It's no secret to the advisor community that the baby boomers are entering the traditional age for retirement this year. En masse, their (and our) primary financial mindset must shift from a lifetime of building wealth to a relatively ill-defined but likely lengthy period of spending as much of it as is prudent ... while sustaining some level of wealth in the process.
Going Institutional
How to achieve this delicate balance? A recent article in The Wall Street Journal, citing a Vanguard Group analysis, points to the intriguing observation that there are actually two distinct groups of investors facing the same critical need to meld spending and capital preservation needs:
1. Retirees
2. Endowment funds/institutions
Like retirees, endowment funds have ongoing, annual spending requirements where the goal is to reasonably determine appropriate withdrawal rates over time, amidst evolving funding needs and market volatility. And yet, surprisingly, we find few examples of institutional funding models applied to retirees' planning needs. By mining ideas from the most successful institutions (such as David Swensen's Yale Endowment Fund model) and amalgamating them with the smartest individual investment solutions (low-cost, index-style investing), advisors can best position retirees to enjoy their golden years.
Flexibility Is the Key Ingredient
Traditionally, retirement spending rates have been calculated by applying William Bengen's 4 percent to 5 percent "safe withdrawal rate." We agree with the sound logic of this widely accepted strategy. But, as reflected within the Vanguard analysis, the overall planning process also requires ongoing flexibility to address evolving personal circumstances as well as the ever-volatile forces within the markets and the economy. As the Wall Street Journal observes, if retirees rely exclusively on the safe withdrawal rate, they "may be overlooking some basic variables -- such as current interest rates and stock valuations -- that will have a direct impact on how long their money lasts."
In other words, the safe withdrawal rate is a good first step, but without ongoing flexibility, a gap emerges, into which a retiree's portfolio can stumble and fall. An institutional model can help bridge this gap.
Strategy Applied To Reality
At our firm, we have turned to David Swensen's Yale Endowment Spending Policy as an appropriate model to layer on top of the initial safe withdrawal rate, to help determine ongoing spending rates. To this, we add a component of account management, in which retirees' riskier, wealth-building investments (equities) are separated from their predetermined number of years' worth of annual "retirement salary" (fixed income). The results look something like this, in process and structure:
1. Effective spending rates based on the Yale Endowment Fund strategy - Enhancing the traditional Bengen-inspired "safe withdrawal rate" to reflect the more nuanced realities of how markets and the economy impact retirees spending rates.
2. Portfolio construction based on passive investment vehicles - Investing with low-cost, index-style solutions, according to the academic evidence on how markets efficiently deliver premium returns over time.
3. Capital preservation through appropriate market/risk exposure - A separate, all-equity account using low-cost, index-style solutions provides market exposure in accordance with individual capital needs.
4. Withdrawal/spending through a twist on traditional asset allocation techniques - A separate income reserve account holds 5-10 years of "retirement salary" invested in short-term fixed income and cash equivalents. This is the equivalent of addressing individual risk tolerance via traditional fixed income allocation.
5. Managing evolving needs and circumstances - Using the withdrawal strategy of the Yale Endowment Fund model, we apply a back-weighted withdrawal formula to smooth out cash flow, with a performance logarithm based on recent returns to adjust retirement salary spending rates.
This structure offers a number of distinct advantages over the more traditional approaches of simply layering the Bengen-based safe withdrawal strategy on top of an existing wealth accumulation plan or loading up on costly variable annuity products.
Smoother, More Realistic Decision-Making
By running quarterly performance logarithms we determine how much, if any, of the equity investment account should be sold to fund the income reserve account. This allows the income reserve account to float below its targeted number of years when equity returns are down, and then refill as equity returns outperform historic averages. It supports a "buy low, sell high" approach, as well as a realistic way to assess when it is alright for clients to spend a little more freely, and when it may be time to recommend modest belt-tightening.