One of the biggest changes between the working years and the years of retirement (partial or full) is the sources of income to pay the various expenses of daily living. While lawyers are working, most receive a periodic payment of income, such as a salary or a draw against partnership income. Sole practitioners might have a less-certain stream of income, but even they can often rely on the proceeds of monthly bills sent out.
By contrast, in later years this source of income will often be greatly reduced, perhaps even eliminated when full retirement occurs. Even if lawyers continue to practice to an extent past the normal retirement age, income will likely be lower than in more active years of practice. In any case, it might become necessary to use retirement assets to fill in gaps in income being earned. This situation presents some challenges to effective financial planning and household budgeting.
In an earlier era, many people (but not many lawyers) had access to defined benefit pension plans, which pay a specific amount each month and continue for life and, in some cases, the life of a spouse. Nearly everyone will have a similar form of payments in the form of Social Security benefits, which also continue for life without regard to personal saving habits. But for most people, Social Security payments will not be sufficient to cover all living expenses, though they will be very helpful.
The era of defined benefit pension plans has ended for most people, except those in government service and unionized industries. And even in their heyday, defined benefit plans, were not available to most lawyers. The prevalent form of retirement saving for lawyers as well as most others in the workforce today, is a defined contribution retirement plan, the type of retirement saving in which contributions are made, often by both employers and employees, and the fund for retirement is determined as the lump sum produced by annual contributions and the earnings on them. Provisions of the Internal Revenue Code make this form of saving very advantageous from a federal tax standpoint, but they do not guarantee a particular lump sum or a monthly benefit.
It’s worth noting that lawyers and other self-employed persons did not always enjoy the benefit of this form of tax-friendly saving. Social Security did not cover self-employed persons until the 1950s, and self-employed persons were not able to contribute to tax-advantaged retirement plans until 1962. Even then, contributions were permitted only at a much lower level than was permitted for common-law employees. The contribution limits are now the same, but it took long years to get to that point. This has surely been a factor in the unwillingness or inability of lawyers to retire at ages similar to those of the general public.]
This presents the dilemma referred to in the title: if your retirement fund is a lump sum account, how much can you safely withdraw each year to enjoy a comfortable retirement, while minimizing the chances of depleting the account while you still need it? (“Dilemma” often refers to a choice between two options, but I am using it in the sense of the multiple choices of how much to withdraw.)
The determination of how much to withdraw is complicated by two factors:
- Retirement accounts can fluctuate in value significantly over time, as the underlying investments increase or decrease in value. If a substantial percentage of the assets in a retirement account are invested in stocks or stock-based mutual funds, the value of the account will rise or fall depending on the behavior of the stock markets. Anyone whose retirement account experienced the stock market declines of 2000-2001 and 2008-2009 can attest to that statement. This kind of fluctuation can be minimized by investing in fixed income assets, such as bonds or bond-based mutual funds. The difficulty with that solution is that bonds have historically underperformed stocks, so a retirement account with a high percentage of investments in bonds will probably be much smaller at retirement than one focused more on stocks. Several commentators, including Dr. Jeremy Siegel of the Wharton School at the University of Pennsylvania, have shown that stocks generally outperform bonds in nearly every 10- to 20-year period over the past 100+ years. Consequently, most people will have a high percentage of stocks in their retirement accounts. This means that there is a real possibility of significant fluctuation in account values, and this can affect the planning of how much can safely be withdrawn each year. That is, while someone might decide that it is safe to withdraw X% of the account each year, that feeling of safety will be undermined if the account declines by 20% one year because of a bear market for stocks.
- In addition to the fluctuation in the value of the retirement account, the expenses that need to be covered by withdrawals also can change significantly. Items such as medical expenses and travel costs can vary substantially from year to year, and the need to withdraw more from the retirement account to cover them will affect how long the account lasts. Some of these costs can be controlled; others can’t. But even those costs that can be controlled or deferred involve a cost, although not a financial one: by putting off activities like travel, you are increasing the likelihood that you will never get back to them.
Given these uncertainties, what if any determination can be made of a safe withdrawal rate from a lump sum retirement? As indicated above, the concept of a “safe” withdrawal rate means a high percentage probability that the retirement assets will not run out during the individual’s lifetime. It does not mean absolute certainty. Even with careful planning, it is possible for a variety of reasons that the retirement account will be depleted. In this context, the term safe means a high percentage of success that the account will not be depleted, when viewed over a large number of different scenarios of investment returns. This type of analysis, called a Monte Carlo simulation, measures success or failure against thousands of simulated investment results. For example, if a particular withdrawal rate has a 95% success rate in thousands of simulated investment results, this suggests a high level of safety; and, conversely, a 25% success rate is a source of concern.
It is not possible to pinpoint a percentage rate of withdrawal and say that it is the safe rate. Some writers have offered a 4 percent rate as being reasonably safe. Others have disagreed. In view of the factors discussed above, it probably doesn’t make sense to focus on a single percentage rate over the entire period of retirement. It’s likely that in early retirement, more money will be spent on things like travel. As one gets older, these expenses will probably decline. In addition, medical expenses will often increase with age. It might be more realistic to aim for a range of withdrawal rates. For example, in the early years of retirement, one might withdraw 5-6% of the retirement account to cover expenses beyond those that can be met by Social Security payments and other sources. In later years, the percentage might drop to 3-4%. Also, the percentage rate might differ depending on the age attained when withdrawals begin. Waiting until age 72, the current age at which most people must begin taking distributions from retirement accounts, could permit the percentage to be higher than for someone who began withdrawals at age 65.
Clearly, this is not an exact calculation, nor one that can be made once to cover the entire period of retirement. It might be more helpful to state a guideline in this way: if the level of expenditures to be covered by the retirement account requires an average withdrawal rate of 3-4% per year, one can feel fairly assured that the account will last a lifetime. However, if 7-8% is needed each year, there is a danger of exhausting the account, and it will be advisable to consider reducing expenses or finding other sources of income.
Lump sum retirement accounts pose problems that did not exist when most people received pensions. The determination of how much can be withdrawn from a retirement account each year requires some careful thought and calculations to produce a range of percentages that help to assure the account will be available over all of the retirement years.
About the Author
Robert H. Louis is a partner in the Estate Planning and Administration Practice Group at Saul Ewing Arnstein & Lehr LLP. He has many years of experience in assisting clients in preserving and passing on wealth and business ownership across the generations, including planning for a happy and rewarding retirement.