The primary concern for just about everyone I meet with is how to retire with the same lifestyle they currently enjoy.  “Retiring” has a different meaning now than it did 20-30 years ago.  Nowadays, people retire TO something.  Whether it be to travel the world, spend time with family, volunteer, start a hobby, or work a dream job without compensation concerns.  Naturally, income replacement is the primary topic for those that are approaching retirement.  With pensions becoming less common, Social Security and income from investments have become the primary drivers to support the retirement lifestyle.  My most recent article (link here) was about Social Security and how to maximize the benefits for retirement.  Studies have shown Social Security represents approximately 40% of retiree’s income.  Therefore, I get a lot of questions on how much clients should withdraw from their portfolios to subsidize the income gap.

It depends.  There are two primary questions that we begin with to come up with the right answer.  First, what are the main spending objectives in retirement?  And second, what level of risk is acceptable?  These factors work in tandem and create many hypothetical “right answers” depending on each unique client.  This is why starting with a strategical financial plan with meaningful spending goals and meaningful stress tests is critical.  All future financial planning decisions will be influenced by these goals, which I find evolve over time.   As I continue to work with my clients, naturally new goals are added, and former goals are either accomplished or removed.  What I find is that as folks are approaching retirement, we typically focus on the “needs.”  Once they start to experience retirement and feel the plan is working, they can begin to relax and think more about their wish-list goals.

I want to clarify two housekeeping items first that are very important.  First, there are a number of “what-if” scenarios that can impact anyone’s retirement. We could have a beautifully designed income plan that is completely wiped away from a significant healthcare or long-term care expense.  I wrote about four of the stress-tests I run for my clients as they plan for retirement here.  This article, however, will be focused solely on navigating a safe withdrawal rate, all else being equal.  Second, I want to change the method of thinking from a safe withdrawal percentage to a safe withdrawal dollar figure.  Using a safe withdrawal dollar figure ensures that the client’s spending goals can be achieved throughout their life (adjusted for inflation), regardless of short term swings in the market.  I have found this method of withdrawals, known as a flexible withdrawal strategy, resonates with clients as they sleep better at night knowing they have a set income each month.  In order to accomplish this, or any prudent income plan for that matter, we must have a defined distribution process to avoid a big mistake.  I once met a client that had a dozen or so securities in his portfolio, and was selling his investments pro rata to meet his income needs.  This is often a default method for big brokerage firms, but not a prudent distribution process.  The reason being it will just about guarantee you are selling certain securities at the wrong time each distribution you make.  Having a prudent distribution process is a critical assumption when we begin the stress tests, as a big mistake can completely negate years or even decades of growth.  With that being said, I will reference withdrawal rates as an average percentage over the life expectancy of a plan, but understand they will fluctuate each year in practice.

Most people I meet with have one of the following primary income goals for retirement:

1. Replace income to maintain their current lifestyle, but without depleting the principal of their investments.
2. Replace income, but with the goal to maximize the legacy transfer to the next generations, or to charity.
3. Maximize spending and die penniless.

Replace income without depleting principal

I find most people strive for this in retirement, mainly because of the psychological benefits it provides.  If you are burning through your principal in your early years, you might naturally have concerns about running out of money.  I had a client I worked with years ago that was consistently needing about 8%-10% of the portfolio each year to supplement his Social Security.  Each time we had market volatility, it was pretty much guaranteed I would get a call from him in a panic.  Over the years, his portfolio was consistently declining in value.  I kept reminding him that his burn rate was too high, but instead of looking at his own expenses, he blamed performance despite wanting to have a relatively safe portfolio.  Conversely, my clients that are in a sweet spot for distributions don’t panic when we go through bouts of volatility.  They are out enjoying retirement knowing we have a solid process and plan in place, which is my goal when I take on a new client. 

In order to accomplish principal preservation while drawing income, we must first understand the objectives for income and the risk capacity for each individual.  I started working with a client a few years ago that had a solid nest egg built up for retirement and wanted to see how to maintain her principal while replacing her pre-retirement income.  However, she was in the mindset (like many folks approaching retirement) of making the portfolio ultra conservative before this transition period.  After running some hypothetical scenarios, I showed her the results of our models.  Looking at the illustration below, the results on the left show a moderate risk portfolio, which as you can see falls in the green zone, or the Confidence Zone.  On the right, we modeled the impact of moving to a conservative risk.  As you can see, becoming more conservative causes this plan to fall below the green zone, or Confidence Zone, which is not ideal.   In some situations, clients that have saved more than enough for retirement can afford to reduce risk without jeopardizing the longevity of their plan.  However, in other situations like the one below, one might need to maintain some risk in the portfolio in order to achieve their income goals and maintain principal over time.  It’s critical to find that sweet spot of portfolio risk when implementing your distribution plan.

Why does reducing risk impact the probability of success negatively for this client?  The reason is somewhat simple.  Given the prolonged low interest rate environment we are still in, the more conservative investments are not yielding much in the way of annual returns.  Therefore, the expected returns annually from a more conservative portfolio are going to be lower than a portfolio taking on a reasonable amount of risk.  This resulted in a conversation of her wanting to maintain some risk in the portfolio so she didn’t have to worry about going through her nest egg too quickly.  After all, she does have longevity in her family and we could be planning for a 30+ year retirement!

I have found that in general, if someone is more conservative, the average withdrawal rate needed to preserve principal will be in the range of 3%-4%/year.  If a client is comfortable with some risk, 4%-5.5%/year can achieve the goal of income and principal preservation.  Finally, someone who is comfortable with a significant amount of risk may even be able to get away with 6%/year or perhaps higher in average withdrawals.  Inherently, the more risk one takes, the less probable the outcome is.  I typically find folks that want to take on more risk will fall into the next category of replacing income but also maximizing legacy. 

Replace Income but maximize legacy

For those who are looking to maximize legacy, of course we need to first make sure their income goals are taken care of.  Once we have tested all possible outcomes and have a solid baseline average of withdrawals, we can then determine how this will impact their legacy objectives.   Naturally, the lower the withdrawal rate the better.  Sometimes, clients may only need 2%-3%/year from the portfolio.  If they are generating an average of 5%/year in returns, this will allow them to grow their net worth over time and potentially keep pace with inflation.  However, in other situations folks still need a reasonable amount of withdrawals to meet their spending goals.  In any event, I will outline three strategies below to help with maximizing returns while drawing down retirement income. 

1. Asset location strategy
2. Spending strategy
3. Tax efficiency

Asset Location is a buzz term used in our industry, but many clients I speak with don’t fully grasp what this means as they are more familiar with the term asset allocation.  Asset allocation is the method in which you determine what percentage of your net worth is dedicated to a variety of asset classes to create the properly diversified investment strategy.  Asset location is more specific on what asset classes you would own based on the different types of accounts you have.  I’ll give you an example.  I am working with a client who has one  Traditional IRA  (which is tax deferred) and another account that is a  non-qualified brokerage account (which is taxable each year).  We strategically own the tax efficient investments in the taxable account, and the tax inefficient investments in the IRA.  This makes sense because the more tax efficient an investment is, the less in taxes you would pay on that particular investment.  It’s like the old saying, “it’s not what you earn, it’s what you keep.”  In this case, it’s not what her before tax rate of return is, it’s her after tax rate of return.  Having an efficient asset location strategy can help with maximizing retirement income simply by taking a holistic view on what investments you should own in each type of account you have.

Having a spending strategy may feel like a given, but rarely do I hear people talk about this the right way.  Many folks focus solely on what percentage of the account they can reasonably draw down.  However, in order to maximize long term performance while drawing retirement income, you have to be strategic based on the timing of withdrawals.  Let me explain.  I have another couple I work with that has three buckets of accounts.   One is a non-qualified brokerage account, the next are Traditional IRA’s, and finally they each have a ROTH IRA.  Sequentially, most experts would agree that you should tap your brokerage account first, your IRA second and your ROTH IRA last.  The reason is to maximize your after tax income as you’ve already paid taxes on the cost basis for that non-qualified brokerage account.  Once you turn age 72, you will then be forced to make withdrawals on your Traditional IRA or 401ks.  For your ROTH IRA, you won’t ever have mandatory withdrawals and they will be tax free if/when you do take money out (as long as they are considered qualified withdrawals).  Therefore, we are taking the most risk in their ROTH IRAs, and the least amount of risk in their non-qualified brokerage account.  By using this approach, we will experience less volatility on the account they are likely to withdrawal in the short term (brokerage account), and will be able to maximize the growth potential on the accounts they won’t be tapping into until longer term, if ever (ROTH IRA’s).  I have found this approach works more effectively than incorporating a singular investment strategy across all accounts.

I talked a lot about tax efficiency in a previous article called the Tax Trap of Traditional 401ks and IRAs here.  This goes hand and hand with a smart spending strategy.  If you want to live a nice lifestyle but also maximize your legacy goals, consider what accounts are more or less tax efficient for that wealth transfer goal.  With the new rules around the elimination of the stretch IRA, leaving your Traditional IRA or 401k to your children is not as tax friendly as it was before The SECURE Act was passed.  Therefore, spend those during retirement and consider leaving the ROTH IRAs (if you have one) or even non-qualified brokerage accounts as your legacy assets.  Currently, non-qualified accounts have the benefit of a step up in cost basis upon the owner’s passing, although this is currently in the cross hairs in Washington to potentially eliminate.  However, under the current rules, a non-qualified account is a great tool to use for those wealth transfer goals.  Therefore, you may want to try to preserve these assets more during retirement and increase spending on those traditional 401ks or IRAs.  Another tool you could add to your arsenal, if you don’t have it already, is a permanent life insurance policy.  This works beautifully with several clients I work with where legacy is an important objective.  It allows for them to leverage the death benefit, which is passed on tax free, while only paying a relatively nominal premium while they are living.  One theme I hear from these folks is there is a psychological benefit in knowing you have something that is guaranteed to pass along to the next generation regardless of what the stock market brings.  It also gives them freedom to spend their retirement accounts without guilt knowing this legacy goal is taken care of by the insurance. 

With all of this in mind, these strategies should apply to all three types of clients who are preparing for retirement.  Those who want to spend income and preserve principal, those who want to generate retirement income and maximize inheritance, and those who want to spend it all while they are living.  All prudent retirement plans should employ these three tactics.  By not following a disciplined plan, the margin for error increases dramatically and the more prone the plan is to risk of failure.

Max spending with no inheritance

For the client who wants to maximize spending without leaving any inheritance, it can sometimes be unnerving as a financial advisor.  However, we start with the same process of unpacking the goals and stress testing those goals based on the income sources and risk tolerance.  The challenge is to figure out a scenario where the withdrawal rate in their last year of life is nearly 100%.  Obviously, I say this tongue-in-cheek as that would involve knowing exactly how long the client will live.  However, we will use our best guess based on longevity in their family history and our life expectancy calculators.  Once we see how much cash can be raised from the portfolio, I will show the client the withdrawal rates over time, assuming an average expected return.  Let’s take a look at this client below.  She doesn’t have children and wants to spend it all while she’s alive.  There are some charities she could leave it to, but she will probably give them money during her retirement years, especially when Required Minimum Distributions kick in.  So, we went towards the path of max spending and dying without any assets left. 

For this client, you can see the withdrawal rates start around 6%-10%/year the first 4 years.  At age 70 she will begin taking Social Security and the withdrawal rate goes down a bit.  However, looking into her late 80s and 90s, you can see how the withdrawal rates ramp up and at the last year of life expectancy, she is taking out nearly 100% of the portfolio balance.  Obviously, you can see the reason this is unnerving.  What if she lives longer than 94? What if there is a long-term care need or major healthcare expense?  What if we have lower than expected average returns?  What about inflation?  All of these stress tests failed miserably in this type of scenario.  Therefore, after sharing these results and discussing the potential risks, we backed down the rate of withdrawal slightly to create a buffer for those unexpected events.  The good news is, I will continue to revisit this with her and track our progress as time goes on.  If we run into some challenging conditions, we can have that discussion about trimming the withdrawal rate.  Conversely, if we are going through periods of significant growth, we can potentially spend more or gift more in those years.  I find this is a nice balance between maximizing spending, but also not doing something that will impact her ability to be financially independent.  Nobody wants to be a burden on others!

In summary, withdrawal rates are not static in our world.  We need to be dynamic to adjust to the cash needs of our clients.  Additionally, the withdrawal rates will be driven by the primary goals of the client, the income sources available to achieve those goals, and the capacity for risk.  This formula will bring to light what a reasonable amount of income that can be taken from the portfolio would be, adjusted for inflation over time.  There is not one right answer, and it’s important to take all of your financial planning considerations, tax considerations and investment considerations before making any decisions.

My firm specializes in this type of planning and we are happy to help you prepare for retirement. You can schedule a no obligation initial consultation here, or by giving us a call at 904-323-2069.

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