Last week I asked which was most important to you:
Never running out of money
Never running out of income
Whether you’re building a house or your ‘financial house’, it begins with a plan – that’s common sense. Yet, I’ve seen more than a few people make major financial decisions BEFORE ever walking through my door for the first time: Ready, fire, aim.
I’ve seen them retire, make Social Security claiming decisions and even pension decisions… then seek out financial advice – moves that often put them behind the 8-ball before they start.
So, what are the hazards retirees face?
- Being underfunded. It’s not uncommon today for people to live thirty years in retirement – one good reason why so many are opting to continue working after their ‘formal’ retirement. It takes a lot of capital to fund thirty years of income after taxes and inflation – for two lives. The problem with this hazard is that it’s extremely difficult, if not impossible, for an advisor to change at the point of retirement.
- Bad timing. This is something we call ‘sequence of returns’ risk. To illustrate using simple numbers and ignoring taxes, imagine this scenario: You retire with $1 million and plan to withdraw 4% annually. That $40,000 combined with Social Security should meet your needs.
If the market goes up 20% and you withdraw 4%, you should have $1,160,000 after the first year. Allowing for a 3% inflation rate, you can withdraw $40,000 + inflation = $41,200 in your second year, which computes to 3.55% of the second year’s beginning balance. Not bad. If the market does that every year forever, you’re fine!
What if the market goes down 20% in the first year as you withdrew your $40,000 (4% of the original balance)? The market loss was $200,000 and you withdrew $40,000. At the end of year #1, you’re down $240,000 and your new balance is $760,000 at the beginning of year #2. And, of course, prices are higher – inflation has driven your living costs up by 3%! You’ll need to take $41,200 in the second year, just as in the first scenario above, but now it’s coming from a starting balance of $760,000, which means your withdrawals now represent 5.42% of assets. Another down year could be disasterous.
Diversification can help. Diversification is all about using asset classes that have low correlation in their movements. Think of pistons in a car: If they all went up and down and down at the same time, where would they all be if the engine were to shut down? Oddly enough, you may not want a portfolio that contains investments that all go up – the opposite could happen, too!
- Withdrawing too much too soon.
Some people may simply not know how much they can, or should, withdraw. With longevity risk becoming greater with our medical advances, knowing how much we can withdraw presents a problem for many.
How do you know how much you CAN withdraw and never run out of money? The government has the answer! They even publish it! It’s the IRS required minimum distribution rules! Just plug your numbers into the calculator and that shows how much can be withdrawn! The RMD rules apply to all qualified plans, but not to Roth IRAs while the owner is alive, and can be used for other accounts as a guide to avoiding longevity risk.
The good news: RMD math virtually guarantees against running out of money within 45 years if the amount withdrawn is that calculated and no more. There’s a practical weakness in this method as a guide for annual income, as well: Remember our sample $1 million portfolio?
Practical: Withdraw 4% of the original account balance each year, adjusted for inflation, regardless of market returns, i.e., $40,000 base adjusted only for COLAs each year. Weakness: Could lead to early depletion of assets if there are continuous market declines.
Not practical: The RMD calculation is based on a percentage of the account value. If the market declines, the percentage could result in a declining income for one or more years.
The bad news: The RMD amount might be less than what’s needed to meet living expenses and, as noted, could even decline! So, asset allocation, using the RMD rules, does not affect portfolio survival; but it does affect how much the retiree might receive each year – an unpredictable income.
How do we create a sustainable LIFETIME income?
That’s our subject for next time.
If you would like help, of course, we can always visit by phone.
Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER® professional and An Accredited Investment Fiduciary® serving private clients since 1991. Jim is Founding Principal of The Independent Financial Group, a registered investment advisor with clients located across the U.S.. He is also licensed for insurance as an independent agent under California license 0C00742. The Independent Financial Group does not provide legal or tax advice and nothing contained herein should be construed as securities or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.