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Category: Retirement Income

Are Financial Advisors Worth It?

"How do fiduciary financial advisors add value?"

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.

What is comprehensive advice?

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.

What are the five value-added practices? I use the acronym “T-I-R-E-S”

  1. Tax planning
  2. Income Distribution Planning
  3. Risk Management
  4. Expense Management
  5. Second set of eyes

Tax planning

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.

Income Distribution Strategy

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!

Risk Management

The major risks you will see during your lifetime from a financial planning perspective are:

  1. Bear market
  2. Behavioral
  3. Longevity
  4. Inflation
  5. Long-term care
  6. Premature death
  7. Incapacity or aging process

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.

Expense Management

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.

Second set of eyes

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:

  1. Tax planning = 1%/year
  2. Income Distribution Planning – 1.1%/year
  3. Risk Management – 2%/year
  4. Expense Management – 0.26% – 0.34%/year
  5. Second set of eyes – 0.5%/year

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.

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OUR PROCESS
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Feeling charitable? Consider strategies that also boost your tax savings.

Tax Benefits of Charitable Giving

The Annual Report on Philanthropy from Giving USA estimates that individuals gave $324.10 billion to US charities in 2020.  This was an increase of 2.2% year over year from the 2019 report.  Despite all of the negative news the media likes to focus their attention on,  America is a very generous country.  However, I run into many people that are uncertain about how to maximize the tax impact of their charitable giving.  There are a few key points at play.  

-It’s estimated that older generations will transfer $70 trillion of wealth between 2018 and 2042 as a result of diligent savings and investing throughout their lifetimes.  
-In 2017 the Tax Cuts and Jobs Act passed, which doubled the standard deduction.  This is the amount individuals and couples can deduct automatically on their tax return.  This led to fewer people itemizing their charitable donations. 
-Finally, the SECURE Act of 2019 has increased the tax liability on qualified retirement plans that pass on to the next generation. 

As a result of all of these factors, many of my clients are interested in giving to charity during their lifetime, but at the same time finding ways it could improve their tax situation during their life as well as for their heirs.  QCD stands for Qualified Charitable Distribution, and DAF stands for Donor Advised Fund.  There are other ways to donate to charity by way of private foundations, establishing special trusts or gifting outright.  However, this article will focus on QCDs and DAFs as they are the most common solutions I see used for my clientele.  I hope you find it helpful!

Let's first talk about Required Minimum Distributions

When you turn 72, of 70 1/2 before 2020, you are required to take a portion of your qualified retirement plans as a distribution by way of the “Required Minimum Distribution,” or RMD.  The amount required is based on a life expectancy table published by the IRS.  Most individuals use the table below, unless their spouse is sole beneficiary and is more than 10 years younger.   The RMD is calculated by dividing your year end account balance as of December 31st, and simply dividing it by the Distribution Period associated with your age.  Example:  Let’s say your IRA account balance at the close of the previous year (December 31st) was $1,000,000, and you are turning 75 this year.  You will take $1,000,000 and divide it by 22.9, which gives you $43,668.12.  That is the amount you will be required to withdrawal before the year is over. 


You will notice that each year, the Distribution Period becomes smaller, and therefore the amount required to be withdrawn goes up.  If you turned 90 with a $1mm IRA, you would be required to withdrawal $87,719.30!  This equates to almost 9% of the account balance.  One exercise I will run through with my clients well before turning 72 is to calculate their projected RMD each year during retirement, and compare that to how much they will actually spend for their retirement lifestyle.  Over time, I often see the RMD increases at a much higher rate than annual spending, therefore creating a surplus in income over time.  

A common complaint I hear:  “The IRS is making me take out all of this income I don’t need!”  If you want to minimize the tax impact on unnecessary withdrawals, thoughtful planning must be introduced years before turning 72.  I often tell my clients that retirement income planning begins at least a decade before they retire in order to optimize their financial plan. 

All retirement plans including 401ks, 403bs, 457bs, other defined benefit plans and traditional IRAs have RMD requirements.  Roth IRAs do not have RMDs while the owner is alive.  Roth 401ks, however, do have RMD requirements. Therefore, many people opt to rolling over their Roth 401ks to their own Roth IRA once they have attained eligibility requirements to avoid the RMD. 

It’s critical to satisfy RMD requirements, otherwise you will be hit with a 50% penalty on the funds you did not withdrawal on time.  Example:  If your RMD amount was $50,000 and you failed to take any money out, you could be responsible to pay a penalty in the amount of $25,000!  

If you turn 72 and are actively employed, RMDs associated with their employer plan could be eligible for deferral.  Any other accounts not affiliated with that active employer will still have an RMD.  Once you separate from service from that employer, you will then begin taking RMDs based on your attained age for that year.  For your first RMD, you have the option to defer the distribution until April of the following year.  This is helpful if you expect your tax rate to go down the following year.  Just note that you will have to take two RMDs that following calendar year, one by April 1st, and the other by December 31st. 

I have some clients who wait until December to pull their RMD if they don’t have a need for the cash flow.  This way they can maximize their tax deferral and keep their funds invested as long as possible before taking the RMD.  On the other hand, if you have a need for the income to meet your expenses, you might opt to take an equal monthly installment to reduce the risk of selling out at the wrong time.  It also helps create a steady cash flow stream for budgeting purposes in retirement.  

Qualified Charitable Distribution

 

A Qualified Charitable Distribution, also known as QCD, allows for you to donate up to $100,000 of your IRA directly to a qualified 501c3 charitable organization.  The Protecting Americans from Tax Hikes (PATH) Act of 2015 has made the QCD a permanent part of the IRS code and allows you to count that distribution towards your RMD that year, but exclude it from your adjusted gross income!  The QCD must come from an IRA (traditional IRA, inherited IRA, or an inactive SEP or inactive SIMPLE IRA), it cannot come from another qualified plan like a 401k or 403b plan.  Of course, the account must also be in the RMD phase.

Example.  If your RMD is $100,000, normally you would be required to withdrawal $100,000 from the balance of your IRA and include the distribution in your gross income.  However, you could instead elect to donate up to $100,000 to a charity, or multiple charities, directly from your IRA and reduce your taxable income by up to $100,000.  Of course, the charity also receives that donation tax free as well.  This results in a significant amount of tax savings for the IRA owner and provides a larger donation to the charity of your choosing.  Also note that the $100,000 limit is annually per person.  If you are married, you would each have that $100,000 limit if you both qualify for a QCD. 

This has become increasingly more beneficial with the Tax Cuts and Jobs Act signed into law in 2017 (TCJA).  The TCJA doubled the standard deduction which for 2021 is $12,550 for single tax payers and $25,100 for married couples filing jointly.  The new law significantly reduced the number of tax payers who itemize their deductions.  Charitable donations are an itemized deduction, so if a tax payer is not itemizing their deductions, the charitable donation has zero tax impact to the tax payer.  Therefore, the QCD allows for the tax payer to essentially get a tax benefit for donating to charity without needing to itemize their deductions.   Excluding the donation from your adjusted gross income could have other tax advantages as it might reduce your Medicare premiums as well as your overall tax bracket. 

It’s important to note that the charity has to be a qualified 501c3 organization.   You cannot donate to a private foundation or a Donor Advised Fund.  However, there is no limit on the number of organizations you donate your QCD to.  Most financial institutions allow you to create a list of the organizations that you want to benefit from your donation, and they will send the checks for you directly from the IRA.

Planning Ahead

 

Many clients I serve run into what I call the tax trap of traditional IRAs and 401ks.  I wrote an article about this and you can read more about it here.  The gist is they are the victim of their own success.  They saved and invested wisely, and accumulated a bulk of their assets in tax deferred vehicles, among other assets.  At RMD age, they are forced to take distributions they may not need, thus creating a negative tax effect (higher tax brackets, higher Medicare premiums, increased social security taxes etc.).  QCDs can certainly help alleviate that tax burden for those that are charitably minded.  However, you still want to do some planning well before turning 72 to optimize your tax situation.  If you plan to donate to charity during retirement, make sure you leave some room in your tax deferred plans to make those QCDs.  On the other hand, make sure your RMD’s wont push you into higher than anticipated tax brackets or bump your Medicare premiums up substantially.   You may want to consider doing some Roth conversions, or leveraging a Roth 401k option in lieu of a Traditional 401k.  The point is, don’t be blindsided by RMD’s, but be intentional well before you begin taking those distributions so you don’t run into the tax trap!

Qualified charities do not pay taxes on distributions.  I mentioned the SECURE Act briefly and also wrote about it in more detail in the article I referenced earlier (link here).   The important thing to note is that it eliminated the inherited IRA for most non spousal beneficiaries.  Therefore, when you leave those 401ks or IRAs to your children, they will be forced to liquidate all of the funds within 10 years, accelerating taxes on those plans relative to the previous law.  This is a further validation for not only QCDs for charitable giving during lifetime, but also for naming those charities as a beneficiary for these tax deferred accounts.  Instead of leaving those assets to your children for your legacy goals, you may consider leaving other assets such as life insurance, Roth accounts, or taxable brokerage accounts that are more tax advantageous for those beneficiaries.   Again, thoughtful planning is critical to provide these opportunities before it’s too late to make any meaningful changes.

Donor Advised Funds

A Donor Advised Fund, or DAF, is an opportunity for individuals to donate cash or securities to these specified accounts, potentially recognize a tax deduction, and allow the funds to grow tax free to be used in the future for charitable giving.  Unlike donating to a specific charity outright, the DAF can benefit as many charities as the donor chooses.  Additionally, I’ve seen clients name their children as successor Donor Advisors in order to teach the next generation how to be a good steward of their dollars.  A big advantage of a DAF is the ability to front load donations.  As I mentioned earlier, many tax payers are taking the standard deduction given they don’t have itemized deductions that exceed the standard deduction amounts.  However, if you plan to donate each year for the next several years to certain charities, you might consider front loading a contribution to a DAF in order to qualify for an itemized deduction, and then spread out the actual donations over several years.  Let’s look at an example.

Brenda is married and normally donates $5k/year to a local animal rescue.  The $5k donation, along with other deductions, does not exceed $25,100 (standard deduction for married filing jointly).  Therefore, that $5k donation is meaningless from a tax standpoint.  However, Brenda will continue to donate $5k for at least the next 10 years.  She has cash savings in excess of $100,000, so she decides to donate $50k to a DAF ($5k x 10 years), which puts her over the standard deduction limit and gives her the ability to deduct that $50k donation!  Going forward, she will make a distribution from the DAF in the amount of $5k/year over the next 10 years to benefit the charity!  Additionally, she can choose to invest the dollars in the Donor Advised Fund, so she has the possibility of growing her account balance even more for her charitable goals.

The DAF also allows for contributions from appreciated assets, like stocks, bonds or mutual funds.  Let’s say you owned a stock that appreciated $100k over the original value.  This is obviously great news, but if you sold the stock, you would include that $100k in your adjusted gross income and would owe taxes.  However, if there is no need for that particular security for your retirement or other financial goals, you could donate that security to the DAF without any tax consequences.   Additionally, the DAF could sell the security and reinvest it into a more diversified portfolio without incurring any taxes either.  This is a powerful tool to utilize for those appreciated securities that don’t have a specific purpose for your own income needs. 

It’s very important to note that a DAF contribution is irrevocable.  Donors cannot access those funds except when used for donations to a qualified charity.  However, there is no time limit on when the funds need to be distributed.  Just like any charitable contribution, make sure it aligns with your financial goals and is coordinated with the rest of your financial picture.  

Conclusion

If you plan to make financial gifts to charitable organizations, make sure you consult with your tax advisor, estate attorney and of course your financial planner.  Make sure your charitable giving is coordinated with your overall plan, and also make sure you take advantage of tax benefits where possible.  There are certainly more ways than a QCD and DAF to satisfy charitable goals, so please be sure that you choose the right solution based on your unique circumstances.  If you would like to discuss your charitable giving strategy, or other financial goals, you can always start by scheduling a no obligation “Mutual Fit” meeting below to learn how to work with us.  We look forward to speaking with you!

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Stress Test Your Retirement Plan

Have you stress tested your retirement goals?

“When you retire, there are two doors in which you can walk through.  Door #1, the people outlive the money.  Door #2, the money outlives the people.  My mission is to help people walk through door #2.”  – Nick Murray

Karen and Pat had a goal to retire in 2009 at the age of 62.  They planned to take Social Security, start drawing Pat’s pension, and then supplement the difference with withdrawals from their retirement portfolio.  Who could have predicted that the Great Recession would wipe out 50% of the stock market value the year before they planned to retire?  They lost nearly 35% of their portfolio, and the decisions that followed ultimately pushed their retirement plans back 11 years!  Pat was a classic “Do-it-yourselfer” and seemed to have the financial house in order, and Karen relied on his handling of their financial affairs.  What I’ve learned is the closer major milestones become, such as retirement, the fear of loss is amplified.  The only way to mitigate the risk of loss is to have a disciplined process that can be followed during the good times, and the bad times, which would have helped Karen and Pat navigate through the Great Recession relatively unscathed. 

Since that experience, I have seen many different events play out that have derailed retirement goals.  On a more positive note, I have personally helped countless families prepare for and execute a successful retirement.  I have come to the conclusion there are 5 major financial risks that could seriously impact financial independence and put you in jeopardy of running out of money.  As part of our financial planning process, we stress test each of these risks to see how our client’s financial goals would be impacted.  The 5 stress tests are as follows: 

1.  Bear Market Risk (a 20% or more drop in the stock market)

2.  Longevity Risk (living longer than you anticipate)

3.  Inflation Risk (what if inflation is higher than we anticipate?)

4.  Prolonged Low Return Risk (experiencing lower returns than expected)

5.  Long-term Care Risk (the cost of needing custodial care later in life)

For a limited time only, we are offering a complimentary Retirement Review to stress test your retirement goals to see how we can help you on your path to financial independence.  By clicking the START HERE below, you will begin the process with a brief questionnaire.  My team will process this information and get in touch with you if we have any questions or initial thoughts.  We will then schedule a 30-45 minute Retirement Review to show you our findings to improve your probability of success.  We look forward to helping you!

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6 Stress Tests for a Bulletproof Retirement

You're invited to join us live on Thursday, September 30th @ 2pm - 3pm EST.

Free Webinar

Have you stress tested your retirement plans? If you are within 10 years of retirement, you must have a plan for the 6 “what-if” scenarios that could derail your financial goals.

The year was 2007, and my parents were all set to retire in just 12 short months. My Dad worked in IT and is a first generation American. My Mom was a preschool teacher and had no retirement benefits. She knew little about what was going on with their financial plans aside from listening to my Dad complain every time the market was down. As we now know, 2007 was the beginning of the Great Recession, which is the worst recession we’ve seen in our lifetime. Stock markets were down close to 50% and unemployment reached 10%. Like many other hard working Americans, the Great Recession of 2008 ended up pushing my parents’ retirement back 11 years. I made it my mission to help every day families prepare for the what-if scenarios when planning for retirement, including:

  • What if we go through a recession like 2008?
  • What if one, or both of us live longer than expected?
  • What if there are changes to Social Security?
  • What if market returns are lower than we anticipate?
  • What if there is higher than expected inflation?
  • What if there is a long-term care event during retirement?

These are the 6 most common concerns that keep my clients up at night.  My value proposition is to stress test each one of them and ensure their plans are bulletproof to and through retirement.  I look forward to meeting you live at our webinar.

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This is my wife, Jessica, and oldest son, Tristan. We have since welcomed twin boys to our family, Julian and Jackson!

What is a safe withdrawal rate for retirement?

What factors go into retirement withdrawal strategies?

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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