On March 9, 2009, the beleaguered domestic stock market picked up its head and began a charge full speed ahead. The market has been positive ever since. While most of us have benefited from this run, it’s prudent to evaluate our income strategy now, during the good times, for the next bear market. Our current bull market just celebrated its 100-month birthday, nearly double the 55-month average. This continuing climb comes on the heels of the first group of Boomers hitting 70½, the age when they must start withdrawing from their retirement accounts.
The word "dynamic" can be defined as “always active or changing.” It’s probably not the first word that comes to mind as we think about aging or retirement. However, “dynamic” is exactly how you want to be with your investments in retirement. This applies both to investment management and annual withdrawals.
Why Retirees Need to be ‘Dynamic’ with Their Withdrawals
The origins of the 4% rule can be traced all the way back to a study by the Harvard endowment in 1973. More frequently cited is the research from financial planner Bill Bengen. In summary, they said that, based on certain market assumptions, retirees can withdraw about 4% of their initial portfolio value every year and be prepared financially for a 30-year retirement. Their thinking means that if you started drawing $40,000 from a portfolio of $1 million and increased that $40,000 every year by inflation, you should be OK. The markets will go up and down, but that $40,000 distribution will continue to increase.
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However, according to research by Vanguard (and almost everyone else), you have a much higher likelihood of success taking 4% of the previous year-ending account balance. This means your distributions are reduced in bad market years and increased in good ones. This works especially well if you have enough annual fixed income from Social Security, pensions, etc. to cover your basic expenses.
Make Sure You Sell Smart
In addition to being dynamic with your withdrawal amounts, you will decrease the risk of running out of money if you are dynamic with what you sell to generate income. In 2008, the S&P 500 was down 37%, while the Barclays Capital Aggregate Bond Index (as it was known then) was up 5.24%. In that scenario, if you are forced to take income, take it from the bond side of the portfolio. That will give the stocks time to rebound. If you are properly diversified, you can employ the most fundamental investment strategy: Buy low, sell high. I must add an important note:
- IRAs allow the flexibility to sell whichever investment you want to fund a distribution
- 401(k)s and other employer-sponsored plans generally make proportional sales. Essentially this means they will sell equal percentages across every investment to raise cash—not a great move in down markets.
Annuities Could Make Some Sense
The U.S. is increasingly moving away from pension plans and toward defined-contribution plans (401(k)s, IRAs, 403(b)s, etc.). As a result, the individual investor determines his own success. However, if you are not comfortable with market risk, or simply don’t want to have to think about retirement planning, it makes sense to annuitize a portion of your assets. Essentially you are exchanging a lump sum for a lifetime income stream. These guarantees often move with interest rates and therefore aren’t very high at the moment. In other words, annuities provide a hedge against market risk and longevity risk.
It is important to note that annuities are long-term investment vehicles designed for retirement purposes. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Guarantees are based on the claims paying ability of the issuing company. Any withdrawals made prior to age 59½ are subject to a 10% IRS penalty tax, and surrender charges may apply.
Dividends are Helpful, but They’ll Only Get You So Far
I’d be remiss if I didn’t mention perhaps the most time-tested income tool: dividends. Much of the Silent Generation still lives off of pensions plus dividends from blue-chip stocks. There is absolutely nothing wrong with this. Of course, those belonging to subsequent generations are less likely to have pensions, so they would need to amass a large sum of money to live off of dividends alone.
Currently, the dividend yield of the S&P 500 is about 2%. That means if you need $100,000/year in retirement, you’ll need a $5 million portfolio, without even considering taxes. That said, dividend-paying stocks should be part of any diversified portfolio. Just remember: In a low-yield environment, like today’s, when you reach for yield, you’re reaching for risk. Keep in mind that the payment of dividends is not guaranteed. Companies may reduce or eliminate the payment of dividends at any given time.
Go Conservative During ‘The Fragile Decade’
Finally, consider timing. Trying to time the market is a losing battle, but positioning your portfolio based on your retirement timing is wise. Your returns during the five years before and five years after retirement determine much of your success. That’s why these 10 years have been coined “the fragile decade.” During the fragile decade, you want to be especially aware of your exposure to market movements. You may not hit it out of the park with a conservative portfolio, but a big loss as you start to draw money could kill you.
Target-date funds were created with the premise that as you get closer to retirement, you should be more conservative. They may be a good tool to take you into that fragile decade—but not out of it. Research by Michael Kitces and Wade Pfau shows that you actually want to increase your equity exposure (increasing your risk) as you move further into retirement. That’s exactly the opposite objective of target-date funds.
If you’re pulling money out of your portfolio, you should have a financial plan that dictates how much you need to earn, how much you can pull, and where you should be pulling it from to sustain your lifestyle. The above advice is general but should be worked into a comprehensive plan. We will see a downturn at some point. No one knows if it will come tomorrow or five years from now, but I know that if I continue to follow my plan, sell my winners and avoid panic, I should be OK.
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