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Portfolio > Economy & Markets > Fixed Income

It's All About Timing: The Impact Of Returns On Distributions

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When the Dow Jones Industrial Average plunged 387 points on August 9th following the disclosure that turmoil in U.S. mortgage and securities market had prompted a credit squeeze at one of France’s biggest banks, retiring boomers who have nest eggs heavily invested in equities might well have questioned whether carefully prepared plans for drawing down those assets needed to be revisited.

The issue is no small matter. A prolonged bear market, say experts, could wreak havoc with boomers’ retirement funds absent appropriate adjustments to distributions to cushion the shock of the downturn. A chief reason is the timing of returns: Two portfolios that yield the same total return over a 20-year period and that are drawn down at the same annual rate can yield widely varying results because of the differences in the sequence of returns from year to year.

“Most people don’t realize the tremendous impact of the timing of returns when they’re doing withdrawals,” says Michelle Hoesly, a chartered financial consultant and principal of Resource 1, Norfolk, Va. “If bad returns happen during the first 5 years of distribution, many times there is no way for the client recover. But if poor returns come later in the distribution phase, then the client is in a better position financially.”

Hoesly calls to mind a hypothetical client who starts with a $1 million retirement account invested in the S&P 500 Index, drawing $75,000 against the account during the first year and increasing withdrawals each subsequent year to adjust for inflation. When the portfolio returns are negative at the start of retirement and positive during the final years, the client runs out of money during the 17th year. When the sequence is reversed, the client enjoys an ending balance of nearly $5 million–even though the total returns for the two portfolios are identical.

To guard against the first scenario, Hoesly suggests that advisors counsel boomer clients to adjust distributions in tandem with swings in portfolio returns. When returns are down, clients should “put distributions on a diet;” when returns are strong, they may allow themselves “a cost-of-living raise.” Hoesly observes that if the client who starts with negative returns in the above example were to reduce distributions by 3% during the first 5 years and take a 3% COLA increase during the last 5 years, he or she would complete the 20th year of retirement with a $1 million balance–the same amount as at the start.

Life insurance and other financial services companies should consider revising their products to allow (per the client’s written approval) for automated adjustments to distributions from clients’ retirement accounts, Hoesly adds. But not all advisors support this approach.

“I don’t think it’s a good idea,” says Robin Tull, a principal and president of Tull Financial Group, Chesapeake, Va. “You can add anything onto a policy–usually at extra cost. But advisors like myself are here to map out life’s journey and make adjustments along the way. That’s what we get paid for.”

Tull agrees, however, that flexibility needs to be built into the retirement plan, both to accommodate retirees’ changing income needs (younger retirees tend to spend more on such things as travel than those who are more advanced in years) and to account for the different times when retirees tap sources of retirement income (e.g., Social Security at age 62, the corporate pension at age 65 and an IRA at 70 1/2 ).

Tull adds that income planning also must factor in the tax implications of withdrawals. Boomer retirees can best leverage their nest eggs, he says, by first drawing down non-qualified money that has already been taxed (e.g., mutual funds), deferring distributions from qualified accounts (such as IRAs, 401(k)s or qualified annuities) for the later years.

Sharon Allen, a certified financial planner and president of Sterling Wealth Management, Champaign, Ill., says the timing of portfolio returns relative to distributions is not so great a concern for her affluent clients, in part because their asset levels are high enough to absorb gyrations in the equities markets without requiring an adjustment to distributions.

But she does counsel clients during down markets to rebalance their equities portfolios by selling (and thus reducing as a percentage of the portfolio allocation) fixed income assets, using the cash from the sale to purchase low-priced stocks. Conversely, during market rises, she will often recommend that clients sell certain equities to offset market gains and capital gains tax.

For Todd Rustman, a principal and president of GR Capital Asset Management, Newport Beach, Calif., the way to insulate clients from market downturns–and obviate the need for adjustments to income distributions–is to subdivide the client’s portfolio into 5-year “tranches.”

So, for example, the first 5 years of income would be drawn from fixed income assets comprising CDs, bonds and/or fixed annuities. Funds slated for years 6 through 10 would include mostly fixed income assets, but also a “smattering” of equities, thus allowing for greater potential growth of principal before the assets are transitioned to an entirely fixed income portfolio during the distribution phase. Longer-term distributions–years 11-15 and 16-20–would contain progressively more equities relative to fixed income assets.

“This strategy allows clients both to control their exposure to the equities market and draw down assets at a constant rate,” says Rustman. “Basically, we’re able to recreate what clients got when they were working, which is a paycheck every month.”


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