With many Americans routinely living 25 to 30 years into retirement—or more—it’s time to rethink planning horizons.
· Successful retirees know how much they need to maintain a reasonable lifestyle; how much they need to save to get there; and how much they can reasonably withdraw from investment accounts each year.
· The long-standing 4-percent drawdown rule may no longer be a viable benchmark.
· Retirees must manage three types of risk as they age: investment and portfolio risk, consumption and inflation risk, and, finally, mortality and longevity risk.
The American College launched a doctoral program in retirement planning to help academicians and practitioners look more closely at the coming retirement crisis and help identify possible solutions. Much has been written in the past few years regarding the new thinking that has emerged regarding safe withdrawal rates and floor income.
At the core of retirement planning are three key questions:
First, how much capital is needed at retirement in order to maintain a reasonable lifestyle until death?
Second, how much should be saved to reach this goal?
Third, how much can be reasonably withdrawn from an investment account to sustain this lifestyle without running the risk of depleting the investment portfolio?
Embedded in these questions are issues of significant importance. Without a keen understanding of the possible answers and their ramifications, you and your advisors could run the risk of making poor decisions that will not be discovered until it is potentially too late. Yet it’s easy for retirees to be lulled into a false sense of security and ambivalence from which they might never recover.
Is the 4-percent drawdown rule still viable?
At the core of this problem is the four percent rule first proposed in 1994 by William Bengen, CFP. His historical analysis of rolling returns concluded investors could withdraw an inflation-adjusted four percent annually from their portfolios with impunity. This soon became the benchmark for distribution planning for nearly two decades. It took the lost decade (2000 to 2009) for many people, including experienced financial advisors to realize that markets are potentially dangerous to a retiree’s wealth.
Dr. Moshe Milevsky, Dr. Wade Pfau and other researchers, using Monte Carlo simulations (that’s not gambling, but a sophisticated financial scenario planning tool), have questioned whether this conclusion is as bulletproof as Bengen suggested. Their research and modeling show a high probability of failure due to “sequence risk”—caused by an unfortunate cycle of down markets. If this happens during the first few years of your retirement, there is virtually no way to recover. You could find yourself in a downward spiral with no way to escape.
Don’t let this happen to you.
Three phases of retirement and risk factors
The investor life cycle has built on three phases:
2. Transition and
In each phase, you must be aware of how these risks will impact your investment and portfolio risk, your consumption and inflation risk, and finally, your mortality and longevity risk. Early models for retirement planning treated all three phases the same. Additionally, there was little thought given to whether the “go go” years of early retirement required the same amount of income as the “slow go” or “no go” years later in your retirement years. Is there an optimum “glide path” for distributions instead of a straight upward slope including inflation? Should you ask your advisor about growth strategies for your portfolio if you are in your 80s, retired and have no legacy intent?
Strategically, does it make sense to grow your portfolio as large as possible, with no eye toward a safe withdrawal rate. Or, should you instead have a floor of real income that cannot be outlived? Dr. Wade Pfau has invested hours of research and effort to show options and ways for retirees to evaluate an optimal divestiture strategy. With no bailout strategy or floor income, a retiree could be heading off the proverbial cliff without an escape route.
What is being termed the Fourth Generation of retirement planning has moved past this prehistoric thinking and is now more focused on a guaranteed income by utilizing a floor to prevent total devastation in the no-go years. Longevity planning is becoming more and more relevant as retirees routinely live 25 to 30 years past retirement.
New strategies include longevity insurance, building this floor with bond ladders and Treasury Inflation Protected Securities (TIPS) or annuities (using mortality credits). Other studies focus on lifestyle “glide paths” that allocate more income in the go-go years of retirement instead of using constantly inflating income assumptions with no practical consideration of age-based spending (not forgetting long-term-care risks). The amount allocated to the floor portion of the portfolio is based on the amount of wealth and income needed. Any surplus would be invested in the capital markets.
Factors that need analysis include risk tolerance, age and bequests considerations. In addition, wise retirees and their advisors will build a “sequence risk” buffer into their portfolio to protect against the dreaded market crash in a capital market portfolio, guarding against a crash during the first six years of retirement (the most vulnerable period). Asset allocation for retirement takes on a whole different meaning from how a portfolio is structured—large and small cap, domestic and international, value and growth.
Retirement planning has entered a new phase of analytics that will both retirees and those who advise them. Be on the lookout for new thinking and strategies to help you and your advisor build sustainable and personally rewarding income streams that will last a lifetime (and beyond).
Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail firstname.lastname@example.org.
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