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If you've saved an adequate amount of money to comfortably fund your retirement, you probably think you are in the home stretch. The only thing left to do is sit back and enjoy your nest egg, right? Not so fast. You may still have to navigate some rough waters, so it may not all be smooth sailing.
For one, you will still have to manage your savings to yield the income you desire to finance your lifestyle.
Financial planners favor three main approaches to converting retirement savings into retirement income: probability-based, safety first and using "buckets." A less common strategy involves weighing utility.
Pfau says this approach is more popular because it mimics the pre-retirement approach, which people already understand. "It's a more natural way for people to think about retirement income."
The approach is based on William Bengen's finding that, historically, starting off with a 4 percent withdrawal rate from a retirement portfolio and adjusting for inflation each year yields a high probability that you won't run out of money over a 30-year retirement period.
You could also use a higher withdrawal rate if you are willing to dynamically cut your spending in the future if the need arises — for instance, after a market downturn.
"If you are not comfortable making adjustments, you will probably want to start with the more conservative (4 percent) rule in the first place so that it is dynamic to the upside, not to the downside," says Michael Kitces, director of planning research at Pinnacle Advisory Group in Columbia, Maryland. "That cuts down to what kinds of trade-offs you are comfortable with."
According to Kitces, people have a greater appreciation of the 4 percent rule after the financial crisis, considering that it is geared to such worst-case scenarios. In the years prior, when the market was doing very well, people wondered if the 4 percent rule was too conservative.
This approach has its detractors, too. Harold Evensky, chairman of Evensky & Katz, a Coral Gables, Florida, financial advisory firm, says that retirees using this retirement income strategy must deal with inconsistency. "They are not getting a consistent cash flow. They never know, even from one day to the next, what the cash flow is going to be because dividends and interest rates are constantly changing. So it's a nonsensical way to plan."
Paula Hogan, CEO of Hogan Financial Management, a Milwaukee financial advisory firm, points to another shortcoming. She says, during the financial crisis, "people who had their base standard of living covered with inflation-protected income and then put at risk in the market what they were able and willing to lose were fine. People who had money that they needed for groceries in the market were not fine."
That's why advisers such as Hogan favor an approach that is geared to meeting essential needs before taking care of discretionary spending. As Hogan sees it, you have only one shot at retirement and you want it to absolutely go right, rather than expecting it to probably go right.
The safety-first approach is geared to how people use their limited resources to obtain the most satisfaction across their lifetimes. It aims to match spending for the preferred standard of retirement living with the right asset to fund this liability.
Most people have a base layer of Social Security, so this approach typically uses other assets to supplement income with a lifetime inflation-protected income, such as inflation-protected immediate annuities. With a lump-sum investment, you basically buy yourself a lifetime income with immediate annuities. A Treasury inflation-protected securities ladder paired with an annuity is another option.
Once those basic needs are taken care of, the rest of the retirement portfolio would be allocated to other investments based on a person's risk tolerance.
This approach is not without shortcomings, either. "The problem with annuity companies is that they don't fail until they do," says Kitces. "It's very binary. Annuity companies are regulated pretty well, so they don't really fail very much at all, particularly the large, secure ones. But you don't have a lot of control or alternatives if they are in trouble."
Another disadvantage is that it can be costly to build a secure floor, and you could lose upside potential if you buy annuities and don't have much exposure to higher-risk investments. Ultimately, it means that it could be harder to meet your more discretionary lifestyle goals.
"Look at what Treasuries are paying today," says Evensky. "You would have to be sufficiently wealthy to be able to hit any kind of a reasonable threshold on that, no matter what your minimum goals. So it sounds very good to a retail client, but if anyone sits down and looks at the impact on their quality of life, they are not going to find it particularly acceptable."
The bucket approach, one that Evensky favors, relies on segregating your money into different buckets based on how soon you will need the money.
Your immediate needs are met through withdrawals from a bucket that contains the safest assets, such as a money market account, or bonds that you hold to maturity. The rest of your money gets poured into other buckets that typically contain more aggressive investments, such as stocks, to meet your future needs.
"All of us can think about our money a little bit differently," says Kitces. "One adviser does 30 buckets for 30 years. The other adviser does three buckets — one for short term, one intermediate, one long term. When I compare the two of them, their actual asset allocation, it's the same portfolio. They've just framed it differently."
Evensky favors a simple two-bucket approach based on what he calls a "five-year mantra." This means he doesn't invest money that people are likely to need in the next five years. The longer-term bucket he invests based on the client's investment policy.
This way, nobody needs to sell securities at the wrong time, he says. "It is immensely cost-efficient because you don't have a lot of moving parts," Evensky says. "And from a behavioral standpoint, it's very powerful because (during the recent market downturn) no one panicked because they knew where the grocery money was coming from."
He finds that tax and transaction costs go up as the number of buckets increases and the need to rebalance the buckets rises. "Instead of making one investment fairly large where the transaction cost is going to be small, you have five smaller, more expensive transactions in the same investment. I think that if you look at those strategies on an after-transaction and tax basis, particularly in a low-return environment, they would fall apart," Evensky says.
In his preferred two-bucket approach, Evensky weighs the transaction costs and taxes against the risk exposure and the desire to take advantage of market momentum.
According to Pfau, while the bucket approach is not necessarily a superior investment strategy, it does have behavioral benefits since people don't panic during stock market declines. However, "It does still rely on having the stock market do well over long periods of time. And if that doesn't happen, it can lead to trouble."
Considering that the 4-percent rule is more geared to avoiding the probability of running out of money, it doesn't really factor in the satisfaction, or utility, that you gain from your retirement savings over your retirement years.
JPMorgan Chase has factored in utility to develop a withdrawal model that, in addition to minding that the retirement-income spigot is turned on during your retirement, is also geared to maximizing the satisfaction you get from your withdrawals across your retirement.
Others have also used the utility concept in retirement planning studies. "A lot of retirement researchers have been using a utility-based approach in the last seven or 10 years," says Kitces. "Mathematically, if you are going to do a retirement where you have to trade off current spending, future spending, the risk of running out of money and the risk of having lots of money left over, utility happens to be one way to weigh those outcomes."
The JPMorgan Chase version uses inputs such as your age, wealth and your expected retirement income, as well as market performance possibilities, to come up with a dynamic withdrawal rate for each year of retirement. The strategy may involve changing asset allocations.
For instance, if you have a high expected income in your retirement years, you can increase your equity allocation. This is because, even though the higher equity allocation raises your risk, the safe bond-like income provides adequate protection in case of equity market downturns. In addition, you could enjoy a higher withdrawal rate than others of the same age who have the same levels of wealth. This is because the steady income provides a floor, protecting you from the risk of withdrawing too much money.
On the other hand, if you have a higher level of wealth at retirement, your withdrawal rate can be lower compared with others of the same age and at the same income levels. This comes about as you will be getting a larger dollar amount from your asset base even at low withdrawal rates. And the satisfaction, or utility, you get from hiking up your withdrawal rate is not going to be much higher once your lifestyle needs are met. Since you can generate substantial income from bond investments, you might want to cut down on your equity allocations to reduce the pain you would experience if you lost money by risking a lot in the market, which is likely to outweigh any additional utility you would get from larger returns.
This sort of utility-based approach is not as common as the others, though. Evensky says this approach doesn't speak to his experience in dealing with real investors. "The problem comes with trying to mathematically model what utility means. I find it useful in thinking through the issues, but not in terms of planning."