Conscientious Financial Planning and Retirement Income Management | 201-741-9528
from Lonier Financial Advisory LLC, Osprey, FL

Three Strategies for Creating Retirement Income, Part One

Three Strategies for Creating Retirement Income, Part One

Saving for retirement is the long, slow (hopefully boring) prelude to the real show—turning your savings into secure retirement income that will last for the rest of your life.

Watching your expenses and saving regularly during a lifetime of employment is crucial, but it may not be enough. You need a plan based on your resources—your current and future household balance sheet—to convert your savings and investments into income matched to your needs. Without a personalized plan, you may come up short. The sooner you start your plan, even in the first few years you begin working, the easier it will be to reach your long-term goals.

There are three common strategies for planning and managing retirement income (Four if you count not having a plan as a strategy!). Not surprisingly, the advocates of each strategy, while agreeing on some common points (maximize your Social Security benefits!), usually see these three approaches as mutually exclusive.

In this and the next post, I will summarize each strategy and discuss what kind of household balance sheet might fit each strategy well, and what kind not so well.

In a third post, I will share with you how I combine the best parts of the first two strategies with the third to build a plan adapted to almost any household balance sheet. This approach provides an all-angle view for building a safe retirement income plan matched to your needs and resources, something that the first two strategies by themselves don’t provide.

1) The Broker’s Strategy—Systematic Withdrawal
The first strategy is the classic financial industry solution—a simple approach a broker/salesperson can apply to most anybody. While working you save in an investment portfolio, and then in retirement you systematically withdraw some ‘safe’ amount from it every year, adjusted for inflation. Like investing, this strategy starts with the portfolio and focuses on total returns. Your balance sheet and income needs don’t enter into the calculation—unless you haven’t saved enough to cover your essential annual expenses, At that point your broker shrugs or, downplaying the risk, offers some new product promising even higher returns.

The typical method is to start with 4% of the portfolio balance the year you start withdrawals, and add an additional 3% of that amount as an inflation adjustment in each subsequent year. Your portfolio balance may go up and down with the market, but your withdrawal amount will steadily increase 3% a year. Over time, your portfolio should grow to cover your withdrawals.

On a straight-line, 4% computes to 25 years, not accounting for market fluctuations and inflation. So there is obviously risk inherent in using this approach to cover a 30-year retirement span.

The underlying risk is a factor of both the portfolio size and the unknown future sequence of market returns:

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  • If the portfolio isn’t large enough, it may not provide enough cash to support your lifestyle at a “safe” withdrawal rate of 4%, tempting you to withdraw more and deplete the portfolio
  • Even a large portfolio can be depleted by an unlucky sequence of poor-returns in the market
  • The net result is you risk running out of money while still very much alive—the very definition of retirement plan failure

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William Bengen first studied what has become known as the “4% rule” in 1993, showing that even 4.5% holds up in historical back testing of the 38 complete 30-year retirement periods from 1926-1963. He has recently updated his studies showing that in the now 57 complete 30-year periods since 1926, only someone retiring on Jan. 1, 1969 and withdrawing 4.5% plus an inflation adjustment would have run out of money (in year 30) during this period, ravaged by high inflation in the 1970s. Acknowledging there is no way of assuring future success, he suggests a number of ways to minimize longevity risk during retirement to offset market losses as they happen, primarily reducing spending, but also reducing withdrawal rates, considering a fixed-annuity, utilizing home equity via a reverse mortgage, and adopting tactical investment methods. There are complications with each of these options.

Recent academic research suggests that while systematic withdrawal may have worked well in the post-war go-go years, the outlook over the next 30 years is less sanguine. The authors show that, contrary to historical averages, projecting the current low-yield climate forward, with a number of different future return scenarios and portfolio stock/bond ratios, results in unacceptably high portfolio failure rates.

“With no real bond yield, hypothetical retirees experience a one in three chance of running out of money after 30 years with a 50% stock portfolio. With the current negative real yield, the odds are more than half that one will run out of money… Reversion to historical mean bond returns will not save the 4% rule. Hypothetical retirees experience a nearly one in five chance of running out of money even if bond returns revert back to the historical mean after only five years with a 50% stock portfolio. If bonds mean revert in ten years [the current 10-year Treasury is the best available forecast, and it’s well below the historical mean], the failure rate rises to one in three.”

Their conclusion is that the current low-yield climate has turned the 4% rule into the 2.5% or maybe the 3% rule, a rate many will find insufficient.

There are a number of variations on the systematic withdrawal strategy, including the IRS formula for annual increasing Required Minimum Withdrawals from retirement accounts after age 70-1/2 that account for declining life expectancy. At age 70-1/2 with a 25 year span to age 95, RMD’s start at 3.65% and gradually increase as you grow older.

Consider that according to the old 4% rule, if you have $1 million, you can safely withdraw $40,000 a year. If the recent academic study is correct, that $40,000 a year is risky—$25,000 to $30,000 is more sustainable. The core problem with systematic withdrawal is you can’t know for sure. Nobody knows what future returns will be. By the time you find out that you’re assumptions are wrong, it will be too late.

So this strategy works best for larger portfolios, for those who are in the so-called “Green Zone” and have plenty of cushion. The larger your portfolio relative to your expenses, the stronger your balance sheet, the more appropriate this strategy becomes.

Bottom line, the more you have saved and invested, and the more controlled your expenses, the less risk you incur taking the small annual withdrawals needed to support your lifestyle, and the more risk you can take with your portfolio and unknown future returns.

2) Bailing with Both Buckets
The second common retirement income strategy is time and asset segmentation, commonly called the bucket strategy. Popularized in a number of books in 2004, it divides your portfolio into different buckets allocated to different asset classes, matching asset risk with each bucket’s timeframe. Many find the bucketed approach to managing a portfolio and annual withdrawals intuitive and easy to understand.

In its simplest form, this strategy divides your retirement and your portfolio into three segments or buckets, near-term (1-5 years), medium-term (5-10 years out), and long-term (10-30 years out).

In the near-term bucket you keep 1-2 years of cash, and 3-4 years of short-term Treasury bonds. You make your annual withdrawals from the cash in the near-term bucket, refilling it every year by selling intermediate term bonds from the medium-term bucket. There’s little risk in this 1-5 year bucket.

The medium-term bucket contains intermediate-term Treasuries and investment grade corporate bonds, and is refilled each year by selling stocks from the long-term bucket. Though in today’s low-yield climate this bucket will not generate much income, it is a low-risk allocation and buffers the higher risk of the stocks held in the long-term bucket.

The long-term bucket holds risky assets (stocks) for growth. Since the short and medium-term buckets provide a ten-year income buffer, you can leave the long-term bucket untouched for a year or two during market downturns, refilling the medium-term bucket once the market recovers.

Along with being easy to understand, time/asset segmentation with buckets makes it easier for many to withstand the temptation to sell out at a loss at market bottoms, since stocks are understood to be in a long-term lock box so that market reversals do not threaten current retirement income. If only for this reason, retirees can benefit from using the bucket strategy to conceptualize retirement income.

In the next post, we’ll discuss some of the drawbacks of the bucket strategy and the third strategy, known as the income floor/upside portfolio strategy, which is the retirement income phase of a lifetime financial plan.

In the meantime, if you have any questions, or comments, please feel free to call, email, or comment below.

–Michael Lonier, RMA℠

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