Retirement looks very different today than it did 30 years ago. In the early 1980s, for a brief period, interest rates on 10-year bonds hovered near 15%. Many retirees still depended on their companies’ defined benefit plans. Imagine sitting on those kinds of prolific instruments, while tooling around America in an RV. 

In 2016, people are looking at a very different picture. Demographic trends have changed. Older people are participating in the workforce longer, for many reasons that have to do with their longevity, changing Social Security policy that allows them to keep working and rising health-care costs. Defined benefit pensions are vanishing. And bonds squirt out a pittance by comparison with their old yield. (The 10-year bond yield at the beginning of this year was 2.45%.) More bad news: Stocks are, by many forecasts, likely looking forward at a decade of mediocrity after rising to nosebleed highs. They will likely revert to the mean, observers worry, which means slower asset appreciation.

These are the conundrums confronted by retirees and also by the advisors who serve them, several of whom will be speaking at the upcoming 8th Annual Inside Retirement conference, which will be held in Dallas May 11-12 and is sponsored by Financial Advisor, Private Wealth and ETF Advisor magazines.

“What’s challenging today is that equity valuations are very high, such that they suggest low returns over the next 10 years,” says advisor Peter Lazaroff, director of investment research at St. Louis-based Plancorp, and one of this year’s conference speakers. “Bond yields are low and their returns … are what they are for the next 10 years.”

He thinks the real risk is that a market correction will happen in the first few years of somebody’s retirement (the “sequence of return” risk). And for that reason, among others, he says his firm tells recent retirees to have one to two years in cash on hand.

So in this kind of environment, do rules of thumb like 60/40 portfolios and 4% withdrawal rates still apply?

Wade Pfau, a professor of retirement income at the American College, says that it’s a lot harder to rely on an investment portfolio and manage the market risk and longevity risk. Instead people will have to look at alternatives—perhaps annuities or even reverse mortgages, which will no longer be the last resorts they used to be.

“If you build home equity into the strategy or if you use risk pooling [with] an annuity, you are able to better sustain a retirement at perhaps a more realistic spending level than would be implied by only depending on the investment portfolio,” says Pfau.

Lisa Brown, a partner and wealth advisor at Atlanta’s Brightworth, plans to speak about flexible withdrawal strategies in this environment. Conventional wisdom about withdrawals tend not to be so wise, she suggests. The usual plan is for retirees to consume their taxable accounts first (regular brokerage accounts, bonds, CDs), which usually means eating principal, then moving on to tax-deferred accounts such as IRAs and then moving on to Roth IRAs toward the end of their retirement years.

The problem with that strategy is that when retirees are consuming money from the tax-deferred accounts later on, the amounts they are forced to take out as ordinary income usually push them into higher tax brackets. The better course might be to take some of that money out before, in the early years, when they are not earning income, until they just reach the top of the more mild 15% bracket.

Brown says what you draw from depends on your holdings—your pensions, Social Security, residual payouts from sale of business—it’s important to understand how those sources are taxed before you decide what taxable or tax-deferred portfolios you draw down from.

“Let’s say in year three [of retirement] they don’t have any stock income coming in and they basically could otherwise be living out of their savings account in the bank and they have zero taxable income that year,” Brown says. “That would be a great year to consider touching the qualified retirement money and leaving some of the taxable accounts alone so that you’re not forced to spend down the lower tax burden investment accounts … to be stuck with the higher tax burden investment accounts later on in life.”

Withdrawing from deferred-tax accounts later in life can also be especially burdensome if you have, say, a medical emergency with a high price tag. If you’re forced to fish $30,000 out for a surgery, you’ll have to fish out the extra tax money for it, too.

William Reichenstein, an author, professor of finance at Baylor University and co-founder of Income Solver, a software package for optimal withdrawal strategies, will discuss tax optimization as well, but in the context of the “tax torpedo” that hits Social Security benefits.

The “torpedo,” he says, “refers to the hump—the rise and then fall in marginal tax rates … due to the taxation of Social Security benefits.” When retirees reach 70 and a half, they have to take their tax-deferred money out. When that income reaches a certain threshold, Social Security benefits are taxed too—it starts at 50% and can go up to 85%. You’re suddenly taxed on $1.50 of income when you only took a dollar from your IRA.

This doesn’t hurt the poor, who don’t reach the thresholds, or the highest earners. It’s a middle-income burden, and those clients need to be ready for it. Because their marginal tax rate will in effect be higher, Reichenstein explains.
“So let’s say it’s a tax deferred account withdraw, an extra dollar withdrawn from the 401(k). Well that causes an extra 50 cents of Social Security to be taxed, so taxable income goes up by $1.50, and 15% of $1.50 is 22.5 cents.” So notice your marginal tax rates, federal alone, is 22.5%.
“Then it would rise pretty quickly to 27.75%.” Why? When you hit the level where every additional dollar of income causes 85 cents of Social Security to be taxed, again, one more dollar of taxable income turns into $1.85, and 15% of $1.85 is 27.75%.

“So now this couple hits the 25% tax bracket. Their marginal tax rates, federal alone, is 46.25%. Twenty-five percent of a $1.85 is 46 and a quarter.”

To some taxpayers, it looks like their tax bill has doubled. “What we want to do is minimize that tax torpedo, doing it by tax efficiently withdrawing money from your accounts in retirement,” Reichenstein says. Again, the conventional wisdom says to take money out of taxable accounts first until it is exhausted, and then tax-deferred accounts later. But, again, it’s not necessarily the best choice. Retirees at age 70 and a half can work to lessen the effect of the Social Security torpedo by deferring Social Security or by, again, taking out tax-deferred money early—in those early retirement days when they are perhaps still in zero tax brackets.

Nothing seems conventional, but that’s not so, according to Lazaroff, who’s planning to give a presentation on 60/40 portfolios. He says the world is sometimes only as complicated as we make it, and that things like 60/40 stock allocations are still realistic in an age of longevity, in his mind.

“I think it’s massively underrated, the 60/40 portfolio,” he says. “You have people thinking, do we need something different? So I think people are reaching for return. They are adopting alternatives without really understanding what the strategies are, what the costs are.” And he says that when you look over a 20-year period, the simple truth of the 60/40 allocation’s effectiveness still rings true.
“In an age of longevity, everybody misinterprets what their real time horizon is,” he says.