I firmly believe that one of the most important and yet challenging jobs financial advisors are called upon to do is to establish a retirement income distribution strategy for our clients. One of the key goals of any financial plan is to produce income that ensures both enjoyment and financial independence in retirement. With this in mind, we need a sophisticated strategy due to two key facts:
- There are a large number of factors that must be taken into consideration and analyzed.
- The margin for error is extremely small.
Reaching the retirement years is a major milestone for most of us. And since retirement is often referred to as the “the golden years,” income will be the cornerstone — the gold in these golden years — for all retirees. It our job as financial advisors to look at a retirement income strategy from all angles, making sure to ask and answer such key questions as:
- How much income do you need?
- How much income do you have from other sources (such as pensions, Social Security, etc.)?
- What percentage of your portfolios should you withdraw?
- Where should you take income from first (IRAs vs. non-IRAs)?
- What are the best options for you to maximize your tax efficiencies?
- What are your optimal spousal options?
- How much travel do you plan on doing?
- Are you charitably inclined?
- What is the best way to invest your money?
- How much inflation adjustment should we build in going forward?
- Is the income you need before or after taxes?
- What tax bracket will you be in?
- Will your income be taxed at ordinary income rates or capital gain rates?
And the list of questions goes on and on.
I’ve found that just about every retiree I meet with has these four common goals in mind:
- Avoiding large investment losses, volatility and sleepless nights
- Paying as few taxes as legally possible
- Having the ability to enjoy their golden years without having the fear of running out of money
- Making sure they have sound transfer strategies in place for spouses and heirs
The adventurer’s analogy
If you’ve ever done any mountain climbing, you may know that approximately 90 percent of the major accidents and fatalities happen on the way down the mountain, versus while climbing up the mountain. You will find there is a great analogy here that can help your clients understand how dangerous it can be if they choose to go it alone.
There are two vastly different strategies to consider when looking at income distribution plans for our clients. The first strategy involves looking forward and gauging what level of retirement income will be needed in the future. This is done while climbing up the mountain. The second strategy — which is far more complex and dangerous, and I believe largely misunderstood — is helping design a strategy for withdrawing income during retirement, or while climbing down the mountain.
Let’s examine two questions that I often ask when I host retirement workshops, and which attendees often have a difficult time answering. (Note: These examples and performance figures are purely hypothetical, and do not refer to any specific investments or portfolio asset allocation mix.)
1. Assuming a period of 20 years, when you are accumulating money for retirement (climbing up the mountain), which of these two scenarios would have a greater impact on your portfolio:
- A +10 percent return every year except a portfolio decline of –50 percent in the FIRST year?
- A +10 percent return every year except a portfolio decline of –50 percent in the LAST year?
The correct answer is actually neither one.As strange as it seems, when you are accumulating wealth and not withdrawing any income (climbing up the mountain), it does not matter whether losses occur in the early or late stages. To help explain, let’s review the numbers. First, let’s keep in mind that in both scenarios you are achieving a +10 percent return in each of the twenty years except one year (which was a steep decline of –50 percent). When you run the numbers, you will see that you end up with the exact same amount of money in both scenarios, whether you suffered the –50 percent loss in the first year or in the last year.
You may be wondering, “How can that be true?” The reason is simply that while you were growing your money, you were not yet withdrawing any income, or coming down the mountain.So the key message here is that it is much less critical to focus on portfolio losses while we are accumulating wealth toward retirement, or climbing up the mountain.