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.