By Ricardo Ulivi, Ph.D. and Sky Nguyen
Setting a “safe” withdrawal rate is a great way to start taking retirement income, but advisors should monitor their clients’ “funding ratios” and “burn rates” to gauge the sustainability of their
“I just don’t want to run out of money during my retirement!”
In my more than 30 years as a financial advisor, I have heard this—or at least some version of it—from client after client. It’s understandable. After all, who looks forward to a retirement that depletes a nest egg far too early?
Truth be told, if this is the only concern on the mind of a person facing retirement, the answer is really quite simple. You need only radically minimize expenses in order to extend savings as long as possible. But who wants to live like a miser?
Retirees didn’t save for years and years just to let the money sit in an account while pinching pennies. They want their money working for them as a resource for attaining their vision for retirement. But, how much can they safely withdraw each year? What happens when uncertainty strikes?
As planners, we can make all sorts of assumptions and projections for our clients, and develop likely cash flow and investment scenarios. But we can’t predict what will happen. As much as we hate to admit it, we are often times just guessing, regardless of our Monte Carlo analyses. So, how should retirees utilize their money now, while at the same time remaining confident that it will be available throughout their lifetimes? Researchers like William Bengen and Jonathan Guyton have provided some answers to this question.
In general, they said that if you invest in specific ways, you can safely draw an initial percentage (4% to 5% of your total savings) and expect to increase this income stream with inflation each year for at least 30 years. Guyton also provided some excellent rules or financial “guardrails” a retiree should implement when the withdrawal rate is too high or when market performance doesn’t match expectations.
Funding ratio and burn rate
Along with these excellent rules, we propose that planners adopt two additional ratios—the funding ratio and the burn rate. These ratios are designed to set off warning signals when spending gets out of line and give planners additional ways of gauging a retiree’s ongoing financial wellbeing. You might think of them as a retirement dashboard. Even if everything is in good working order when retirees begin their journeys, you can’t ignore the gauges and warning lights along the way.
The funding ratio is well-established as a warning indicator for defined benefit plans. It is calculated by taking the market value of a retiree’s portfolio and dividing it by the present value of future expected withdrawals. The funding ratio should be 100% (or higher for extra protection). If the ratio stays at 100% from the first through the last year of a person’s retirement, there will always be enough money to meet planned withdrawals.
What if, during one’s retirement, the funding ratio falls below 100%? This suggests that there are not enough savings to meet future withdrawal needs. Something must be done. One remedy is to implement the financial “guardrails” explained by Guyton. At minimum, one should consider cutting planned withdrawals to ensure that the funding ratio returns to the safe level of 100%.
The other benchmark we recommend is the burn rate. This is the rate at which next year’s planned withdrawal rate differs from this year’s actual rate of return. If it is negative, it means the retiree is withdrawing more than he is earning.
If the burn rate is positive, it means the retiree is withdrawing less than she could, and her capital will grow. If retirees do not want to deplete their capital, their burn rate should be zero. The higher the burn rate, the faster capital will be depleted.
To illustrate, let’s apply the funding ratio and burn rate to a hypothetical case in which a married couple, “Bob and Mary,” is planning for their retirement. Bob is a 63-year-old doctor and Mary is a 60-year-old housewife. Bob is retiring at the end of the year with a $1,000,000 IRA. Bob and Mary would like to withdraw $64,000 per year, with annual increases to match inflation, to the age of 93. Assuming 3% average inflation, their withdrawals should be $64,000 for the first year, $65,920 for the second year and so on. If their portfolio is diversified and well managed, including equities, we would expect that their $1,000,000 account will earn an average annual compound return of 6.5% throughout retirement.
Let’s explore how Bob and Mary’s retirement might play out if the market doesn’t cooperate, and if warning signals are ignored and no corrective actions are taken.
Table 1 summarizes a retrospective analysis of Bob and Mary’s retirement plan over a 30-year period. It reveals some unpleasant details. Their initial withdrawal rate was clearly too high at 6.4%. Even more worrisome is the fact that their funding ratio was projected to be 73.6% at the end of the first year of retirement—well below the funding ratio of 100% that indicates longterm sustainability.
The burn rate indicator is also blinking yellow. Though only -0.1%, this burn rate signals a troublesome future. It means that Bob and Mary withdrew money faster during the first year than the portfolio earned it. They withdrew 6.4%, yet only earned 6.5%.