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.
However, let’s assume you are still receiving a +10 percent return in every year, but you are now retired and beginning to withdraw 6 percent of your portfolio as income. In other words, you are climbing down the mountain.Using the same twenty-year period, if your portfolio appreciates +10 percent per year for nineteen consecutive years, and then suffers a –50 percent loss in the last year, your portfolio will still have more than 30 percent of its original principal. What this tells you is that, due to the fact that you suffered this large loss in the later stages of your retirement distribution years, you still have lots of quality retirement options. However, if you suffer the loss of –50 percent in the first year, here’s where it gets tricky and dangerous, because you actually end up running out of money in approximately 13 years. Wow!
As you can see, although this uses an extreme –50 percent loss in year one, it clearly illustrates the harsh reality that running out of money is much more of a possibility when you suffer large losses in the early stages of retirement and you are withdrawing income, or climbing down the mountain. (Note: This example does not factor in important considerations such as inflation and taxes, which can significantly increase your ability to run out of income much sooner.)
Now let’s look at question No. 2.
2. If your portfolio declines 50 percent in year one and then appreciates 50 percent in year two, is your portfolio back to even?
The answer is no. To use another example: If you have a portfolio of $100,000, and you suffer a 50 percent loss in year one, you will obviously be left with only $50,000. However, if during year two, this $50,000 portfolio increases by +50 percent, your portfolio value will only be $75,000. In order for your portfolio to get back to even ($100,000), you would need to experience a whopping +100 percent gain in year two. Again, this extreme example helps illustrate the point that it becomes much more critical to focus on avoiding the large losses that can be suffered in the early years of a retirement income strategy.
The reality is that most people mainly rely upon financial advisors for the wealth management part of their retirement plan. This is understandable, since managing our client’s wealth is clearly a large part of what we do. But I believe it is much more important, and yet often overlooked, to remember that our ultimate objective is to create a retirement income strategy that is not solely focused on achieving the best possible rate of return, but rather making sure we do not make that unforgivable mistake of running out of money.
When financial advisors are asked to construct a sound retirement income strategy, you could easily argue this all-important strategy can be compared to hiring a mountain climbing guide to help someone climb down a mountain. Both jobs require a tremendous amount of hard work and expertise, and both jobs have the ultimate objective of making sure their clients avoid a large fall that could cause irreparable losses.