In Part One of this two-part post, I reviewed the most common retirement income strategy, systematic withdrawal and “the 4% rule” which is its hallmark. We noted that among other concerns, the current low-interest rate climate threatens the success of this approach, which slowly spends down your portfolio throughout a 30-year retirement. A recent and widely-referenced academic study shows the projected failure rates going forward for 4% annual withdrawals to be unacceptably high, suggesting that a safe withdrawal rate is more like 2.5%-3%, that’s $25,000-30,000 a year on a $1 million portfolio at the start of your retirement. Systematic withdrawal is portfolio-oriented and dependent on future total returns, which no one knows.
I also introduced a second retirement income strategy, time and asset segmentation, also known as the bucket strategy. In this strategy, your portfolio is divided into three buckets, near-term (1-5 years), medium term (5-10 years out), and long-term (20-30 years out). The near-term bucket holds cash and short-term bonds and is replenished each year from the medium-term bucket, which hold intermediate term bonds. The long-term bucket holds riskier stocks, which will probably not affect the first two buckets in down markets, and which is used to replenish the medium-term bucket when market conditions are favorable.
Our discussion of the bucket strategy continues here.
Properly done, the bucket strategy should use the balance sheet view from the third strategy described below, the income floor/upside strategy, to at least determine the amount needed to cover annual expenses in addition to pension and Social Security. This becomes the number used as a multiple to populate the 5 and 10 year near-term and medium-year buckets. Anything left over goes in the long-term (upside) bucket.
Not everyone does this minimal planning, instead spreading their portfolio’s cash, bonds, and stocks across the buckets in a more traditional 40/60 or 60/40 ratio. Because stocks are in the long-term bucket, this can feel safer than it actually is. The risk is still much the same with the bucket strategy as with systematic withdrawal. Regardless of how it’s bucketed, if the portfolio is not large enough to sustain market fluctuations while supporting the needed level of withdrawals for annual expenses, you will run out of money.
Both systematic withdrawal and the bucket strategy start with your investment portfolio and focus on total returns—which are uncertain—with continuing exposure to market risk might be more appropriate to a younger you in the savings phase of your career, when your earned income could offset market losses over the long-term. Merely having stocks in a long-term bucket—investing for the long term—does not ensure that your money will be sufficient to support your lifestyle or that it will last as long as you live.
During your working years while you are saving and building your nest egg, asset allocation is crucial to long-term success. During retirement, how you allocate your portfolio or whether you adopt a systematic withdrawal or a bucketed method is not the critical success factor. Success in retirement depends on a steady flow of risk-free income sufficient to cover your expenses as long as you live, whatever strategy you use.
In other words, your number one retirement goal is to support your lifestyle without the risk of running out of money! There’s no room for failure in a successful retirement plan.
3) Income Floor and Upside—A Lifetime Plan for Retirement Income
The third strategy starts with your balance sheet and your lifestyle, not your investment portfolio, to determine how much you need to cover your expenses and how best to ensure that you will. This strategy has emerged in the past decade from the academic field of lifecycle finance, savings and investing, and is based on the asset and liability matching method well-run pension funds use to ensure future pension payments.
During your working career, the income floor/upside strategy looks at your household income potential, your accumulating and future resources, and your future expenses to determine a safe savings rate that will produce enough savings to securely support your projected retirement and other goals. The earlier you can start this process, the more successful you will be in meeting your goals. You allocate your growing savings across a broadly diversified portfolio balanced between stocks (higher-risk) and bonds (lower-risk) based on your balance sheet and goals. The focus is on savings and risk-adjusted growth, not on market moves and total returns, which can lead the unwary astray.
As you approach retirement, the strategy becomes more focused. It starts by identifying your essential annual retirement expenses and your discretionary, aspirational goals for retirement, including legacy wishes. Think of this as listing your needs/wants/wishes.
The strategy then uses a combination of pension, Social Security, and risk-free income to cover essential expenses and possibly some level of discretionary expenses. This is your retirement “income floor,” the base you must have to sustain your lifestyle. Whatever you have above the floor goes into an “upside portfolio,” for wants, wishes, and legacy.
Because your income floor is risk-free, your retirement income plan is secure, and your remaining upside portfolio can resemble a more conventional investment portfolio, with a balance of stocks and bonds as in the systematic withdrawal strategy, or the medium and long-term buckets of the bucket strategy. Depending on the strength of your balance sheet—the amount of your savings—your upside portfolio may have more or less cushion above the floor and so can afford more or less exposure to market risk. The more cushion you have, the more risk you can afford.
The critical difference between the income floor/upside strategy and the other two strategies is the risk-free income floor. The other two approaches do not set-up a risk-free income floor that will last as long as you live. Instead, they project a probability that a certain withdrawal rate will not exhaust the portfolio, with some small percentage possibility that it will. The income floor/upside strategy does not leave this to chance.
The kind of risk-free floor you need to secure your retirement depends on your balance sheet—whether you are under-funded, “OK” (“constrained”), or well-funded, as we’ve discussed earlier in this series.
If you are under-funded, you cannot afford to expose your savings to market risk—even a small market loss will only make your retirement situation less tenable. Instead, those with limited savings need to trim expenses, consider working longer, and consider purchasing insured income in the form of low-cost simple income annuities. These provide the maximum safe effective income rate available—higher than any systematic withdrawal rate commonly considered “safe.”
You can maximize the annuity benefit further by spending some of your savings as cash and laddering CDs or Treasury bonds that mature as cash for the early part of your retirement, and purchasing a deferred income annuity that begins paying later in retirement—this provides a higher guaranteed payout than an immediate income annuity and is often called “longevity insurance.”
If your funding is “OK,” meaning constrained, you need to exercise caution and not swing for the fences in the market. As you near retirement, you should be moving away from risk and embracing a strategy that provides a secure outcome. Instead of holding a classic portfolio of stocks and bonds, you might convert your portfolio to cash and short-term bonds for immediate use, purchase a ladder or Treasuries (TIPS or Zeros) for medium term funding, and purchase a deferred annuity for longevity insurance. If your funding is just “OK,” you may have enough to securely fund your essential expenses and some discretionary spending throughout your retirement, but you may not have enough funds for an upside portfolio exposed to market risk for additional growth. Be happy you can stop worrying about the market and enjoy your non-working years!
If you’ve had a good saving habit during your working career and find that you are well-funded, you have more options both for your income floor and for an upside portfolio. Ideally you would build out a full 30-year bond ladder over the next few years as your income floor, spending each rung for annual expenses the year it matures. By taking a couple years to build the ladder, hopefully you will get some boost from increasing interest rates on the long end of the ladder.
Or you could build out a five or ten-year bond ladder and keep the rest at risk in an upside portfolio, waiting for yields to improve or other options to clarify. This works best if you have a enough cushion that a 20-40% market downturn in the upside portfolio would not cut into any of the funds needed from the portfolio to finish building out the full floor later.
If your upside portfolio is large enough, your secure income floor can essentially be a systematic withdrawal from the upside portfolio, with your floor being some percentage of the full portfolio earmarked for retirement income funding. Since the floor is not secured, you need to monitor the portfolio carefully and move at least the amount earmarked for floor to cash or secure flooring as the markets begin to turn down. This can be risky, especially if your portfolio does not have a sizable cushion, in which case a bond ladder is a better sleep-at-night solution. This is a very different way to manage a portfolio from what you may have done during your working and saving years—you’re trying to protect your income, not score a few extra points in the market. You have more to lose than you stand to gain.
To summarize, the income floor/upside strategy uses the strength of your balance sheet relative to your essential and discretionary annual expenses to build a risk-free income floor that will last as long as you live. The income floor is built from a combination of cash and short-term bonds, immediate and deferred simple income annuities, and laddered Treasury and investment grade corporate bonds that matches your current and future expenses. Only once this floor is secured is any additional funding exposed to risk in an upside portfolio designed for long-term growth.
In accountant-speak, you have matched your assets with your liabilities. In real life, your retirement is not at the mercy of the stock market.
This strategy provides a secure retirement. The drawback, of course, is that in our current low-yield world, income flooring is expensive, meaning, you need to save more and spend less while still working to make your future income floor stretch 30 years.
This isn’t unique to the income floor/upside strategy. As we’ve seen above and in Part One, the low-yield climate also undermines the total return focus of both the systematic withdrawal and the bucket strategies as well, shortening the potential life of any withdrawal portfolio.
Make A Strategic Plan!
Now you know about the main retirement income strategies, which is a good thing. But it’s not enough just to know about them to have a successful retirement. You need to make a plan built on a sound strategy that is based your household balance sheet. Following such a plan can give you both the means and the peace of mind to enjoy a long, successful retirement.
Next time I’ll show you how to use the best parts of the systematic withdrawal strategy and the bucket strategy to enhance and clarify the security and peace of mind that comes from a well-executed income floor/upside strategy.
In the meantime, if you have any questions, or comments, please feel free to call, email, or comment below.
–Michael Lonier, RMA℠