There will come a time when you have to figure out how best to draw income from your retirement accounts. In the old days, many a retiree would simply live off their interest income and dividends and preserve their principal for worst-case outcomes and bequests.
Then, in October 1994, the Journal of Financial Planning published a paper by Bill Bengen, titled Determining Withdrawal Rates Using Historical Data, which spurred, according to Michael Kitces, publisher of the Nerd's Eye View blog, a new body of research focused on determining what amount is safe and sustainable to withdraw from a portfolio over an extended period of time.
In his paper, Bengen suggested that retirees could safely withdraw 4% per year, adjusted for inflation, over the course of a 30-year retirement using a 50% stocks/50% bonds portfolio.
During the more than 20 years that have followed the publication of Bengen's seminal paper, "this line of retirement-income research has added many new layers, introducing both refinements and complexity to the original safe withdrawal rate framework," Kitces wrote in the Fall 2014 issue of the Retirement Management Journal. "The end result gives a more complete picture of what is and is not sustainable spending, but in the process has also led to significant confusion, misapplication, and a great deal of criticism."
Systematic withdrawal plans (SWPs) are, of course, one way to create income in retirement. But there are many other strategies and tactics, including buckets, ladders, time segmentation, asset-liability matching... and the list goes on.
We'll take a closer look at these strategies and tactics. For now, we wanted to give you a sense of the strategies and tactics that financial planners use today with their clients.
Many aspects of how advisers deliver retirement income remain highly individualized by practice. For example, advisers remain divided on the investment philosophy they use for managing retirement income portfolios, with a plurality of advisers relying on a total return approach, but significant segments using alternative methods such as a pooled or bucket methodology or an income floor or hybrid approach.
The Three Core Approaches
Risk-adjusted total return approach, with a focus on optimizing total return on assets and using systematic withdrawal to provide cash flow. According to the report, more than two in five advisers, or 45%, use a total return methodology for generating cash flow for retirement clients. These advisers are not focused on income as an outcome for managing portfolios but instead work to generate an optimal total return consistent with the client's risk parameters. They then draw down the portfolio as needed and appropriate to satisfy client income needs. The total return approach is similar to how most advisers manage portfolios for pre-retirees using a securities or fund-oriented approach and typically does not involve significant reliance on guaranteed solutions such as annuities.
Pooled or time-segmented approach, with an emphasis on protecting clients from market volatility by allocating assets across duration-based short, intermediate, and long-term pools or buckets. According to the report, nearly one in three advisers, or 30%, rely on a pooled or bucket approach. These advisers often "deconstruct" portfolio management into different duration or objective-based pools of assets. Many clients are attracted to the perceived protection offered by a pooled approach which often involves a short-term bucket that shields the client from selling off assets during periods when capital markets are trending down.
Income floor or hybrid approach, with the goal of providing assured income for essential client expenses while managing other assets for ongoing growth and to satisfy client discretionary expenditures. Roughly one in four advisers, or 25%, use an income floor methodology combining guaranteed or income producing solutions to meet current cash flow needs with a diversified total return approach to generate long-term gains to maintain purchasing power and sustain the portfolio over time. This philosophy attempts to integrate aspects of the total return approach and the bucket methodology.
The most common withdrawal rate targeted for retirement-income clients is 4%, although many advisers do not adhere to this target.
Enjoying the Journey as Well as the Destination
In his practice, Neal Van Zutphen, the president of Intrinsic Wealth Counsel, uses an asset-liability matching strategy and the concept of "bands of time" (based on Somnath Basu's research) along with a humanistic life planning process.
"My early years of experience led me to use this method as I discovered the 'set inflation-adjusted' future income stream model often times created the client need to work longer, save more to accumulate more for an overinflated future lifestyle need," says Van Zutphen. "I found that none of my long-retired clients are spending at the levels we had originally projected and all of them have "slowed" down over the years and spend less than expected."
The key point here, says Van Zutphen, is the capital need to fund an inflation-adjusted annual income to life expectancy can require significantly more capital than needed, "depriving the client of enjoying the journey as well as the destination," he says.
The alternative, he says, is to figure out how much they will spend over time using a line item and year-specific strategy -- adding in new expenses, modifying others and eliminating other expenses. "This is far more realistic than assuming expenses are a certain number and go up each year at a set inflation," says Van Zutphen.
What's more, he says there are several benefits to helping clients think about their expenses with line items versus a set number (80% of pre-retirement income or $X,000 per month with X% inflation).
First, it creates awareness of "where and how they are spending money today"
You can use different rates of inflation for various line items: healthcare expenses at 7%, fixed mortgage at 0%, college expenses at 10%, etc.
It creates a system to check and see if current income and expenses and free cash flow are as estimated and helps to determine what is available for goal funding (short-, intermediate- and long-term goals).
It also tells us whether their current assets and current savings/investments are sufficient to fund retirement and other goals.
If we discover they are short, it shows the client what expenses are non-discretionary and what expenses can be modified.
It gets them thinking about how much they will spend pre- and post-retirement and the modified discretionary expenses are something the couple can see and agree to change
If they can see where changes are needed prior to retirement, they can also explore what expenses remain post-retirement, change, up or down or go away or what new expenses (Medicare Part B, special vacations, auto replacement, one car, two cars, no cars)
The key point here for individuals and couples: It is the client making the decisions and not the planner "telling" them they must stop spending on "X."
I have a couple of clients that send me their monthly expenses and we modify lifestyle expenses each and every year. This helps the clients control lifestyle expenses and also helps them stay mentally sharp (cognitive exercise).
My experience has been that clients who explore the specifics of their lifestyle expenses have been able to enjoy an earlier retirement and have been able to do so with less capital. So, they have been able to do more while they were/are healthy enough to do so. Unfortunately, I also have a few retired clients whose spouses died way too young.
My retired clients recognize that the planning requires at least annual updates and because of health and other life issue, planned trips and other expenses get shifted from year to year. One client I have accelerated their European trip because he was going blind. So, they made it the trip, and enjoyed all they could. A few years later the last of his eyesight went. The great news? He has no regrets and we still track expenses (their daughter helps with QuickBooks).
There are, says Van Zutphen, downsides to this method. "It is more work upfront for clients and planner," he says. "It requires more time and effort and couples can experience 'value judgments' on how money is being spent or planned to be spent -- not much different than the couple discussing how much to spend on vacation, home remodel, retirement home and the fear associated with transitions from accumulators to de-cumulators and the fear of running out of money before they run out of life."
According to Van Zutphen, parents and grandparents want to leave money behind. "This is true even when the couple state they are not concerned about leaving an estate," he says. "Their behaviors speak louder than their spoken goals."
From a portfolio management point of view and determining the timing and maximization of Social Security benefits, Van Zutphen says this creates the kind of specificity needed to structure cash flow needs in three- to five-year periods or bands of time, and ensures sufficient liquidity to meet planned expenses without the need to worry about market volatility. "This is what helps clients to sleep well at night," he says.
And lastly, Van Zutphen says there is nothing the planner can do which will overcome what the client will not do. "The planning process is an ongoing collaboration and the planner's role is to assist clients in making good decisions -- as life happens -- the efficacy of the planning process is in this relationship of collaboration," he says.
Got questions about the new tax law, Social Security, retirement, investments, or money in general? Want to be considered for a Money Makeover? Email Robert.Powell@TheStreet.com.