George Foreman once said, "The question isn't at what age I want to retire, it's at what income." Over the years, much good work has been done by people like Bill Bengen, Jonathan Guyton, Michael Kitces and others to answer the question, "What is a safe withdrawal rate?" They have conducted considerable research and back-tested various periods and portfolio allocations to determine what rates of withdrawal, improved annually by inflation, will sustain portfolios during retirement. This article is certainly not intended to evaluate their work or to propose an alternative safe withdrawal rate. Suffice it to say that the back-testing validates their work and conclusions. My purpose is to discuss the implementation of cash-flow strategies during retirement, which may differ considerably from the empirical data that has been presented.
Based on the experience of our firm, the following are our observations about providing cash flow for our retired clients:
1. Generally speaking, people do not want to be told how much they could spend; they would rather have us help them determine how much income they will need to support the lifestyle they want and reach all of their financial goals. So our first step is to calculate the probability of attaining their objectives with the amount of money they have accumulated in their portfolios. While we run Monte Carlo simulations, we understand that "black swans" do occur and updates are needed on a regular basis. Annual reviews to assess how clients are progressing are imperative. While an assumed inflation rate is used in our projections, we understand that nothing can replace actual results (more about this later). If it is determined that the clients' portfolios cannot sustain their desired cash flow, we discuss changes that will be necessary to ensure the money lasts for their lifetime. This may require a gradual reduction in their spending habits, alternative portfolio allocations or the use of other retirement income vehicles such as annuities or reverse mortgages. The point here is that planning requires us to tell our clients something other than, "You can withdraw X percent per year."
2. I have yet to get calls from clients who just discovered that the CPI for the previous year was 2.96% and, as a result, they want an increase in the withdrawal rate of that same amount for the following year. The first flaw in looking at the national inflation rate is that every individual experiences his or her own inflation and it would be a rare coincidence when any one client's rate would mirror this one. What is included and excluded in the government rate will have a significant effect on what our clients actually experience. Housing, for example, includes rent or "owners' equivalent rent." So for our clients who own their own homes, housing inflation could be a meaningless number if they have a mortgage (which would be fixed and not subject to inflation) or have no mortgage at all. It is also interesting to note some of the items that are not included in the CPI-for example, life insurance premiums and income taxes. Our projections, of course, take into consideration clients' actual core expenses, debts, income taxes, extraordinary expenses and other projected income and expenses to determine what they need and can withdraw from their portfolios.
3. Our experience has been that clients usually do not request annual increases. Typically, they will receive income for several years before they discover that it isn't enough to pay some expenses. So we will get calls requesting additional money for items like property taxes, insurance or other irregular expenses that do not occur monthly. When this happens, we have conversations with the clients about whether an increase in their monthly withdrawals is necessary. Since we have been regularly running updates, we have a good handle on what they can safely withdraw on a regular basis.
4. Most clients will adjust their spending habits based on market conditions without hearing from us. When markets are increasing, we get many more calls for items such as new cars, vacations, gifts to grandchildren and other large expenses. However, when markets are not doing well, clients often restrain their spending. We don't need to tell them to do so. It is human nature that optimism will cause people to spend more while declining markets may trigger tightening of their belts. It is extremely difficult, if not impossible, to project these changes in behavior in our Monte Carlo simulations.
5. Our clients do not want to agonize over whether market fluctuations will affect their lifestyles today. After all, they were looking forward to retirement as a period when they would experience peace of mind and freedom from worries about money. In fact, that may be one of their prime motivations for hiring a financial planner. While they may adjust their spending habits as mentioned above, they do not want to exacerbate the temporary declines in markets by selling assets that are losing money. So we establish a "spending account" to cover at least one year of expenses. It is invested in cash, most likely a money market.
Their investment account will have bonds or CDs that will be laddered for three to five years. At the end of each year, when their spending account is almost depleted, we simply transfer the cash from a matured bond to the spending account and begin the process anew. Depending on the markets, we may or may not rebalance the portfolio at that time. If we need to sell equities to purchase another bond and equities are down, we will delay the rebalancing. This process provides our clients with the peace of mind that their income is secured and they can ride out the market decline until the recovery. While our clients certainly do not enjoy market volatility, this system of providing cash flow through good and bad markets significantly reduces their stress.
We acknowledge the importance of research papers determining safe withdrawal rates. The people who have done this work have performed a valuable service for all advisors. However, I am sure all of them will acknowledge that nothing takes the place of good, solid financial planning with regular updates. Only then can our clients be assured that they are on the right track to accomplish their financial goals. Goals and objectives are very diverse and differ considerably among various clients, but one goal is universal. No one wants to run out of money before running out of life, and it is our job as planners to ensure that that never happens. Putting a withdrawal rate on automatic pilot may not accomplish that. Financial life planning updated annually has a much better chance of success.
As Jonathan Clements once wrote, "Retirement is like a long vacation in Las Vegas. The goal is to enjoy it to the fullest, but not so fully that you run out of money."
Roy Diliberto is the chairman and founder of RTD Financial Advisors Inc. in Philadelphia.