Is there a retirement crisis? The debate centers on how much people have saved or set aside for retirement. But the focus on savings amounts misses the point. Retirement isn’t about achieving some magical retirement savings number. Instead, it’s about generating sustainable cash flow to meet your goals, needs and wants.
The pivot from defined benefit pension plans to 401(k) plans in the private sector not only requires people to be responsible for their own savings, but also their own retirement income.
Gone are the built-in annuity and pension payouts. The shift places the savings, investing and income generation burdens onto the individual. But with concerns about Social Security funding and its reliability in the future, individuals feel uncertain about generating retirement income.
A recent study in the Journal of Financial Planning showed individuals performed poorly on a retirement literacy quiz. Only 26 percent of participants passed with a score of 60 percent or higher.
In financial services, a niche market of retirement income planning has started to take hold. But there’s no consensus regarding the best or most efficient way to generate retirement income.
In the past, Americans heavily relied on pension plan annuity payouts, government pensions and Social Security. Professionals now typically approach retirement income planning using one of three strategies:
1. Systematic Withdrawal Strategy
This is the most popular retirement income strategy. It takes an investment portfolio consisting of bonds, CDs, stocks, mutual funds, etc., and then sell off investments each year to generate the income needed.
This strategy prefers a total returns approach that seeks greater long-term returns and rebalances investments over time but aims at generating a steady and inflation-adjusted cash flow for the retiree from a volatile investment portfolio. The withdrawal spending rate that’s sustainable would depend on the risk tolerance level, returns of the investments and time horizon.
A lot of the systematical withdrawal strategies take guidance from the 4 percent safe withdrawal rate literature. This research shows that the most you could spend from a 50/50 stock to bond investment portfolio for 30 years was roughly 4 percent of the initial account value adjusted for inflation.
So, if you have $1 million, you could withdraw roughly $40,000 a year for 30 years (adjusted for inflation). And you wouldn’t run out of money based on historical U.S. returns, even in the worst-case scenario.
However, the 4 percent rule isn’t and wasn't supposed to be a strategy – it’s just a guideline for sustainable withdrawals. A systematic withdrawal strategy might start with 4 percent, but as you make adjustments for fees, taxes, market conditions and investment diversification, you can increase the average withdrawal rate significantly. Some research shows that if done correctly, you can achieve closer to 6 percent average withdrawal rates as long as you can cut back on expenses during down market years.
The biggest upside of the systematic withdrawal strategy is long-term market investment of the portfolio. This gives the individual a good deal of upside and provides a decent opportunity to increase their wealth and spending over time if the markets perform well.
The biggest drawback of the systematic withdrawal strategy is the risk associated with the markets, especially during the first five or so years of retirement. Sequence-of-returns risk – the risk of poor market returns early in retirement – can cause a portfolio to quickly deplete if you need to take significant withdrawals from an investment portfolio early in retirement when the markets suffer a significant downturn. To effectively use a systematic withdrawal strategy, you need to have some market risk tolerance and adjust to market downturns.
2. Flooring Retirement Income Strategy
Also known as the “essential vs discretionary” approach, the flooring retirement income strategy somewhat opposes the investment and risk management style of a systematic withdrawal strategy. The strategy prioritizes spending goals between needs and wants. Your income for your retirement needs – or essential expenses – should come from a secure income source. While your wants – discretionary expenses – can have more risk associated with them.
One of the biggest challenges with a flooring strategy is separating needs and wants. Once you account for taxes, housing, food and health care expenses, you might have listed 80 percent or more of your expenses for a year.
To create a floor of income you can use a variety of products and strategies. Social Security and pensions provide a floor of income. Additionally, you can layer annuities or set up a bond or TIPS ladder to generate a secure income over time.
The downside to buying secure retirement income is you often give up returns for safety. The likelihood you’ll grow your wealth decreases with this strategy as compared to a total return systematic withdrawal strategy. However, if you layer in lifetime income, the annuities will keep making payments for life. This strategy often resonates with individuals who want security and are a little more risk averse.
3. Time Segmentation Strategy
The third strategy, often called the “bucket” approach, aims at appealing to the emotional side of decision making as it is close to a mental accounting strategy. Buckets, or groupings, of investments are set aside for different time horizons in retirement.
For example, you might set up three investment buckets. The first bucket will provide income for the near term, perhaps the first five years of retirement. Safe income sources like cash, bonds, CDs and term annuities fund this bucket.
The second bucket might have a more mixed investment allocation of bonds and CDs or mutual funds. This provides growth potential but still isn’t fully invested in the market.
The third bucket, which you won’t use for over 10 years, can take on more risk because it’s a long-term investment. Since liquidation won’t happen for years, you can invest this bucket entirely in stocks and provide a stronger long-term return approach.
The biggest drawback to the bucket approach isn’t in the initial set up, but in how it operates over time. As bucket one empties, when do you refill it? Often bucket approaches don’t have a set model for when to refill; they follow a wait and see approach. This makes academic or modeling of bucket approaches more difficult.
The bucket strategy clarifies why you are investing in the market and why you have secure or safe income sources in your plan. Many individuals find this strategy appealing because they can relate to it and it presents a clear picture of their investment plan.
In the end, the debate of what strategy is best or most efficient remains. All three strategies provide certain benefits and have their own drawbacks. The strategies should tailor to each individual investor depending on their goals, investment experience, income sources and risk tolerance level.
Systematic withdrawal tells us we need to take on some market risk to generate higher returns and increase our wealth. The flooring strategy tells us the value of having safe income sources to help cover necessary expenses. The bucket approach tells us we need a story and reason for the investments we choose. This helps a client buy into the strategy, understand and follow it. Ultimately, each strategy has its share of strengths so it doesn’t have to be an all or nothing approach – combining aspects of all three could be quite beneficial.
