Since I entered this profession almost 40 years ago, I have noticed that the distribution recommendations financial advisors make to clients in retirement fall into one of five approaches — ones that, taken on their own, risk not meeting client expectations.
They are:
4% rule: Withdraw 4% of your account balance initially and adjust that dollar amount for inflation annually. (Given low-interest rates these days, it is questionable if this rate is even sustainable.)
Fixed percentage: Withdraw the same rate annually based on prior year-end values.
Fixed-dollar amount: Withdraw a set dollar amount every month or year.
Systematic withdrawals: Withdraw only interest and dividend income leaving principal intact.
Bucket plan: Hold some assets in cash equivalents, some in fixed-income, and some in equities filling the cash bucket when low from the fixed-income bucket or the equities bucket, depending on which is appropriate.
These methods are vulnerable to factors including market volatility, low-interest rates, inadequate savings and investments in place. Then there’s the possibility of clients retiring too early, clients living too long, risk-tolerance mismatch, inflation risks, unknown tax consequences and out-of-pocket health care costs.
Of all the above, the most critical risk to guard against is the longevity risk because it is a multiplier of all the other risks.
Therefore, I contend that unlike the accumulation phase of life when clients and advisors are more focused on the total amount of assets, in the distribution phase — retirement — advisors must help clients recognize and focus instead on the amount of income needed in golden years. Some clients often spend too much early and, to their chagrin, become destitute later. Or, they sacrifice too much lifestyle in the early years of retirement, thinking they want to leave a legacy — only to die too soon.
Key phases
None of the distribution approaches detailed above provide optimized outcomes for the majority of clients in my experience. Instead, advisors can enhance strategies by recognizing the three phases of retirement as follows:
1.The go-go phase: Early years in retirement are when clients are very active. They perhaps include much travel and acquisition — buying a new toy such as a boat, etc.
2.The slow-go phase: Typically, in the middle years, clients are settled and mellow out.
3. The no-go phase: In this phase, the retiree could require much caregiver help, long-term nursing home care, and includes the final act of passing away.
Financial advisors should be aware that for different reasons, phases one and three are each more expensive than phase two. Therefore, using the 4%, fixed-percentage, fixed-dollar amount, systematic withdrawal, or bucket plan methods mentioned above do not work as they do not alleviate all the risks optimally.
Blend and customize
Instead, I contend that a blended approach of strategies, customized to suit each client’s situation, when combined with insurance strategies, provides a better outcome. When tailoring such a course for a client, it is essential to:
- Determine clients essential vs. discretionary expenses and legacy objectives.
- Fill gaps between Social Security (plus any other pension income) and essential expenses, preferably using an annuity to eliminate the longevity risk for needed guaranteed income.
- Ensure the client has adequate life insurance and LTC insurance for the no-go phase. Premiums for these are a part of essential expenses.
- Divide remaining assets to be used for discretionary spending using the bucket plan — the buckets being “now” (the next 1-2 years), “soon” (3-5 years), and “later” (years 5-plus) and invest in capital preservation, fixed income and growth equity strategies respectively. We typically use 20/30/50 allocations as that seems to offer an ideal balance.
- Optimize allocations and distributions by using a tax-diversified approach of taxable, tax-deferred, and tax-free assets.
In my practice, the portfolio created for a client factoring in the above methods is designed to generate about 6% income for the go-go phase and provide about 4% income for the slow-go stage. We ensure that the long-term care costs are shifted to an insurance company, and the legacy benefits are in place tax-free via life insurance.
We have found that this approach provides clients with greater peace of mind, and there is evidence to support the fact that clients who have greater certainty of outcomes live longer, healthier, and more purposeful lives.
