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Maximize Your Retirement With This Distribution Strategy

Maximize Your Retirement With This Distribution Strategy

January 13, 2020
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It is the year 2020 and people are living longer, and that means spending more time in retirement. Spending more time in retirement most likely means needing more money. Companies and organizations are well aware of this phenomenon, and as a result pension programs virtually everywhere are being slashed or eliminated entirely. This leaves main street America having to save on our own to get us through retirement - we all know how good we are at that. Now that we have saved our entire working lives, how do we make sure that we won't out-live our money once we stop working? How can we make sure our money outpaces inflation? Let me show you what I believe is the most efficient solution.

Drawbacks of the typical fixed percentage or "lifestyle withdrawal" strategy

Whether you're brand new to investing or in a league of well-versed investors, you've likely heard of the "4% withdrawal rate". The "4% withdrawal rate" is a long lived rule-of-thumb that has been touted as a "safe" withdrawal rate from an individual's retirement portfolio to help ensure it lasts 20 or so years before being depleted. For purposes of this article, a retirement portfolio is a portfolio of investments subject to market fluctuation - it does not include Social Security, pensions, or income from rental properties. The assumption has always been that the 4% will consist primarily of interest and dividends from the investments, and minimal invasion of principal. The rule also provides room to adjust for inflation each year if needed.

The first problem I have with this rule is that it must be followed year-in and year-out. If the retiree needs an additional lump sum of money (or multiple) in any given year, it can drastically reduce the portfolio's compounding power going forward. While one may not expect to take additional withdrawals, this strategy doesn't leave much room for the unexpected.

A second issue is timing. If a new retiree starts withdrawing a fixed percentage, and their portfolio drops drastically within the first few years (due to market downturn combined with withdrawals), their portfolio will likely deplete much sooner than anticipated. The timing is something no one can control - you can control (to an extent) when you start to take withdrawals, but you can't control or predict the markets. 

The third issue I have is that rules of thumb (4%) will not work for everyone. We all know that everyone has different expenses and desired qualities of life. Not only that, but everyone will have a different amount of savings by the time they choose to stop working. In this case, will 4% be enough? or will the investor require a 5%, maybe 6% withdrawal rate? What if one's fixed costs alone are equivalent to 4% or more of their portfolio?

Here's an example of this type of strategy illustrated by Thornburg Investment Management:

Lets take a look at using a 5% annual fixed percentage/lifestyle withdrawal strategy while adjusting our withdrawals each year for inflation. The hypothetical investor starts with a $1,000,000 portfolio and begins retirement in 1973.

Figure 1 shows the increasing (adjusted for inflation) annual withdrawals by the retiree for the first 10 years.

Figure 2 shows the the same hypothetical retiree's account balance over time. As you can see in this situation, the portfolio only lasts 21 years.1


This illustration helps explain that there are numerous factors other than withdrawals that impact a portfolio's longevity. The reason the portfolio in this example falls short of expectations is because the retiree retired in a time of rising inflation, coupled with multiple years of market downturns, and made no adjustments to withdrawals. If the retiree in this example had needed a 6% withdrawal rate to meet expenses, the portfolio would have lasted only 14 years!

Retirees who rely on their life savings to meet their necessary expenses and lifestyle goals cannot afford a possible situation like this, nor can they endure the risk associated with timing markets or economic cycles. What can we do to help mitigate this risk? Let's try implementing an "endowment spending policy".

The "endowment spending policy"

An "endowment spending policy" is a little more complex than the "lifestyle strategy" withdrawal method but can drastically increase a portfolio's longevity. The key difference is that this strategy adjusts the amount of withdrawals depending on portfolio performance and inflation. It accomplishes this by combining a percentage of the prior year’s spending amount with a percentage of the current market value of the investment portfolio - in order to determine the next year’s annual spending amount.

To begin using an endowment spending policy, retirees and their advisors must decide upon two things: The initial spending rate, and what formula should be used for the smoothing rule.

The spending rate is simply the annual withdrawal percentage the retiree would prefer or would need to use (i.e. 4%, 5%, or 6%). The smoothing rule is the rate in which annual withdrawals are increased or decreased depending on the performance of the portfolio investments. For example, a 90/10 smoothing rule assumes that 90% of the spending
amount will be based on the prior year’s spending, and 10% will be based upon the portfolio’s current valuation.1

Calculating a spending policy

Let's take a look at this chart which illustrates an example calculation for an "endowment spending policy". In this scenario we will take the same retiree from the previous example with a $1,000,000 portfolio, a 5% spending rate, and a 90/10 smoothing rule. Therefore our first year is set - the first year's withdrawal amount is $50,000 (5% of $1,000,000).

The first row illustrates the hypothetical portfolio value on January 1st of each year. The second row labeled "spending amount" shows what the retiree is able to withdraw or "spend" each year - after it's calculated. The third row indicates the acceleration or deceleration of the rate in which the portfolio is spent - notice how it does not continuously increase each and every year.

Explanation of Calculation:

The bulk of the calculation starts in Year 2 onward. Therefore focus on the column labeled "Year 2".

  1. Start with our smoothing rule by multiplying 90% by the previous year's spending amount ( $50,000 x .90 ) = $45,000
  2. Then take 10% of the current value of the portfolio on Jan 1st, Year 2 which is $800,000. ( $800,000 x .10 ) = $80,000. Then multiply that $80,000 by your initial spending rate of 5% - this spending rate does not change, you will continue to use this same rate in the future calculation years. ( $80,000 x .05 ) = $4,000
  3. Add steps 1 & 2 together for a subtotal. ( $45,000 + $4,000 ) = $49,000
  4. Multiply the subtotal by the previous year's change in inflation to get a Cost of Living Adjustment (COLA) - We use the "Consumer Price Index" or CPI to represent changes in inflation. ( $49,000 x .06 ) = $2,940
  5. Add the subtotal and the COLA together to get the new spending amount. ( $49,000 + $2,940 ) = $51,940

The bottom line

Let's look at a comparison of the two withdrawal strategies discussed:

When you compare an endowment spending strategy to a lifestyle, or basic fixed percentage withdrawal strategy, you'll see that you have the potential to drastically change the outcome of your retirement portfolio. The chart above illustrates the differences in the two portfolio distribution strategies over the same 21 year time frame. If the retiree implemented the endowment spending policy we gave, his/her portfolio would not only have been sustained, but also have a value of $1.8 million!

How is this possible? There were certain years when spending had to be slowed due to poor market and investment performance. The endowment policy does not let you increase withdrawals simply because inflation is rising - remember the illustrated time frame was a period of rising inflation. This left more money in the portfolio throughout those difficult years, and therefore allowed for a more powerful compounding effect when markets did perform well. Over time, the compounding can become overwhelmingly exponential.

If you are retired or will be retiring in the next 10 to 15 years, I highly recommend you consult with an advisor/planner that understands retirement distributions and strategies in depth. Today we are in a low-to-no inflation environment, and have already experienced the longest bull market in U.S. history. Where do you think we will be in the next 10 to 15 years? Will your portfolio survive?

      

Cameron Valadez is a CERTIFIED FINANCIAL PLANNER™ in Riverside, California


 

Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events or a guarantee of future results. It is meant for educational purposes only.  It should not be considered investment advice, nor does it constitute a recommendation to take a particular course of action. Please consult with a financial professional regarding your personal situation prior to making any financial related decisions.

All investing involves risk and the potential to lose principal, and there can be no guarantee that any investing strategy will be successful. The hypothetical examples are for illustrative purposes only and should not be deemed a representation of past or future results. The examples do not represent any specific product, nor do they reflect charges or other expenses that may be required for some investments.  The S&P 500 is an unmanaged index which cannot be directly invested into.

1Thornburg Investment Management