Inflation is running hot, the market is volatile, and I-Bonds have become attractive. This article addresses the basics of I-Bonds and how you can assess if they are right for you.
Inflation is running hot, the market is volatile, and I-Bonds have become attractive. This article addresses the basics of I-Bonds and how you can assess if they are right for you.
In my nearly 14 years in this business, I’ve seen financial advice given by many different professionals. Insurance agents, stock brokers, bank representatives, real estate professionals, next door neighbors and the like. I’ve seen some great advice given, but also some terrible advice. This often times leads to the general public to think “are financial advisors worth it?” This is especially the case now given the lines are blurred between different segments of the “financial services” industry. Vanguard did a study called “Advisor’s Alpha” which I have found is the most helpful and accurate summary of value-added services a comprehensive financial advisor provides. I’ve referenced it to clients and other professionals since 2014 when it was originally published. To summarize it briefly, they outline seven areas of advice that add value to the client’s portfolio by way of net returns annually. They have assigned a percentage to each of the categories which amounts to approximately 3%/year in net returns! In this article, I will highlight some of the key components of their research, as well as put my own spin on it based on my thousands of hours working with clients directly.
First things first, not all advisors are comprehensive (and that’s okay). However, this article is specifically for firm’s like mine that are focused on comprehensive advice and planning, and I would argue the 3%/year figure is on the low end. I will get into this more shortly.
Here is a breakdown of Vanguard value-added best practices that I mentioned previously:
The first thing that should jump out to you is that suitable asset allocation represents around 0%/year! This is given the belief that markets are fairly efficient in most areas, and it’s very difficult for an active fund manager to consistently beat their benchmarks. This is contrary to the belief of the general public in that a financial advisors “alpha” is generated through security selection and asset allocation! What’s also interesting is that the largest value add is “behavioral coaching!” I will get into more about what this means, but I would 100% agree with this. Sometimes, we are our own worst enemy, and this is definitely true when it comes to managing our own investments. It’s natural to have the fear of missing out, or to buy into the fear mongering the media portrays. So if you take nothing else away, the simple notion of having a disciplined process to follow as you approach and ultimately achieve financial independence will add 150% more value than trying to pick securities or funds that may or may not outpace their benchmarks!
Before I dive into my interpretation of their study, I want to note that I will be using five major categories instead of seven. Some of the above mentioned can be consolidated, and there are also some value added practices I, and many other comprehensive planners, incorporate that are not listed in their research.
There are four major components of tax planning a comprehensive financial advisor should provide. The first component is what we call “asset location.” The saying that comes to mind is “it’s not what you earn, it’s what you keep.” Well, taxes are a perfect example of not keeping all that you earn. However, some account types have preferential tax treatment, and therefore should be maximized through sound advice. Certain investments are better suited for these types of tax preferred accounts and other investments tend to have minimal tax impact, and therefore could be better suited OUTSIDE of those tax preferred accounts. A prime example is owning tax free municipal bonds inside of a taxable brokerage or trust account, and taxable bonds inside of your IRA or Roth IRA’s. Another example could be leveraging predominantly index ETF’s within a brokerage account to minimize turnover and capital gains, but owning a sleeve of actively managed investments in sectors like emerging markets, or small cap equities inside of your retirement accounts. According to the Vanguard study, this type of strategy can add up to 75 basis points (0.75%/year) in returns if done properly, which I would concur.
The second component is income distribution. This is often thought of much too late, usually within a few years of retirement. However, this should be well thought out years or decades in advance before actually drawing from your assets. One example I see often is when a prospective client who is on the brink of retiring wants a comprehensive financial plan. Often times they have saved a significant sum of money, but the majority of the assets are held inside of tax deferred vehicles like a 401k or IRA, and little to no assets in a tax free bucket (Roth). This type of scenario limits tax diversification in retirement. On the contrary, someone who has been advised on filling multiple buckets with different tax treatments at withdrawal will have many combinations of withdrawal strategies that can be deployed depending on the future tax code at the time. I have incorporated the rest of the income distribution value-added practice in the next section, but this practice as a whole is estimated to add up to 110 basis points (1.1%/year) in additional returns!
Legacy planning is the third component of tax planning that a comprehensive financial advisor should help with. This isn’t discussed in the Vanguard study, but it’s safe to say a comprehensive plan has to involve plans for your inevitable demise! You might have goals to leave assets to your heirs, especially if you are fortunate enough to have accumulated more than you will ever spend in your lifetime. With the SECURE Act, qualified retirement plans are now subject to the “10-year rule,” and therefore accelerating tax liabilities on your beneficiaries. However, if you incorporate other assets for legacy that can mitigate the tax impact on the next generation, this can save your beneficiaries hundreds of thousands, or even millions of dollars simply by leveraging the tax code properly.
Finally, navigating tax brackets appropriately can be another way a comprehensive advisor adds value. If a client is on the brink of a higher tax bracket, or perhaps they are in a period of enjoying a much lower tax bracket than normal, planning opportunities should arise. If you are in an unusually higher tax bracket than normal, you might benefit from certain savings or tax strategies that reduce their adjusted gross income (think HSA’s, pre-tax retirement account contributions, or charitable giving). If you find yourself in a lower tax bracket than normal, you might accelerate income via Roth conversions or spending down tax deferred assets to lessen the tax burden on those withdrawals. Additionally , considerations on the impact on Medicare premiums in retirement should also be taken into account when helping with tax planning.
As you can see, even though I am not a CPA and I’m not in the business of giving tax advice, helping you be strategic with your tax strategies is part of the comprehensive planning approach. All in, you should expect to increase your returns up to 1%/year (or more depending on complexity) by navigating the tax code effectively.
In my personal practice, this ends up being a significant value add given the work I do with post-retirees. A systematic withdrawal strategy in retirement will involve a monthly distribution 12 times throughout the year. This reduces the risk of needing a sizeable distribution at the wrong time (similar to the concept of dollar cost averaging). For a 30 year retirement, this means 360 withdrawals! Most retirees have at least two different retirement accounts, so multiply 360 by 2 for 720 different income decisions to navigate. In my experience, the selling decisions are often what set investors back, especially if they are retired and don’t have the time to make it back. By putting a process in place to strategically withdrawal income from the proper investments at the right time, and maximize the tax efficiency of those withdrawals, this can add up to 1.1%/year in returns alone, according to Vanguard’s study! I’ve also had clients tell me they value their time more and more the older they get. Instead of spending their retirement managing income withdrawals each month, they would much rather travel, play golf, go fishing, spend time with their grandchildren etc. So yes, I would agree with the Vanguard study that 1.1%/year is appropriate for this category, but I would also argue the peace of mind of not needing to place trades while you are on an African Safari with your spouse is priceless! Yes, I did have a client who admitted to this, and no, his wife was not happy! That’s why they hired me!
The major risks you will see during your lifetime from a financial planning perspective are:
Vanguard’s study focuses mainly on the behavioral risk (value add up to 1.5%/year) and re-balancing (.26%/year). As I mentioned earlier, it’s fascinating they rank behavioral risk as the largest value add out of any category! What is behavioral risk? Let me tell you a quick story. A client of mine was getting ready to retire at the beginning of 2020, right as the pandemic reared it’s ugly head. He had 30+ years working in higher ed and climbed the ladder to ultimately become president of his college for the last 15 years. He is a brilliant man, and a savvy business person. When the pandemic hit us, he was terrified. Not only did he see his portfolio drop from $2.5mm to $2.25mm in four weeks, but he was worried this could lead to the next depression which his parents lived through. We had at least a dozen conversations during those weeks about how he was losing sleep every night, which of course was miserable for he and his wife. Finally, in our last discussion he informed me he wanted to sell out of his retirement investments and move to cash. I plead my case in that we had a well thought out diversified strategy, and looking at the math, we had enough resources in fixed income investments to pay his bills for the next ten years! However, I told him it was his money and I was ready to place the trades if that is what he wanted. He told me he would think on it for the next 24 hours. The next day, he called me and said I was right, we had a plan, and he wanted to proceed with sticking to the plan. Well, by the end of 2020 his account not only fully recovered, but it grew to $2.75mm! I am not pumping my chest on performance, but by being the behavioral coach he needed at that time earned him $500k of growth in his portfolio (a whopping 22%).
I can literally share a hundred of these stories not just from the pandemic, but stories from 2008/2009, the dot com bubble etc. The point is, having an advisor you trust that can help you navigate through the ups and downs of the market and tell you what you NEED to hear, not what you WANT to hear is invaluable. Furthermore, it can free up your time to focus on what matters in your life and have the professionals worry about the market for you!
So all in all, I would agree on the 1.5%/year value add for behavioral coaching and .26%/year to help re-balance the portfolio properly. However, Vanguard’s study doesn’t even take into consideration proper insurance planning and estate planning advice a comprehensive advisor gives to their clients which are also value-adds in and of themselves. In that sense, I would argue this category can add up to 2%/year in additional returns to a client.
This is oftentimes overlooked when working with a financial advisor. Much of the public believes working with an advisor will be more expensive! However, many of them are used to being sold high commission investment products or services that are overpriced. However, through due diligence and leveraging the proper research, Vanguard estimates clients should save on average 0.26%-0.34%/year on expenses. From my personal experience, this might even be on the low end. However, for arguments sake and given it’s their research, let’s say we agree with the value-added range set forth.
Vanguard doesn’t reference this in their study, but that objective point of view is sometimes necessary to drive positive change. I don’t have any specific data on how to quantify this, but I hear time and time again from clients that they so much appreciate having me as an accountability partner. Think about trying to get in tip top shape without a coach or personal trainer! You might do okay, but you certainly wouldn’t push yourself as hard as you could have if you had a coach or trainer. On the contrary, I often hear from new prospective clients how information overload and the fear of making a mistake has caused a whole lot of inaction, which can significantly hurt returns and performance. Think about a surgeon attempting to perform surgery on their own body! They simply wouldn’t. Not that I am comparing my occupation to a surgeon, but someone working to achieve financial independence would benefit substantially from a trusted third party to help navigate all of the different financial decisions they will encounter in their lifetime. This also could be true for married couples who might have differing views on finances. After all, financial reasons are the #1 cause for divorce in America. If I can help a married couple get on the same page with their financial vision, that is a win for them, no questions asked! Without specific data, I would have to say my gut feel is that objectivity should add an additional 0.5%/year in returns over the duration of a relationship, as well as more self confidence and peace of mind that you are on the right path.
If we tally up our TIRES acronym:
This gives us a total value add range of 4.86% – 4.94%/year in additional returns. My firm’s average fee is roughly 0.85%/year. This is why I get so excited to help new and existing clients. The value you receive, is far greater than the cost to pay me, creating a win-win situation. Now, not EVERY client will experience in additional 4-5% in additional value. Some might receive 2%/year, some might receive 10%/year! However, all of you who have yet to work with a comprehensive planner, or for those of you working with an advisor who may not be doing a comprehensive job, it might be time to reevaluate and see what holes you need to fill. If you are interested in learning how to work with me directly, you can schedule a mutual fit meeting with the button below. Or, you can visit my “Process” and “Fees” pages on my website.
In simple terms, a Health Savings Account, or “HSA,” is an account owned by an individual that can be used to pay for health care expenses, either now, or in the future. The accounts are eligible for those who have a High Deductible Health Plan and are funded with pre-tax dollars. If the funds are used to pay for qualified expenses, the funds can also be withdrawn tax free for those purposes. If leveraged appropriately, it will be the most tax efficient vehicle you will utilize for retirement planning.
Fidelity conducted a study that estimates a 65 year old couple will need $300,000 earmarked to pay for healthcare expenses. This does not include costs for long-term care services. $300,000 of course represents true expenses, meaning the funds used to pay for those expenses will be net of taxes. If the bulk of your retirement savings are held in a traditional 401k or IRA, you will need close to $450,000-$500,000 in your account balance earmarked for healthcare costs alone. Therefore, many of my clients are leveraging the HSA as part of their overall retirement planning strategy, and I’ll summarize some of the benefits in more detail below.
1. You recognize a tax deduction today.
If you are single, the maximum contribution is $3,600 for 2021 ($3,650 for 2022).
If you are married and participating in a family plan for insurance, the maximum contribution is $7,200 for 2021 ($7,300 for 2022). If you are over 55, there is a $1,000 catch up contribution available as well. Unlike other tax efficient saving strategies, your adjusted gross income level does not phase you out of a contribution. Also, you don’t need to worry if you itemize your deductions or take the standard deduction come tax time, all contributions will reduce your taxable income. You will typically have the ability to make your HSA contribution before tax time. This is helpful as you could wait until March or April before making your contribution from the previous year after you estimate what your tax liability might be. Of course, consult with your tax advisor on federal and state tax impacts of making an HSA contribution.
2. Tax efficient growth
Once the contributions are made, the growth from year to year is not taxable. Unlike a taxable brokerage account (investing in stocks/bonds/mutual funds), you will not receive a 1099 for interest or capital gains purposes. Furthermore, the distributions are also tax free as long as they are used for qualified healthcare expenses. Unlike a normal retirement account, you don’t have to wait until 59 1/2 to take those qualified distributions. We will cover what a qualified healthcare expense is later, but think about the tax power of this vehicle. All other retirement vehicles that you take a tax deduction up front grows tax deferred, not tax free. Furthermore, tax free retirement vehicles like Roth IRAs, Roth 401ks, etc., don’t allow for a tax deduction up front! Therefore, the HSA has the best of both worlds from a tax standpoint in that it’s tax deductible, and grows tax free (as long as it’s used for qualified healthcare expenses).
A health savings account can be used for current medical expenses, or future medical expenses. This means you are not required to “empty out” your HSA at the end of the year, unlike it’s cousin, the Flexible Spending Account. This means that the HSA can be used in a year where you have abnormally high medical bills (major surgery, having a child, unexpected ER visit etc.), or can be used in future years, or better yet in your retirement years. Furthermore, there is no limit on the timing of reimbursement. Let’s say you had major surgery in 2021, but had some cash on hand to pay for the expenses. Therefore, instead of taking an HSA distribution, you decided to let it compound and invest it for the long term. Let’s say 15 years later, you needed to raise some cash. Well, let’s say that surgery set you back $5,000 out of pocket, you could reimburse yourself for that surgery that occurred more than a decade ago. This feature also allows you to grow the funds over time with compounding interest before reimbursing yourself. Make sure you have a process to archive receipts, which often times can be done with your HSA provider. The final component of flexibility is portability. If you leave an employer, the HSA always remains with you. You can even roll it over to a different HSA provider if your new company offers a plan that you want to participate in.
4. Growth opportunities
Given the ability to make contributions over your working years without the requirement of withdrawing funds, the HSA also offers an opportunity to accumulate a sizeable balance that can be used in your retirement years. Additionally, you can even invest those unused funds in a basket of securities such as mutual funds or ETFs for even more growth opportunities. Typically, the HSA provider will require some reserve amount that cannot be invested, let’s say $1,000. Once you exceed the $1,000 mark, you can choose from a menu of investment options that suit your time horizon and risk tolerance.
The tax deduction up front, the tax free growth, flexibility, and growth opportunity are all reasons why this vehicle is the most powerful vehicle you can utilize for retirement savings. We already know healthcare is going to be a major expense during retirement, so why not get the most bang for your buck when paying for those healthcare expenses and leverage the HSA?!
Anyone who is not enrolled in Medicare and is enrolled in a high deductible health plan is eligible to participate in an HSA. Most of you probably won’t worry about this, but you cannot be listed as a dependent on someone else’s tax return. Some may view the high deductible health plan requirement as a downside, but most high deductible plans still provide your preventative care like annual physicals, child/adult immunizations, screening services and other routine check ups with little to no out of pocket charge. The minimum annual deductible required to qualify as a high deductible is $1,400 for individual coverage and $2,800 for family coverage. Additionally, the maximum out of pocket expense plus deductible needs to be $7,000 for individual plans or $14,000 for family coverage. These are the basic requirements for the health insurance plan in order to be eligible for an HSA. As you can see, the deductible may be slightly higher, but the tax benefits of the HSA contribution alone can help offset that slightly higher out of pocket cost. Furthermore, that tax free compounded growth on your investments makes the high deductible plan worth it in many instances allowing you to build up that retirement health care nest egg.
The list of qualifying medical expenses is very extensive. Chances are, anything that is non cosmetic is likely a qualified medical expense, including costs associated with dental and vision. If the HSA distribution is deemed non-qualified, the funds are taxable and subject to a 20% penalty if you are under the age of 65. Here is a link to a resource that provides a list of all qualified medical expenses: CLICK HERE
Outside of the traditional list, I wanted to point out a few that might not come to mind initially.
This is monumental, given the likelihood of retirees needing long-term care. The most recent statistic is 70% of those 65 and older will need some type of long-term care services during their lifetime. On average, women receive care slightly longer at 3.7 years vs. men at 2.2 years. Given the costs associated with long-term care, it is prudent to incorporate a plan well before you retire, whether it’s buying insurance, “self insuring,” or a combination of the two. For those who decide to buy insurance, you can withdrawal funds from your HSA tax free to pay the premiums, as long as it’s a qualified long-term care policy. Traditional, stand alone, long-term care policies without any cash value features are generally qualified policies, and HSA funds can be tapped to pay these premiums. Hybrid policies, however, are a bit more complex. These hybrid policies combine life insurance with a long-term care benefit, so if you never need long-term care services, typically your beneficiary will receive some sort of death benefit when you pass away. These policies have historically been considered NOT qualified, and HSA funds could not be used to pay these premiums tax free. However, companies are now identifying what is called a “separately identifiable long-term care premium,” which would be allowable as a qualified premium, and therefore HSA funds could be used in this situation. Consult with your insurance agent and tax advisors to ensure you don’t make any mistakes here.
If you decide not to buy insurance, or you plan on buying a small policy and “self insuring” for any additional long-term care costs, an HSA is a home run tool for this pool of dollars. Long-term care services are in fact qualified expenses, and HSA funds can be tapped to pay these costs. It’s estimated that a private room nursing home is upwards of $105k/year in the US (depending on where you live). If you needed to tap $105k/year to pay into a nursing home and only had tax deferred accounts on your balance sheet, such as a 401k, you would need to make distributions in the amount of $125k-$150k/year depending on your tax bracket. On the contrary, a $105k expense is a $105k distribution from an HSA given the tax free nature of these withdrawals.
I wrote an entire article on long-term care planning. If you are interested in reading more, you can use the link HERE.
This would apply to Medicare part B, C and D. However, Medigap policies are not considered qualified expenses. This is important because if you build up a substantial HSA balance, you could guarantee that you will have qualified medical expenses simply by way of being enrolled in Medicare. Additionally, there might be years where your Medicare premiums go up based on your income (think selling a business or real estate property, Required Minimum Distributions etc.), and you can use the HSA to offset that increase in premium.
If your spouse is named as beneficiary when you pass away, your spouse will take over and continue the tax benefits as an HSA. Basically, there are no changes. However, when the HSA is passed to a non spouse (adult child or other beneficiary), the account is no longer an HSA and the full balance is taxable income for that beneficiary. Nobody has a crystal ball, but if you are building significant savings in an HSA, you might want to have a process to make regular reimbursements during retirement so you don’t create a tax windfall for your heirs. Given the flexibility in the timing of reimbursements, you can very easily go back over the years and pay yourself for medical bills incurred in the past. One other final disclaimer on that note. You cannot reimburse yourself from an HSA for expenses that were incurred before that HSA was established! If you set up an HSA in 2015, you can only reimburse yourself for expenses as long as that HSA was established (2015 and beyond).
Medical costs are pretty much a given, so why not take advantage of the IRS tax code and maximize your ability to pay for them now and in the future. If you are young and healthy, I would strongly encourage the use of a high deductible health plan combined with an HSA. If you have concerns about the higher deductible given your medical history or unique situation, simply do the math on the tax savings of making an HSA contribution vs having a slightly higher out of pocket expense for the deductible. Most HSA providers even give you calculators to help you with that math. However, the real power is in the ability to build up a substantial nest egg with tax free compounding and investment opportunity within the HSA. This will allow for you to recognize some tax relief while you are working and contributing, but have another layer of tax free distributions to supplement your retirement income. This is especially true if you no longer qualify for Roth IRA contributions or don’t have a Roth 401k/403b option available at your employer. Even if are are closer to retirement, don’t let that discourage you. You can still max out the HSA contribution every year, invest the funds in a well diversified portfolio, and have a decent account balance to pay healthcare costs in your retirement years.
Be sure to consult with your tax advisors and financial planner before making any changes to your situation. If you would like to schedule a call with me to review your situation and figure out what strategy fits in your overall plan, you can book a “Mutual Fit” meeting by clicking the button below.
70% of those 65 and older will need long-term care services. The question is, how will you pay for it? We will address buying insurance vs “self-insuring” in our article.
Planning for retirement after losing a loved one is difficult. The key is taking it one step at a time and consult with the right professionals.
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:
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.
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.
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.
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They say it’s not what you earn, it’s what you keep. I agree with this wholeheartedly as it relates to not spending more than you make (obviously). However, in my line of work, being sensitive to the TAX efficiency of a retirement plan is critical. If I can save my clients $10,000 or even $20,000/year in taxes during retirement, that’s huge!
In a world where it seems like companies are moving away from customer service and towards automation, I wanted to have a practice where the focus was on white-glove service and treating every client like family instead of a number.