with a composite expense ratio one-tenth as high. Put $54,000 in SCHB, Schwab US Broad Market; $27,000 in VXUS, Vanguard Total International Stock Index; $14,000 in SCHZ, Schwab US Aggregate Bond; and $5000 in BNDX, Vanguard Total International Bond Index. To replicate the target date fund, gradually shift from stocks to bonds as you approach the target date. With a 5% gross return, the target date fund would grow to $290,000 and the homemade portfolio to $348,000 (Forbes, June 30, 2014). Many target date funds have an expense ratio as high as 1.20%. Many ETFs can be purchased without commission from the mutual fund family that issues the ETF. Do the calculations that verify the above numbers. You can look up these ETFs on finance.. You might set your target date to an age many years after retirement, for example for retirement at age 66, set it at age 96.

During retirement gradually move toward investments that are not subject to interest rate risk and market risk. For example you can hold a ladder of individual bonds which you plan to hold to maturity.

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Roth 401(k) accounts are subject to required minimum distributions (RMD) at

Age 70 ? . However, once you leave your employed, prior to Age 70 ? , the Roth can be rolled over to a Roth IRA which has no RMD (T. Rowe Price Investor, March 2014). For information on IRAs and 401k, see IRS Publication 590 at .

T. Rowe Price Social Security Benefits Evaluator allows you to calculate the complex alternatives for collecting benefits. If certain selections are made, the benefits are only slightly more than half of the maximum amount. See the articles in this course on Social Security one of which is "Delayed Social Security Retirement and Increased Benefits," March 2014.

The average investor underperforms the market. They make poor decisions about when to buy and sell instead of staying the course in the market (T. Rowe Price Investor, March 2014).

"The coming longevity battle," Scott Burns, Denton Record Chronicle, March 23, 2012:

From 1990 to 2008, while most Americans gained three years in longevity, white women with little education lost five years.

In 2008, college educated whites lived ten years longer than black Americans with less than a high school education.

For men born in 1912, higher income white male workers lived 1.2 years longer than lower income white workers. For men born in 1941, they lived 5.8 years longer.

Net Retirement Income Replacement Rate Provided by Social Security

Retirement age

62

65

70

2010

28%

38%

2030

24%

31%

Increased to 43%

Notice the declines in net retirement income replacement rate, and the above several widenings of the gap. There is also an interplay here of income level, educational level, and race. (See studies by Hilary Waldron, an economist for the Social Security Administration; by demographer S. Jay Olshansky; and economist Alicia H. Munnell of the Center for Retirement Research, Boston College. )

In 2010, for the median income level, Social Security replaces 38% of preretirement income (Center for Retirement Research, Boston College).

Scott generalized for income level, age, and educational level. See if you can generalize and apply the above data.

Two questions. Did Wei Sun and Anthony Webb withdraw a constant nominal 4% or did the withdrawals increase each year at the rate of inflation? Perhaps they were working with a real rate of return on investments which would not require an inflation adjustment. See the article in this course, "Varying Annuities and Real Rate of Return." How can you use the RMD method to conveniently calculate the amount of money required to fund retirement? For age 70 retirement, would you use an amount P where the first withdrawal R is 3.6% of P? The SEW was calculated as a Monte Carlo historical test of survivability and efficiency. (See the References.)

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Exercises: Show your work. Name answers, variables, and numbers. Conduct discussions in complete sentences.

#1. (a) When Scott used 6% in the AARP calculator, he said the compounded annual growth rate for income from Age 70 to Age 100 would be 3.37%. The balance would peak at Age 82. He said these figures improve if you use 7%. Do the calculations to check Scott's figures.

(b) Based on your research, what average rate of inflation do you suggest? What average rate of return on investments do you suggest? Give references. What is wrong with using long term constant averages in projections?

#2. (a) Assume at Age 70 a retiree needs $50,000 in living expenses and has $25,000 in Social Security. According to the 4% Rule, how much should be in the retirement fund? (b) Put this number in the AARP calculator and use 6% return. (c) Print and discuss the graphs and tables. (d) What rate of inflation would annual withdrawals keep up with? At what age does the balance peak and what is the balance? How much remains at Age 85, 95? How far short of the needed $25,000 is the IRS RMD withdrawal at Age 70? What could be done about this?

#3. If at Age 70, the retiree can spend 4% income in dividends and interest, what percentage can he withdraw by the Modified RMD strategy?

#4. Fit a quartic polynomial to Table 1. Graph it and discuss. Use Trace and build a table for Ages 70, 75, etc. which repeats Table 1, gives the polynomial values, and gives the accuracy differences. See pages in Chapter 12 of the TI84 manual including page 12-25, and 12-26. Is there an available regression that better fits the data?

#5. For our first table from the AARP calculator, do a regression for Age and Minimum Distribution, and for Age and Balance. Graph and discuss.

#6. Since traditional IRAs and 401ks require minimum distributions and Roth IRAs don't, other things being equal, is there a financial advantage to changing the traditional to a Roth? What are the IRS rules for making this change?

#7. Wei Sun and Anthony Webb presented a Base withdrawals of life expectancy strategy which uses a formula to spend all financial assets over one's life expectancy, as predicted by life tables. Their formula is Annual withdrawal = (r / (1(1 r)t )) wealth , where r is the risk free interest rate of return and t is the remaining years of life expectancy. They say there a two significant drawbacks. What are they? (a) Calculate the above Annual withdrawals for the 4% AARP table, and our Table 1, for Age 70 using 2% as the risk free rate of return. (b) Is 2% a reasonable figure? (c) At earning of nominal 4%, does this withdrawal suggest that the fund might run out of money? Try Age 75, Age 95. What percentage of wealth would be withdrawn if there was one year of life expectancy left? (d) Can you graph the percentage withdrawal from Age 65 with t = 31.9 years to t = 1 year? Discuss the graph. (e) Why is the IRS Uniform Life Expectancy at Age 100 as large as 6.3 years?

#8. (a) Calculate the amount of money P required to fund retirement starting at $50,000 the first year, and increasing at 3% inflation each year, earning 6%, and lasting 35 years.

(b) Assume that there is a 10% loss in P to start with. How long does the money last? If there is a 40% loss as in 2008, how long does the money last? What do they call this effect?

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#9. Calculate your own retirement planning program from scratch. Put up your own time line with ages and dates, your choice of retirement age and longevity, the cost of living for retirees in today's dollars, your own rate of inflation, the annual cost of living at retirement, the annual cost of living at the target death date, your own rates of return on investment during savings and during retirement, your own savings program, and your own estimate of Social Security at retirement. Calculate the amount of money needed to fund retirement. Calculate the cash value of your Social Security at retirement. Calculate the total retirement worth at retirement. If you use the 4% rule, calculate the rate of interest required for the money to last. Calculate how much is left on the table with the 4% rule, if you earn 9%. Do some graphs. Do any calculations you wish and report anything you wish. Explain details, give references, and justify some of your assumptions. If you use an on-line retirement calculator, explain all of it, and check it with mathematical formulas.

#10. Use the TI 83/84 and mathematical formulas to solve the following problem efficiently by a program or by efficient use of the TVM Solver. Do not reinter by hand calculated answers. Describe your device and method (code).

Let us assume that a 25-year old single person needs $35,000 a year to live in 2014 dollars and expects to retire at Age 65. The person will have Social Security benefits that are $14000 a year in 2014 dollars. The person has a level retirement program $5000 a year in 2014 dollars, both of which increases at the rate of inflation until retirement. With inflation at 3.2%, retirement living expenses would increase at 3.2% per year. We will assume that salary increases each year at the rate of inflation before retirement. Let us assume that the person saves for retirement and the savings earn 7% and the person lives until Age 95. Fill in the blanks.

Assuming $35,000 in 2014 dollars, the cost of living at Age 65 would be __________________ and the cost of living at Age 95 would be __________________ .

We can calculate the total retirement assets P needed to provide all of the increasing living expenses from Age 65 as long as the person shall live to be

P = ______________________ .

Assuming that before retirement, benefits increase at the rate of inflation, we can calculate the value EMP at retirement of the level retirement program. We can calculate the value SS of Social Security with its COLA at the time of retirement.

EMP = ______________________ and SS = __________________________ .

The person has on hand $5000 in retirement savings in 2014, which has a value B at the time of retirement. B = ______________________ .

We can calculate the value Z needed at retirement to supplement the above resources at Age 65. Z = ________________________ .

We can calculate the value J = first savings at the end of the first year and increasing each year at the rate of inflation, assuming that salary increases at the rate of inflation, to accumulate the value Z which at Age 65, supplies the needed retirement supplement.

J = __________________________ .

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What is wrong with using a constant rate of return and inflation during the retirement income withdrawal stage? What do the above figures tell you in comparison to the RMD or 4% rules? How could you improve this problem? (We are not using italics variables since the TI 84 program code is not in italics.)

References:

Wei Sun and Anthony Webb, "Retirement Withdrawals: Can You Base Them on RMDs?" AAII Journal, Dec. 2012. To find this article on the internet, simply Search.

Scott Burns, "How to overcome fear of required distributions," Denton Record Chronicle, Sept. 28, 2014.

Blanchett, David, Macief Kowara, Pen Chen, "Optimal Withdrawal Strategy for Retirement Income Portfolios," , Research publications.

See IRS Publication 590 for rules for required mandatory withdrawals, on .

Wei Sun and Anthony Webb, "Should Households Base Asset Decumulation Strategies on Required Minimum Distributions," Center for Retirement Research, Boston College. They give a table of RMD in accordance with IRS beginning at Age 65. They explain the SEW.

Wei Sun and Anthony Webb, "Can Retirees Base Wealth Withdrawals on the IRS' Required Minimum Distributions?" Center for Retirement Research, Boston College, October 2012.

References in this course:

"The 4% Rule for Retirement Withdrawals"

"Evaluation of Five Methods of Retirement Withdrawals," May 2014.

"The Mathematics of Financial and Social Responsibility."

For a free course in financial mathematics, with emphasis on personal finance, for upper high school and undergraduate college, see . Register and they will e-mail you a password. Simply click on an article in the annotated bibliography, download it, and teach it. Unit 1: The Basics of Mathematics of Finance, Unit 2: Managing Your Money, Unit 3: LongTerm Financial Planning, Unit 4: Investing in Bonds and Stocks, Unit 5: Investing in Real Estate, Unit 6: Solving Financial Formulas for Interest Rate, Unit 7: More Advanced or Technical. For about thirteen more advance or technical articles, see the UMAP Journal at COMAP. The last section is Additional Articles on Financial Mathematics or Related to Personal Finance. In all, there are about eighty articles.

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