Aligning withdrawals with retirement goals
Traditional retirement income planning assumes that retirees need a steady, inflation-adjusted income stream to cover all their expenses.
Traditional retirement income planning assumes that retirees need a steady, inflation-adjusted income stream to cover all their expenses.
But since not all retirement living expenses are the same, advisers should consider expanding their repertoire of withdrawal strategies by considering the distinct types of expenses investors face during retirement.
First, there are essential expenses, such as food, transportation and health care, which generally increase with inflation and should be funded by an continuing, inflation-adjusted income stream.
Then there are discretionary expenses, such as travel and entertainment. These are important expenses, but they are not essential; expenses and funding for them can be more flexible. Discretionary expenses don’t require a guaranteed income stream.
Finally, mortgages, although essential, are generally expenses that are finite in duration and do not increase with inflation. These can be funded separately as well.
To help demonstrate the importance of aligning each expense type with a portfolio withdrawal strategy, let’s consider the Reeds, a hypothetical married couple nearing retirement.
James and Susan Reed, 62 and 59, respectively, are three years from retirement and have set $215,000 as their annual retirement income goal. They have $3 million in investible assets and expect to live beyond 90, based on their family histories.
Like most of the other 16,000 retirees filing for Social Security benefits each day, the Reeds look to Social Security for only a portion of their retirement income — $55,000 of the $215,000 total. Therefore, they must rely on their investment assets to fund the remaining $160,000 annually, which equates to an annual withdrawal of approximately 5.33% from their $3 million investment portfolio.
While their investment portfolio seems large, James and Susan potentially will have to make their assets last for more than 30 years after retirement. Therefore, taking inflation-adjusted withdrawals of 5.33% for more than 30 years is not likely to be sustainable.
However, if the Reeds take a closer look at the composition of their expected $215,000 annual expenses, they can align each type of expense with an appropriate income source.
Based on suggestions from their adviser, here’s how they plan to do it:
The Reeds expect to use their Social Security retirement benefits to fund about half of their continuing essential expenses of $115,000, which are expected to rise with inflation.
They also plan to set aside half ($1.5 million) of their investment portfolio to fund the remaining $60,000 of continuing essential expenses through inflation-adjusted withdrawals at a sustainable 4% a year.
To cover their annual mortgage expenses of $55,000, the Reeds plan to set aside $750,000 of their investment portfolio. This will cover the fixed-rate-mortgage expenses on their two residences through fixed-dollar withdrawals, with no inflation adjustment.
Funding their discretionary expenses of $45,000 will be $750,000 in investment assets. The Reeds could take inflation-adjusted withdrawals of 6% to reach the $45,000, but that could deplete the portfolio entirely within the Reeds’ lifetime.
A better alternative would be to use fixed-percentage withdrawals of 6%. Under this method, their discretionary spending can increase during times of good market performance and decrease during downturns.
Since the Reeds plan to withdraw a reasonable fixed percentage of 6%, they are not likely to deplete the principal value of their account significantly. Therefore, this account may also be able to fund unexpected expenses and/or legacy goals.
In general, many investors would benefit from using inflation-adjusted withdrawals for essential expenses and fixed-percentage withdrawals for discretionary expenses.
Of course, because each investor’s situation is different, no single withdrawal strategy will work best for everyone. But as the 72 million baby boomers retire over the next 20 years and ponder how to fund their retirement safely, financial advisers skilled at employing advanced tactics, such as tailored withdrawal strategies, are likely to gain market share.
Frank Porcelli is a managing director and head of BlackRock Inc.’s U.S. retail business.
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