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Retirement Planning and Income Distribution

Friday, March 30, 2012

J. Brock Dexter, CFP ®

Retirement Planning

Events since summer of 2007 have many people wondering if they will ever be able to fully retire.  For those who worked hard and saved for retirement, the saying “no good deed goes unpunished” rings true.  First, home values plummeted, then markets tumbled and interest rates followed.  Social Security and Medicare are “troubled assets” no one seems to want to fix.  For those on the cusp of or early into those so-called golden years, serious doubt lingers about their retirement prospects.  “I can’t afford another 2008” is a frequent investor comment and one most often made by those nearing retirement.

Just about every financial planner conducts some form of retirement planning for clients.  For accumulators, the process is designed to gauge how well they are tracking toward reaching their retirement goal.  For those already retired, the process is an annual check-up.  But for those approaching their desired retirement age, the process often falls short in delivering an answer to the inevitable and obvious question, “Do I have enough to retire?”  
Answering this question is difficult due to the myriad assumptions utilized in the retirement planning process.  How much will the retiree spend, what will the inflation rate be, what portfolio return is expected, will social security and Medicare be available during the retirement years, and how long will retirement last (longevity)?   Many planners use the same approach to managing the retirement years as they do the accumulation stage of life.  They often assume that long-term historical market averages will prevail when projecting portfolio performance, for example.  That is fine for accumulation stage projections where a client has 30-40 years longevity.  But for a client about to enter retirement, a more personalized approach and realistic assumption is required.

The Key Retirement Planning Factor

It is possible to be a multi-millionaire and at the same time be insolvent.  My retirement planning experience indicates the most vital factor in predicting successful retirement outcomes is how much the client plans to spend in retirement.  Planners know that regardless of the nest egg size and the portfolio rate of return assumption, it is possible to over spend.  If excess portfolio draws occur early in retirement and during a bear, or worse, secular bear market, the outcome may be catastrophic.  Thus, the most important planning assumption is how much the client needs to sustain the desired lifestyle and what is the minimum required spending need.

The best method to estimate the living expense need is to use current, known expenses as a starting point and adjust for age and known life events.  As people age, certain expenses tend to go away while others increase, such as long term care expenses.  Additionally, we break down the expenses as either discretionary or nondiscretionary.  Paying for food, health care, etc. is essential.  Paying for the vacation home, annual cruise etc. is not.  We also plan for the occasional, one-time outlay for items such as new cars, new roof etc.  Time spent accurately estimating the actual expense need during the early years of retirement instills a high level of confidence in the client about the outcome.

Answering the “Question”

Retirement projections come in many forms, such as Monte Carlo simulations, straight-line projections and stress tests.  Regardless of the method used, assumptions on the expected inflation rate, portfolio return rate, expenses, social security, Medicare, pension income, and longevity are discussed in advance with the client.   Realistic assumptions are a must given the projection is just that; a projection.  Thus, when reviewing retirement projections with a client, I emphasize that the illustrated outcome is unlikely to play out; rather, it is an indication of probable success since reality always varies from projected outcomes.

In our attempt to be conservative in projecting retirement outcomes, we may eliminate social security benefits or the annual cost of living adjustment (COLA) as an assumption.  We run multiple scenarios, like one with a long term care event and how that affects the result.  We use lower than historical market returns, higher than average historical inflation, and higher than current tax rates in an attempt to stress-test retirement assets.  While no one can guarantee success, we do increase client confidence in the probable outcome using this technique.

Retiree Types

Regardless of the type retiree, making the decision to retire is never easy.  It is almost always an irrevocable leap of faith.  The decision made, there is usually no going back and cutting the paycheck umbilical cord is a difficult mental hurdle.  Just the change in everyday routine is more than many can fathom.  From a financial perspective, the decision is much easier for some than for others.

There are three basic types of potential retirees:  the truly wealthy for whom money will not be an issue during retirement as long as they apply sound wealth management principles, the retiree who appears to have sufficient assets to successfully retire but who must constantly monitor their finances to avoid outliving their assets, and those who may never be able to fully retire.  I’ll limit my discussion to wealthy and on the cusp retiree types.

Wealthy Retiree

Wealthy means current assets are more than sufficient to sustain the desired retirement lifestyle based on appropriate assumptions.  Wealthy retirees are more concerned with avoiding estate taxes than running out of money or cutting back on expenses when times are tough.  For this type retiree, the income distribution and post-retirement issues differ significantly from those of other retiree types.

Post retirement issues usually include income and estate tax reduction planning, estate liquidity, charitable giving, lifetime gifts to heirs without gift tax consequences, funding college for grandchildren, and other legacy planning.  While the assets at the point of retirement entry are deemed sufficient to allow consideration of the above planning issues, even the wealthy retiree requires proper wealth preservation and income distribution strategies.

On the Cusp Retiree

This retiree appears to have sufficient assets to successfully navigate retirement, but a significant variation in key assumptions, such as spending, may derail the plan.  These retirees require constant retirement monitoring.  A catastrophic event, such as the need for nursing home care or the premature death of a spouse and subsequent loss of a pension, may also derail the retirement plan.

Post retirement, this retiree needs annual retirement income tax planning, risk management planning (such as long term care, permanent life and medical insurance), and annual cash flow reviews.  When times are tough, this retiree may need to eliminate discretionary spending and, in a worse case event, cut back on basic needs spending too.  A solid income distribution plan is an absolute must for this retiree.  Wealth preservation techniques must be coordinated with portfolio growth strategies to make the outcome positive.

Retiree Asset Management

During retirement, every asset, not just portfolio assets, are employed in a coordinated plan to achieve a successful outcome.  We break down expenses into categories based on a hierarchy of needs then we allocate resources toward funding those needs.  The first and most obvious priority is nondiscretionary spending which also includes emergency funding needs.  Discretionary spending is next followed by altruistic goals, such as passing on assets to heirs or to charity.  

To fund nondiscretionary expenses, we first turn to non-portfolio assets such as pension and social security income.  Realistic assumptions must be made about longevity when using non-portfolio sources of income.  If these outside sources of income are insufficient to cover living expense needs, then portfolio income is required and it must be properly structured as a steady, reliable income source.

Among the nondiscretionary expenses are unpredictable life events, such as acts of nature or sudden illness.  Failing to account for these type events can lead to catastrophic outcomes so managing these risks is essential.  For example, a Long Term Care insurance policy can fund nursing home costs and help preserve assets.  Medicare and an appropriate supplemental policy will cover the majority of health care costs.  Life insurance is often used in pension maximization strategies or for estate liquidity.

Generally, discretionary spending is funded by portfolio income.  The assets targeted for this spending are available for distribution, but may be held back during hard economic times and depressed markets to preserve the portfolio.

Legacy assets fund charitable giving and inheritances.  Obviously, this is the lowest funding priority restricted to those assets not required to fund retirement needs. 

Retirement Income Distribution

When referring to income distribution, we refer to portfolio draws to cover lifestyle requirements in retirement.  As previously stated, the amount of portfolio distributions depends on such factors as social security, pension and other non-portfolio income sources.

Key Portfolio Factors

Portfolio positioning and management approaching and during retirement are crucial to a successful outcome.  Clients who are heavily dependent on portfolio income are more vulnerable to market volatility than those with significant non-portfolio income.  One can imagine the high anxiety and fear experienced by a person retiring in 2007.  Losing 40% of your portfolio value in the first year of retirement followed by a possible string of flat returns in the ensuing years leads everyone but the wealthy to make serious adjustments to their retirement plan.

Client longevity is another vital factor.  Expected longevity defines the investment time horizon.  Far too many investment advisors and planners use the same time horizon assumptions used during the accumulation phase to project retirement cash flows.  They assume that if you experience a 2008 type crisis, you’ll have time to recover.  Managing a retiree’s portfolio in this fashion is a seriously flawed strategy in our view.  Whether or not we like to admit it, from day one of retirement the investment time horizon is shrinking.  That means the available portfolio recovery time from a down market is far less than most assume.  Based on historical market performance, it is entirely possible that from day one of retirement to death a retiree could experience little or no portfolio growth.

Mitigating the Risk

To limit the effect a down market has on retirement cash flow, TWM uses a “pocket” strategy.  One pocket is your “stay rich” pocket and the other is your “get rich” pocket.   The amount maintained in each pocket varies based on your phase in life.  Retirees relying heavily on portfolio income to sustain their retirement needs will obviously require a larger stay rich pocket.  These assets are essential to funding the nondiscretionary and discretionary needs.  However, most retirees also need portfolio growth in order to successfully navigate retirement, so some assets must be in the more risky get rich pocket.

The stay rich pocket must hold enough assets to fund 2-5 years of retirement expenses.  These assets are invested in stable value instruments which might include laddered CDs or bonds, TIPs, bond mutual funds or ETFs, FDIC insured structured products, and money market funds.  In a low interest rate environment, high yield equity investments with lower than average price volatility may be used to supplement fixed income investments.  While some inflation protection is desirable, the primary goal of the stay rich pocket is wealth preservation and income.

The get rich pocket holds equity style investments based on client risk tolerance.  The time horizon for these assets stretches to the client’s life expectancy and, as time marches on, must be adjusted downward.  Income and realized capital gains produced by the assets in this pocket are distributed as required to replenish the stay rich pocket or reinvested for growth.


TWM has the experience and knowledge to help every type of retiree navigate the treacherous retirement waters.  We coordinate every facet of your retirement plan to include:

  • Wealth preservation techniques
  • Portfolio allocation and income distribution planning
  • Best time to start social security and how to maximize spousal and survivor benefits
  • Medicare plan selection and supplements
  • Pension maximization
  • Risk mitigation strategies
  • Income and estate tax reduction strategies
  • Lifetime transfers to heirs and gift tax avoidance
  • Charitable giving during and after life

Retirement is the culmination of one’s life work.  Those fortunate enough to retire face an unknown future which can lead to some very anxious moments.  For those early in the accumulation phase of life, retirement issues are distant.  But for those approaching or already in retirement, the issues are an imperative.  Proper wealth management strategies are essential to a successful retirement.  With so much on the line, retirees need someone they can trust to help them make correct and timely decisions about retirement.