- The era of defined benefit pension plans has ended for most people, except those in government service and unionized industries.
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:
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.