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Portfolio > Portfolio Construction

Road To Income Paved With Good Withdrawal Strategies

By Jim Connolly

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The road to regular retirement income must be paved with good withdrawal strategies, not just good intentions, say many financial planners.

In fact, during a recent presentation by Hartford Life, Joseph Eck, vice president-institutional solutions group, and John Diehl, senior vice president of the retirement solutions group, outlined the balance between investment allocations and withdrawal rates (see chart.)

But in order to reach that point, a number of planners say they start by looking at other factors such as a client’s balance sheet and income statement, or a client’s cash flow.

“The bottom line, is that you have to know what you own and what you owe (balance sheet) and you have to know how much income is coming in and how much is going out (income statement),” says Bedda D’Angelo, president of Fiduciary Solutions, Durham, N.C.

With these factors as a base, then a planner can calculate a client’s return on investments, which she says should fall in the 8% to 12% range. If an 8% return is achieved, D’Angelo says, 4% can be withdrawn and 4% reinvested so that the portfolio’s principal grows to cover inflation.

Where many people “go wrong,” according to D’Angelo, is that they do not track investment performance, and consequently, are “clueless about whether or not their original assumptions are holding up.” Part of the reason, she continues, is that mutual funds use a time weighted return to measure a fund manager’s performance. A time weighted calculation does not reflect cash flow, she adds. Rather, an internal rate of return must be calculated, D’Angelo continues.

Time weighted return looks at performance over a specified time period without considering inflows and outflows. Conversely, a dollar weighted, or internal rate of return, accounts for deposits and withdrawals in an account and how that impacts percent increases and decreases in the portfolio.

The other factor, she says, is that while professional managers “regularly get 8-12% annualized returns, amateurs virtually never do.”

But, the “key to safe withdrawals” is the 8% return with the 4% withdrawal and 4% reinvestment, she reiterates. Coupled with a well-diversified portfolio of 5 asset classes at an appropriate risk/return level, D’Angelo asserts that “there is no 5-year period this century where you would have been in danger of dipping into principal.”

Additionally, she notes, the assumptions that are made about a portfolio need to be reviewed annually to see if the portfolio is on track and whether the withdrawal rate is still appropriate. Anytime an assumption is altered and the portfolio changed, then it takes a business cycle, roughly 6 years, to see the results of that change, she adds.

A withdrawal rate of around 4%, adjusted for inflation, is a good rule of thumb, according to Kevin Brosious, a certified financial planner and president of Wealth Management, Allentown, Pa.

However, he cautions, this drawdown rate assumes “a healthy allocation to stocks.” By healthy allocation, Brosious suggests at least 50%, including international stocks. If there is not a healthy stock allocation, then both rates of return and withdrawals will be lower, he continues.

Jerry Miccolis, a certified financial planner with Brinton Eaton Wealth Advisors, Morristown, N.J., says, “there is really no substitute for a comprehensive cash flow projection.” Used as a base, he explains, cash flow projections “help address financial questions of virtually any type, including withdrawal rates.” He cautions that “simple rules of thumb on withdrawal rates are dangerous, as each situation is unique.”

Phillip Watson, a certified financial planner in Franklin, Tenn., prefers to build a financially storm-proof portfolio and not focus on withdrawal rates. “I don’t bother with trying to identify a number that represents a safe withdrawal rate. In my opinion it’s irrelevant. Furthermore, it causes clients to focus in the wrong direction.”

What Watson maintains is helpful is to “build portfolios that will stand up through all economic conditions and cycles.”

Watson maps out how he creates a portfolio for clients who are moving closer to retirement. At this point, he says, his firm starts to shift to a cash-flow bond ladder. The ladder is composed of U.S. Treasury strips and exists inside tax-deferred accounts. At maturity, it is either pulled from the IRA and spent or used to purchase new rungs, depending on how equities in the portfolio have performed, whether it would be better to sell the equities and pay capital gains from a tax management viewpoint, and whether there are required minimum distribution requirements, he adds.

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