One of the most persistent analogies I have heard in my career as a financial adviser is the story of climbing and descending Mount Everest. As the story goes, more climbers perish on the way down the mountain than do climbing up it. We then equate our clients’ wealth journey with that of climbing Mount Everest – spending lots of time and effort to get to the summit of peak financial wealth (i.e., retirement) only to be left with the question, “How am I to descend the mountain safely?”
While many analogies are tired and overdone, this is actually not a bad one. The problem is this: We as an industry have done an awful job at guiding our clients down the mountain with the same degree of care that we provide on the way up.
Until just within the last decade or so, our standard answer for descending the retirement mount has been the venerated “4% Withdrawal Rule,” popularized in the mid-’90s by historical study of withdrawal rates by William Bengen. Although this rule has been regarded as relatively failsafe, many of the assumptions used in its origination are incongruent with many of the assumptions we make for our clients’ retirement roadmap today.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
There is a better way to help clients build an income strategy for retirement, and our clients deserve just that.
3 Alternatives to the 4% Rule for Your Income Plan
Most advisers are already familiar with the concept of probability-based planning using Monte Carlo analysis. The same concept holds true for distribution planning. Although we cannot ensure a given level of income from the portfolio over time, we can reasonably expect the portfolio to provide it in most scenarios.
The task becomes how to actually structure the withdrawals to stay within the acceptable probability of success range. Within this category there are two similar but distinct ways to converting a portfolio into income throughout retirement.
Income Approach No. 1: Dynamic Systematic Withdrawals
The first approach is what is called dynamic systematic withdrawals, or systematic withdrawals with guardrails.
This approach modifies the traditional systematic withdrawal approach by introducing decision rules, or “guardrails,” to determine when and how distributions may increase or decrease over time. These decision rules are set forth at the creation of the plan and inform the decision to reduce withdrawals to accommodate increased risks related to the markets, longevity, inflation or sequence risk.
Some examples of these rules inlcude Jonathan Guyton’s and William Klinger’s decision rules, floor and ceiling rules, and targeted portfolio adjustments. In their study, Guyton and Klinger found that a sound set of decision rules could potentially increase the initial withdrawal rate by as much as 100 basis points.
Who may want to use this method: This approach may be the most appropriate for retirees who are willing to tolerate some fluctuation in their retirement paychecks (subject to some limits, of course) but who want to start out with as high an income as possible.
Income Approach No. 2: Bucketing
The second probability-based philosophy of converting a portfolio into retirement income is called time-segmentation or, more commonly, bucketing. The term “bucketing” has been used and reused to fit a wide set of applications. Within the context of retirement income planning, bucketing refers to the breaking up of retirement into distinct time increments and investing for specific outcomes at specific times. The idea is, if I know I won’t need to touch a sum of money until some specified date in the future, I will be more comfortable riding out fluctuations in the value of that bucket.
A simple way to set up buckets is to separate the portfolio into time segments corresponding with the “Go-Go” years, the “Slow-Go” years, and the No-Go” years of retirement, although there are many ways to achieve the same end using other methods of segmentation. These different time periods in retirement typically represent different spending patterns.
Who may want to use this method: This second approach to retirement income planning may be the most appropriate for retirees who desire more structure in their plan and who would typically need more behavioral coaching along the way using systematic withdrawals. These clients may have a lower-than-average risk tolerance for their age, and they are likely to be more detail-oriented.
Income Approach No. 3: Safety-First Planning
Our third approach to retirement income planning has wide acceptance in the academic community, garnering support from multiple Nobel laureates and a wide array of academic thought leaders. The safety-first approach, also known as the flooring approach, is tied to the academic theory of life-cycle finance. This theory seeks to address the question of how to allocate resources over one’s lifetime so as to maximize lifetime satisfaction, given existing spending constraints.
Put simply, in the safety-first approach you help the client categorize their expenses into needs, wants and wishes. You then create a floor for their needs using pensions, Social Security, bond ladders and income annuities. In this process, it is essential that the financial adviser does not project their own perception of what should be considered needs and/or wants. This should be left entirely up to the client(s), with the adviser as a guide.
Who may want to use this method: This approach lends itself more to individuals and couples who focus more on their cash flow than their wealth and to those couples who are relatively healthy with long expected lifespans.
The Bottom Line on Income Planning
Whichever approach you and your client ultimately decide upon, one thing is inevitable: You will have presented your client with a thoughtful and methodical approach to designing their plan, their way. After all, what good is a Sherpa who guided you all the way to the top of Mount Everest only to tell you he didn’t know how to safely get back down?
-
Can the 'Guardrails Approach' Protect Your Retirement Investments?This investing method helps retirees avoid running out of money, even in a highly volatile market.
-
Social Security Is Taxable, But There Are WorkaroundsIf you're strategic about your retirement account withdrawals, you can potentially minimize the taxes you'll pay on your Social Security benefits.
-
Social Security Is Taxable, But There Are Workarounds
If you're strategic about your retirement account withdrawals, you can potentially minimize the taxes you'll pay on your Social Security benefits.
-
Serious Medical Diagnosis? Four Financial Steps to TakeA serious medical diagnosis calls for updates of your financial, health care and estate plans as well as open conversations with those who'll fulfill your wishes.
-
To Stay on Track for Retirement, Consider Doing ThisWriting down your retirement and income plan in an investment policy statement can help you resist letting a bear market upend your retirement.
-
How to Make Changing Interest Rates Work for Your RetirementHigher (or lower) rates can be painful in some ways and helpful in others. The key is being prepared to take advantage of the situation.
-
Within Five Years of Retirement? Five Things to Do NowIf you're retiring in the next five years, your to-do list should contain some financial planning and, according to current retirees, a few life goals, too.
-
The Home Stretch: Seven Essential Steps for Pre-RetireesThe decade before retirement is the home stretch in the race to quit work — but there are crucial financial decisions to make before you reach the finish line.
-
Three Options for Retirees With Concentrated Stock PositionsIf a significant chunk of your portfolio is tied up in a single stock, you'll need to make sure it won't disrupt your retirement and legacy goals. Here's how.
-
Four Reasons It May Be Time to Shop for New InsuranceYou may be unhappy with your insurance for any number of reasons, so once you've decided to shop, what is appropriate (or inappropriate) timing?
