Financial advisors confront the complexity of generating retirement income for their clients every week. Coordinating Social Security claiming strategies, variable spending patterns, minimizing Medicare premiums, tax-loss harvesting and tax-efficient withdrawal sequences across accounts and holdings is one of the most challenging problems in finance.
This is the first of two articles to raise awareness of the opportunity advisors have to upgrade their current financial planning process and the tools to provide specialized advice that can make their clients’ money last longer. This article outlines and compares different “decumulation” approaches advisors use today.
Let’s start by reviewing the history and comparing the methodology of different withdrawal strategy processes. Then we’ll spell out a new framework that creates the maximum value for clients. A recent survey by the American College shows that 71% of clients would look for a “retirement income specialist” as the top attribute when selecting an advisor. Consequently, top practitioners will need to learn how to incorporate sophisticated tax-efficient withdrawal strategies into their practice to differentiate themselves, and grow and satisy their clients’ demands.
Retirement Income Projection Methodology
Advisors focusing on “coordination” of their clients’ entire household balance sheet, providing “holistic advice,” are winning assets and clients. Fortunately, breakthroughs in research and software development over the last 10-plus years have helped identify opportunities for advisors to “fill in the gaps.” Consequently, they can provide more sophisticated advice for generating income for families entering into or in their retirement.
Let’s examine the evolution of retirement income advice over four phases, where the last is our new proposed framework on how advisors can showcase their value and maximize clients’ wealth over other approaches used in the industry.
Products And Rules Of Thumb
A proliferation of products designed by asset managers and insurance companies to address income have flooded the market. Single product solutions and default solutions in 401(k)s are not going to solve a household’s issues, when “coordination” of resources and liabilities is needed to provide the best outcome. Don’t get us wrong. Smart low-cost products that are transparent will be part of the solution. But a single product and advice directed to a single account is not the answer, when smart planning and ongoing management are required. As the case in this article shows and detailed cases in the second article will show, advice at a household level significantly outperforms single-product solutions and guidance designed solely for a single account.
Similarly, much has been written about the 4% rule and other “safe withdrawal rates.” This is important work. However, this area of research provides only a “rule of thumb” or a guideline. For advisors that manage clients’ money and generate financial plans, these guidelines are not specific enough to tell you when to claim Social Security, how to minimize taxes, or exactly what to buy or sell to generate the income your clients desire.
‘Conventional Wisdom’ And Proportional Withdrawal Sequences
The best financial planning software programs that most advisors use recommend the same general withdrawal sequence to generate income in retirement. Several years ago, we described this withdrawal strategy as the “conventional wisdom.” We estimate that over 80% of advisors still recommend that their clients generate income by withdrawing funds from taxable accounts until exhausted, then from tax-deferred accounts until exhausted, and finally from tax-exempt accounts until exhausted. Advocates of this Conventional Wisdom approach argue that delaying paying taxes as long as possible and letting qualified assets grow tax-free for the longest possible time period are the best approach to generate income for clients.
Note that most large institutions still recommend this withdrawal sequence. If you are a financial advisor, you clearly can provide more value to your clients—over $1 million more in the case outlined later in this article—despite assuming the same holdings, pre-tax risk, and spending levels for the client. Advisors need to “add on” technology to help them identify better strategies that will add more value to their clients’ accounts.
Recently, you may have seen Charles Schwab and Fidelity advertising their new withdrawal strategies directly to consumers. Don’t be fooled. Financial advisors reading this article have a huge opportunity to demonstrate their added value by contrasting these new strategies against those using a “proportional” withdrawal sequence.
Essentially, proportional withdrawals are determined by calculating the ratio of the client’s taxable, tax-deferred, and tax-exempt accounts relative to the total value of all savings and using those percentages to fund the spending amount. For example, in a current year, if taxable accounts are 30%, tax-deferred accounts are 50%, and the tax-exempt accounts are 20% of the total household value, then the withdrawals using these percentages will be taken from each account type to fund the spending.
Typically, this strategy beats the “conventional wisdom” strategy. However, in the case discussed in this article, the Conventional Wisdom strategy beats the Proportional strategy. The key insight, however, is that a financial advisor can recommend a withdrawal strategy that beats both Conventional Wisdom and “Proportional” strategies almost every time with the next two approaches. Neither the Conventional Wisdom nor Proportional strategies incorporate tax-efficient withdrawal sequences that exploit the rising and falling pattern of marginal tax rates that are caused by the taxation of Social Security and income-based Medicare premiums.
Multiple Accounts Sequences With Partial Roth Conversions
In 2015, we published an article in the Financial Analysts Journal showing that multiple account withdrawals tied to a tax threshold can beat the Conventional Wisdom strategy by more than seven years. The lesson is that an advisor can fill in the low tax-rate years by withdrawing more funds from tax-deferred accounts in these years up to a dedicated tax rate. These withdrawals may also include partial Roth conversions each year to a strategic level. Very few tools and software products exist today that model multiple account withdrawals to one threshold (e.g., a tax bracket) over the entire plan horizon.
Again, this approach is more flexible than the Conventional Wisdom and Proportional approaches. But withdrawing funds to a single threshold for the entire planning horizon is far from optimal. In our next article, we will demonstrate that such a strategy will substantially underperform a dynamic multi-phase withdrawal strategy.
Dynamic Withdrawal Sequences With Optimal Withdrawal Targets (OWL Approach)
Let’s consider a new retirement income framework that clearly outperforms other approaches every time. Note, this framework does require advisors to learn new details and incorporate new analysis, but given the extra value it provides clients, it is worth it.
This proposed new approach enables a person’s income and money to last longer. This approach incorporates four factors: 1) Changes and updates based on client, capital market, and tax changes, 2) coordination of decisions including Social Security optimization, Medicare premium minimization, longevity hedging, and whether to purchase guaranteed income, 3) partial annual Roth conversions and 4) Optimal withdrawal levels (OWL), which have two critical dimensions.
The advantages of this two-dimensional OWL framework are that they offer clients more options and flexibility. Two of the critical benefits are: a) Multiple phases or time segments where a withdrawal sequence changes over different time periods and b) dynamic changes in withdrawal levels or targets over time over the different time segments. Using a single target like a tax bracket or average tax rate over the entire planning horizon significantly underperforms the optimal strategy, which is illustrated in the following case study.
The OWL approach makes sense to clients because it personalizes the withdrawal sequence. There are times when clients’ marginal tax rates spike, like when Social Security starts, when Medicare premiums start or when RMDs start. A dynamic withdrawal sequence will change the order of withdrawals and target levels in the client’s life over different periods.
Case Example—Comparing The Value Of Common Withdrawal Strategy Approaches
We will show here how advisors can add significant value by 1) applying more detailed, dynamic, withdrawal strategies and 2) incorporating household rebalancing with asset location within the process, adding even more “advisor alpha” to the clients’ accounts. For a typical client with $4.5 million of assets spending $19,000 a month (see client profile details), we used IncomeSolver.com to compare these five withdrawal sequences:
Conventional Wisdom, Proportionate, Multiple Accounts to Average Tax Rate (ATR), Multiple Accounts to one Tax Bracket, and Dynamic Withdrawal Sequence with Multiple Phases and Multiple Targets.
Figure 1 compares the “total values,” which are the sums of spending, which requires after-tax funds, plus the after-tax value that heirs will inherit, where tax-deferred accounts are reduced by 25% to reflect an estimate of the embedded tax liabilities. The key lesson is that advisors can add more than $1 million in additional after-tax value to clients’ accounts compared to the Conventional Wisdom strategy that is recommended by eMoney, Money Guide Pro, and other popular software products. If an advisor uses partial Roth conversions with an average tax rate or tax bracket over the entire planning horizon, we show how he or she can add $335,718 to $471,093 more total value to a client’s accounts by recommending a multi-phase strategy that changes the withdrawal target in each phase.
Finally, we vary the rebalancing from account level—that is, rebalancing each account back to its target asset allocation—to using a household target asset allocation. We rebalance the household to the same pre-tax asset allocation and risk level, but change the location of the holdings as we rebalance. Figures 1 and 2 show the values added when incorporating household rebalancing with asset location into the withdrawal sequences.
An additional $479,037, beyond the Total Value in the graph above, can be found by incorporating asset location. Note, the same risk level and holdings are used. When modelling this case in IncomeSolver.com, we changed from account rebalancing to a household target asset allocation used for rebalancing and the same holdings were relocated to different accounts to minimize the tax drag and increase expected returns over time. More details and two more cases will be provided in the second article.
Advisors have a clear opportunity to differentiate their services when it comes to “retirement income specialization.” Almost all firms are using software that recommends the “conventional wisdom” withdrawal strategy. We contend that all advisors should “add on” the new framework outlined above to find significantly more money for their clients’ accounts. Since clients want retirement income expertise, this is a huge opportunity for advisors to stand out and win more clients. In the second article, we will highlight three cases with details showing how advisors can add hundreds of thousands of dollars to clients’ accounts by applying this new withdrawal strategy methodology.
Go to IncomeSolver.com/FA-Mag-CaseStudyDetails to see all the assumptions and Strategy Details summarized above. Income Solver ran over 1 million different combinations of withdrawal strategies and returned a list of the top combined strategies.
William Reichenstein and William Meyer are co-authors of the book Social Security Strategies: How to Optimize Retirement Benefits, 3rd Ed. Meyer is chief executive officer of Social Security Solutions and managing principal of Retiree Inc., which developed www.incomesolver.com. Reichenstein, PhD, CFA, is head of research for Social Security Solutions and Retiree, Inc. and is a Professor Emeritus at Baylor University.