How to help clients transition from earning money to taking distributions.
It may entail just a few minor account adjustments
to you, but clients who've accepted their final paycheck and are now
looking to their portfolios for income may be less than calm,
particularly if their only guaranteed income is Social Security.
This discomfort is somewhat a function of the proportion of retirement assets the client has been able to accumulate in the form of lifetime annuities, such as guaranteed payments from financially sound government or private employer defined benefit plans, or in dividend-paying stocks, mutual funds and bonds, as opposed to balances accumulated in IRAs and defined contribution plans. The latter, of course, carry no guarantees and must be managed by the client or an advisor both to produce required returns and required cash.
I remember clients of my own on the edge of retirement-a husband and wife-both professionals who'd reached upper-management positions with an educational institution and a state government, respectively. Yet, aside from several smallish 403(b) plans and IRAs, all their money was tied up in taxable accounts. It took two years of meetings reviewing retirement projection "what-ifs," new investment strategy options and even post-retirement business opportunities before they could agree they were ready to take the plunge. Today, these clients live on a combination of portfolio distributions and income from a successful business providing Italian villa rentals to overseas travelers.
Says Derrick Kinney, a senior financial advisor with Ameriprise Financial in Arlington, Texas, and the best-selling author of Master the Media to Attract Your Ideal Clients: A Personal Marketing System for Financial Professionals (John Wiley & Sons, 2004), "Most clients have a pretty good understanding of contributing to their retirement accounts, but they are very confused about the best ways to pull money out of those accounts. I meet with clients every quarter because educating them about this transition gives them confidence and a greater comfort about their retirement."
So does having a strategic plan. Advisors find that when they can show clients a clear methodology for replacing the paycheck with certain cash flows based upon rational portfolio design, investment and cash distribution strategies, clients begin to relax. Kinney's own system goes something like this: "I might use a 'carve-out' strategy with a client. That's where we park six to 12 months of income needs in a cash account that is then direct-deposited into their checking account like a paycheck. The remainder of the portfolio is invested in four or five other categories that might include preferred stock, immediate annuities (if not leaving money to the kids), private placement REITs, Diamonds or ETFs. Then, twice a year, we 'harvest' the dividends from these investments and move them into the cash account to be used in replenishing the client's checking account."
When he meets with his clients to describe this concept, says Kinney, "Their eyes seem to light up as they begin to understand how they'll move from accumulating to accessing their hard-earned money."
Obviously, each client requires a little different strategy. Kinney says he's found that baby boomers are perhaps the most sensitive to the need to simulate a paycheck, and they may want two to three years of income needs in a cash account. "All clients want to know they're not going to outlive their income, but some place equal importance on knowing the source of the money they're going to receive every two weeks in retirement," adds Kinney. "Clients sometimes think they have to take as income whatever their portfolio will provide [in the way of interest and dividends]. A big grin comes on their faces when I show them they can take a predictable amount each month."
Every advisor who's dealt with this planning scenario seems to have his own system for recreating the paycheck; that is, there's no one accepted methodology within the profession, but lots of good systems to fit your particular client. Tony Proctor of Proctor Financial in Wellesley, Mass., uses what he calls his "time-weighted cash flow methodology," an intricate asset allocation system designed to throw off predictable income for retired clients.
"Using a proprietary, 28-page spreadsheet, we first look at the cash flow the client's portfolio needs to generate on a year-by-year basis [over each remaining year of his lifetime] and then we calculate the net present value of those flows," says Proctor. "For example, a client might need $50,000 five years from now, so we determine how the 'mini-portfolio' that will produce that $50,000 should be allocated over that five-year timeframe." Depending on the time period, each one-year's-cash-flow portfolio is some mix of equities, cash and/or fixed income. The result of Proctor's exercise is a series of portfolios that span the client's lifetime and his overall asset allocation today is, in effect, the consolidation of all of these portfolios.
"The client's portfolio needed for the [current and] next year will probably be all in money market accounts from which we can direct-deposit to his checking account, thus recreating his paycheck," says Proctor. He sets that amount at what the client predicts he'll need in the way of "on-going" expenses; extraordinary expenses items are covered by checks the client writes against his account.
If Proctor's system is intricate, Bernie Kiely's system in quite simple, but effective. Kiely, of Kiely Capital Management in Morristown, N.J., says, "We generally have our retired clients in 50% stocks and 50% fixed income, which includes money markets. They keep three months' worth of cash living expenses in the bank. Then, every month, we wire one month's cash needs to their bank account, thereby keeping three months in cash." The three-month allotment is enough, presumably, to cover any extraordinary expenses that may arise.
Of course, the first thing clients (and, sometimes, advisors) want to know is ... what happens to my paycheck recreation system in a bear market? Kathleen Cotton of Cotton Financial Advisors in Lynnwood, Wash., has an answer for that: "Over and above the client's current cash needs, we hold four to six years of income in a bond ladder designed to 'surface' money each year, that we can use for income if the equity market isn't a viable place to take the money from. This got us through the 2000 to 2002 blight just fine-not that clients didn't lose money, but they didn't lose as much as they would have if we had cashed in equities during that environment to provide them their 'paycheck.'"
Bob Wacker of R.E. Wacker Associates Inc. in San Luis Obispo, Calif., is more optimistic about his ability to make sure the client's cash is going to be available in spite of equity market movements. Says Wacker, "Since we expect the funds we invest for our clients to have a greater return on an ongoing basis than their money market fund, I have never seen the point in taking out the entire year's distribution and setting it aside in a money market fund. If the money market fund earns less on average than the investment pool, you are reducing the client's return."
What Wacker does, in contrast to most other advisors, is a "reverse-dollar cost averaging" by moving required living expense amounts out of the client's pool of investment assets each month into some more accessible account. "We keep the money invested until it's time to withdraw that month's distribution," at which time the withdrawal gives Wacker the opportunity to rebalance the client's investment assets.
He also grapples with the decision of taking the monthly withdrawal from his client's taxable or tax-deferred accounts. While some clients have only taxable accounts or only tax-exempt accounts, many have both qualified and nonqualified money. "The decision as to which account to take the distribution from is almost always a tax-driven decision," acknowledges Wacker. If his client is in a low tax bracket, Wacker will take the funds from his IRA, or he may even decide to move the client's IRA balance to a Roth IRA account and fund the client's living expenses, instead, from the client's taxable accounts.
If the client is in a moderate to high tax bracket and/or a rollover to a Roth IRA isn't feasible, the sheer size of the IRA may provide a ready-made paycheck, as it did for one of Jody Shumacher's clients. Shumacher, with Focus Financial Advisors Inc. in Rockford, Ill., tells of one of her firm's physician clients who didn't retire until he was age 70, accumulating by that time a $3.5 million IRA. "We set up the required minimum distribution for his IRA on a monthly basis, just as he'd received his salary when he worked. The required minimum distribution is now greater than any paycheck he ever received," says Shumacher and, continuing to grow, the doctor's IRA is larger than what he started with before taking distributions.
Once you've put a system in place that's working to everyone's satisfaction, there's always the issue of how much income clients really need in retirement. The common wisdom among planners and consumers alike, for many years, was that it would take only 60% to 80% of a person's preretirement living expenses to keep him afloat in retirement.
But is this realistic? Whereas this may once have been accurate, Kinney points out, "Travel [and similar] expenses go away, but they're often offset by rising health care costs." It probably doesn't have to be pointed out to the reader how much faster health care costs are rising than other consumer expenses.
Planning to meet living expenses that will continue at close to preretirement levels, then, Kinney spends much of the time he devotes to quarterly meetings with retired clients reminding them that it's safest to pull down, ideally, not more than 4% to 5% of their portfolio's total value per year for income needs. "Even if the portfolio is earning 8% or 9% year, they can't draw it all out," he says.
Once the client has a clear picture of how much he can withdraw, the portfolio structure and investment philosophy that will produce the necessary liquidity, and the paycheck recreation system that will get the money into his bank account, he should be able to calm down and start enjoying his retirement.
David J. Drucker, MBA, CFP, a
financial advisor since 1981, now writes, speaks and consults with
other advisors as president of Drucker Knowledge Systems. Learn more
about his latest books, Tools & Techniques of Practice Management
(National Underwriters, 2004) and The One Thing... You Need to Do as
Told by the Financial Advisory Industry's Top Coaches, Consultants and
Industry Insiders (The Financial Advisor Literary Guild, 2005), at