Priorities change as we progress through different phases of life, and investment objectives are no exception. We grow up conditioned to look at “rate of return” as the main measurement of investment performance. However, the amount and sustainability of income distributed from a portfolio is more important for most retirees. This focus on retirement income is understandable but the best way to achieve it is not well understood by many investors.
How much can you withdraw without having to worry about running out of money?
We provided some background on Sequence of Return risk and the 4% rule in last week’s post: The Sustainable Withdrawal Rate. Our article stated that, historically, investors have been able to withdraw 4% from their investment portfolio of 60% stocks/40% bonds, increase their withdrawals each year to keep pace with inflation, and not run out of money in a typical 25-30 year retirement. Some research has shown that the 4% rate may not be bulletproof in light of today’s historically low bond yields, and also the 4% rate did not always work in other countries based on their stock/bond market returns.
Other research shows that initial withdrawal rates above 4% (e.g. 4.5-6%) can be prudent as long as the retiree is willing to reduce withdrawals if certain adverse conditions materialize. This “dynamic” withdrawal strategy was pioneered by financial planner Jonathan Guyton and published in the Journal of Financial Planning in 2004. An example of a dynamic withdrawal strategy may be: retiree will cut spending if the withdrawal rate rises more than 20% from where it started (e.g., rising above 6% if it started at 5% initially), and spending can be increased if the withdrawal rate falls by more than 20% from its origin (e.g., falling below 4% after starting at 5%).
Specific changes retirees can make to their investment portfolio to increase their probability of success (regardless of the initial withdrawal rate):
1) Reduce Volatility – Most people immediately assume fewer stocks and more bonds when their investment objective is retirement income. I would add that the bond portion of the portfolio should also be bonds that act like bonds. There are lots of different types of bonds (government, investment grade corporate, high yield, floating rate, convertibles, etc.). You want bonds that do not go up or down in conjunction with stocks. Some categories of bonds (e.g., high yield) behave similarly to stocks, while others are almost completely uncorrelated.
2) Increase Yield – Everyone loves the idea of living off the interest and not touching the investment principal. However, this is not the best way to think about investing for retirement income. The portfolio should be built for total return (income and growth). Investing based solely on yield ignores the unpredictability of interest rates and the need to grow income to keep pace with inflation. That being said, a portfolio with the main objective of distributable income should have a higher yield than an accumulation portfolio. This is accomplished partly by the allocation to bonds, but also the types of stock should shift toward dividend payers, dividend growers, and “value” stocks. Value stocks have higher dividends and historically lower volatility than growth stocks.
3) Rules for Rebalancing – Studies of sustainable withdrawal rates assume that an investor sells proportionately from each asset class (stocks and bonds) to free up cash for withdrawals. The portfolio is systematically rebalanced to the original 60/40 allocation. A study entitled “Income Harvesting,” published in the Journal of Financial Planning in 2008, demonstrated that better results can be obtained by segmenting the portfolio into tiers based on time horizon (i.e. when you will need the money), and then following decision rules for rebalancing the portfolio. The idea is that in normal years, as you withdraw money from the safe, liquid portion of the portfolio, you rebalance to the planned allocation. However, you should not rebalance during major market downturns. The safest, most stable assets in the portfolio can be used to fund distributions for 4-5 years, giving the stocks time to recover before selling any of them.
You can pretty much put your money under a mattress and not worry about any of this if you only need 1 or 2% from your portfolio to supplement your retirement income. However, as your withdrawal rate rises into the 3-6% range, these little changes can make all the difference. For more information on investing for retirement income, read our Retirement Planning Frequently Asked Questions. Feel free to call or email with questions. Have a great week!
Disclosure: The charts used herein are hypothetical and are used simply to illustrate a concept. They do not reflect the performance of an actual product, index or account, nor do they reflect a specific time period. The charts also do not reflect any taxes or other fees that, if applied, would reduce performance. Before investing, investors should carefully consider the investment objectives, risks, and expenses.