A FRESH LOOK AT SUSTAINABILITY

BRINGING COMMON SENSE TO A CRITICAL DECISION

We have all heard the expression: “Save for a rainy day.” Most people also “Save for retirement.” Both sayings describe accumulating money to be used for paying expenses, outside of regular income from employment. The first of these is short term, unplanned and unpredictable; the other is long term and planned. In both cases, the intention is to spend down the account, and the hope is that the funds are enough to meet the goals.

The investment industry provides several options for individuals to invest sensibly for their monetary needs during retirement, such as IRA and 401K plans. The investment process provided by financial advisors focuses primarily on asset allocation and investment selection (often with active management of the assets) in the hope of enjoying adequate asset growth. Coupled with contributions during the working years, everyone expects to accumulate enough to sustain adequate withdrawals throughout the retirement years.

Surprisingly, very little attention is given to this question: “How much can I withdraw from my retirement portfolio?”

This is an area where answers to this critical question vary dramatically, and the methods for determining the appropriate “spending rate” are quite different. Some of this confusion comes from a fundamental error: failing to start with the goal.

Sadly, the investment industry tends to “put the cart before the horse” by beginning with the investment process, rather than starting with the client’s life goals and then directing the investment process toward accomplishing those goals. This results in investment advisors telling clients how much they can spend – dictating the client’s goals, rather than accomplishing them.

We will take a fresh look at answering this question of how much we can spend during retirement. We begin with the client’s life goals, and then make the common-sense decisions to invest and spend from the portfolio to accomplish these goals. 

MISUNDERSTANDING THE GOALS AND WHAT RISK MEANS

To bring together the investment process and the client’s objectives, we must first eliminate misunderstandings, including:

• what are the client’s life goals over the retirement horizon,
• what it means to “sustain” the investment portfolio, and…
• the true risk of incurring losses at the beginning of the retirement period.

UNDERSTANDING THE CLIENT’S LIFE GOALS

Our analysis begins by setting the client’s retirement horizon at thirty years. Since the “full retirement age” is now 67 years, our horizon reaches until age 97 years for our retirees. Current government projection of the average lifespan is now 84 years (the average of 82.6 years for men and 85.2 years for women.) Our retirement horizon stretches 12 – 14 years beyond the average life expectancy, and this helps to produce a conservative estimate of the success of our investment program, in the context of the planned spending schedule we use in our analysis.

We split the retiree’s horizon into three 10-year phases, each with its own monetary goals:

• “Enjoy” in years 1-10 of retirement describes a high initial withdrawal rate (relative to beginning assets.) Since retirees are at their best health, we plan for them to enjoy their time, engaging in delightful activities. This may include travel, visiting with family and friends, and engaging in hobbies and other pursuits as they “enjoy life.” This is expected to be more expensive than everyday living, requiring a high “spending rate.”
  
  
• “Maintain” in years 11-20 describes a “down to earth” level of spending that reflects everyday living. We expect to maintain the retirees’ regular standard of living.
  
  
• “Care” in years 21-30 describes the highest spending rate of all three phases, with the intention of funding the extra care and services that retirees will likely require.

These three phases have two things in common:

a) they all require substantial regular withdrawals from the portfolio, and

b) they draw down the portfolio significantly.

UNDERSTANDING SUSTAINABILITY

Funding these high withdrawals requires drawing down the portfolio’s value – we will be “spending the corpus.” After all, the entire purpose of the retirement savings plan is to accumulate money that is meant to be spent to fund retiree living costs.

Unfortunately, the traditional withdrawal rate recommended by financial advisors is too low to meet the retirees’ life goals.

Why would a financial advisor suggest spending rates in the range of only 4%, regardless of the life goals of the retirees? The sad answer is that this low spending rate preserves the investment portfolio in perpetuity. That may be an appropriate withdrawal rate for a multi-generational foundation or endowment or pension plan, but it is contrary to the retirees’ goals.

Therefore, we must take a fresh look at this key decision of finding a truly sustainable withdrawal rate. Our retiree horizon is 30 years, not infinity - therefore, our spending rate can and should be increased above the perpetuity spending rate.

Remember, our purpose is not to maintain the portfolio corpus, but to pay for our clients’ life goals.

For retirees, “sustainability” means having the assets needed to make the withdrawals in the “enjoy,” and “maintain” and “care” phases of retirement, while also preserving an adequate ending portfolio amount. This remaining surplus amount provides two benefits to the retirees:

• safety cushion as an offset to unexpected or negative events, and
• residual amount for gifting.

We have identified the three factors that form a goals-based retirement plan: asset allocation, spending plan, and residual value. 

UNDERSTANDING SEQUENCE OF RETURNS RISK

We often hear warnings about the risk of a market downturn at the start of the retirement withdrawals. The concern is that the combination of lower portfolio values accompanied by a withdrawal of assets has the potential to deplete portfolio assets to a level where future withdrawals cannot be supported. The result is “outliving your assets.”

There are several solutions, including:

• cash matching several years of initial withdrawals, giving growth assets time to recover,
• moving to a more conservative asset allocation, and
• lowering spending goals.

The first suggestion is highly recommended for any “spending policy” portfolio, since it brings a degree of certainty and liquidity from assets that are already part of the bond portfolio.

The second suggestion is also wise, and already reflected in target date funds, which prepare a “glide path” that decreases equity exposure as people get closer to their retirement age. We suggest continuing this glide path over the retirement horizon.

It is equally important to maintain adequate diversification within and across the asset classes, including equity, bonds, and alternative investments. This is critical at times of market stress, when a severe downturn in one asset class may be offset by gains in the others. We had written about this approach in our article on asset allocation in the absence of market forecasting.

Smart Asset Allocation Strategies for an Unpredictable Future | First Rate, Inc.

We suggest that sequence of returns risk is both misunderstood and overstated. This causes unnecessary worry, and it erodes investor confidence, pushing them toward overly-conservative asset allocations that introduce “return deficiency risk.” This often results in insufficient capital to fund planned expenditures. In trying to fix the asset erosion problem, this creates another version of the same thing – with a less hopeful long-term outlook.

To illustrate the proper evaluation of sequence of returns risk, we begin with our return expectations for the markets and for our three glide-path asset strategies. Our diversification is reasonably consistent across these three asset strategies:

RECENT EXAMPLE OF SEQUENCE OF RETURNS RISK

There are two problems with the “scare tactic” that drives these warnings of impending doom from initial losses. The first is that it focuses on the downside risk of an all-equity portfolio. However, retirees typically hold lower exposures to equity. Diversification lowers the severity of potential losses even further.

The second problem is that these dire warnings do not consider the recoveries that follow downturns. It is well known that a key risk in the equity market is missing out on the substantial recoveries that follow downturns. For this reason, investors are encouraged to focus on “time IN the market” rather than “returns ON the market.”

To illustrate both points, we look at the 2-year period around the “Great Financial Crisis” of 2008. Substantial declines in equities made headlines, and given the natural sensitivity to losses, this period remains a focal point in risk analysis. The returns on the segments of our diversified portfolio demonstrate the substantial benefits from both diversification and market recoveries, as demonstrated in the following two tables.

We see the diversifying effects from holding a mix of equity, bonds and alternatives. We also see that losses in one period were matched with substantial gains in the following period. The result was a 2-year return in each asset class that moved from the “extreme” range into something more manageable and in line with expectations for both gains and losses.

We can also see how diversification helped produce portfolio returns that were relatively stable, experiencing single-digit losses that would not put the portfolio’s value at risk. In fact, the worst loss occurred in the 60-40 portfolio, and it was less than six percent. For the retiree with the shortest time horizon, the lower equity exposure coupled with the diversification effect produced a gain in 2008 of nearly five percent – during what some called “the worst equity market in a generation.”

We acknowledge the volatility in the investment markets, along with the emotional stress when one of the portfolio segments experiences a short-term loss. However, our prudent diversification process provides quantifiable, credible support to encourage investors to move into their retirement phase with confidence in their ability to fund their planned expenditures and to enjoy the benefits from having invested during their working years.

Our next step is to examine our spending plan. 

CASE STUDY FOR OUR 3-PERIOD, GOALS-BASED SPENDING PLAN

Here are the expected returns and risk statistics for our three strategies, created from our capital markets forecast. These summary statistics are used in a 3,000-scenario Monte Carlo analysis, where we make constant withdrawals throughout three decades of volatile investment markets.

The mean return expresses our return expectation in any given year; this is what drives our Monte Carlo process. The standard deviation measures the market uncertainty we face in any year, in terms of underperforming or outperforming our expected return. The compound return is the expected long-term rate of asset growth.

Inflation is a key risk for any long-term investor. Our goal is to make withdrawals that “keep up with the cost of living” and maintain the client’s standard of living. We expect that each withdrawal will be enough to fund living expenses as time goes by. And when we look at the value of the portfolio (net of withdrawals) we consider its value relative to the beginning value of the portfolio. This is a viewpoint based on “current dollars.”

To simplify this analysis – making it more intuitive and understandable – we express our results relative to our current portfolio value. To do this, we adjust our withdrawals, portfolio returns, and portfolio values for inflation. Our initial portfolio value is set at $5 million, and our review of the ending portfolio value will be relative to that initial amount. If our ending portfolio value is $5 million, then we have preserved the entire value; if the ending value is $1 million, then we preserved 20% as a safety cushion or for bequests.

This eliminates the confusion caused by inflated future values, where we have more dollars that do not buy as much. Over our 30-year horizon, inflation would convert $5 million current dollars into $10.8 million future dollars that have the same purchasing power - that would not be a “real” gain. This is why all our results are expressed in “real” current dollar terms.

SPENDING PLAN FOR OUR 3-PERIOD RETIREMENT

The “Enjoy” decade has a 7% initial spending rate; this is applied to the beginning portfolio value of $5 million, producing an initial withdrawal of $350,000. This amount increases each year at the inflation rate of 2.6% and in our analysis, we use its constant real value, as we increase the portfolio value by its inflation-adjusted return. Over this decade, the expected real annual return is 4.7% (7.4% nominal return discounted at 2.6% inflation.) This puts the withdrawal and the investment return on the same inflation-adjusted basis.

The “Maintain” period reduces the spending rate to 5% which is a rate that we expect to preserve the value of the portfolio (net of withdrawals) over the decade. Its expected real return is 4.4 percent.

The “Care” period doubles the spending rate to 10% so that the real withdrawal amount increases significantly. Its real expected return is 4.1 percent.

MONETARY OUTCOMES

Our primary focus is on preserving the portfolio value over the retiree’s 30-year horizon. Sustainable spending is determined by balancing the competing claims for income and residual portfolio value, subject to the realities of market returns for the asset allocations which adjust to the client’s decreasing tolerance for investment risk.

These factors form the basis for a conversation between the client and the investment manager. The analytics we will review are key to determining the proper decisions regarding investment strategy, withdrawal rates and target residual value.

Our first exhibit shows the real portfolio value (in today’s dollars) as we move through the three 10-year periods. We focus on the median result, which is the midpoint of all outcomes. The expected result is higher than the median, because it includes the substantial upside returns and monetary outcomes that are likely to occur. This means that the uncertainty of outcomes is more likely to reflect higher values, making our median projection a conservative estimate.

We expect to spend down the portfolio’s value during the initial period, preserve it during the second period and draw it down once again in the final period, leaving $685,000 of the original $5 million. This is a “residual cushion” of nearly 14% of the original portfolio value. This money can be used to meet unexpected expenses (if needed) or it can be gifted.

A more complete summary of our monetary results includes the cumulative withdrawals made over the investment horizon. We see that the initial $5 million supported withdrawals of over $8 million over thirty years. When combined with the ending portfolio, the “total value earned” was about $8.75 million. This is 1.75x the initial investment, with most of that gain distributed to the retirees to fund their monetary life goals.

This clearly shows the emphasis on turning the retiree’s investment assets into a stream of income over their remaining lifetime. Most of the portfolio’s value was spent, rather than simply being preserved (in keeping with the client’s goals.)

Our final exhibit shows the details of the investment and spending program. The portfolio value declines after each decade of spending, and the spending rate adjusts so that the monetary withdrawals are enough to fund the client’s upcoming expenses. We doubled the spending rate for the “Care” decade because we needed to generate higher withdrawals on a portfolio that had declined by almost half over the prior two decades.

The risk of missing the final payment (#30 at age 97) is ten percent, and the risk of missing the final two payments is four percent. This is reflected in the “Total Real Withdrawals” value for the “Care” period, which is slightly smaller than the sum of ten expected payments. The “risk of outliving your savings” is low, as is the severity of any shortfall.

What if we spent a bit less at the start?

Initially spending less might meet the client’s financial goals with a more desirable balance across the retirement periods. The value of this process is in aligning our market assumption, investment strategy, withdrawals and ending portfolio value.

This second scenario reduced the initial spending rate by 100 bps from 7% to 6% in the “Enjoy” phase, reducing the monetary withdrawal by $50,000. This retained a higher portfolio value, allowing us to reduce the spending rate in the “Maintain” phase by 75 bps from 5% to 4.25% while continuing to fund the client’s desired standard of living.

The result of more modest initial spending means that the “Care” phase is now expected to produce about 30% higher income and a final portfolio surplus value that increased from 14% to almost 18% of the initial investment. This is perfect for the client who wants to trade off a bit of “enjoyment” to gain a little more “care and gifting.” And the risk of missing the final payment is reduced from ten percent to five percent.

MAKING THE MOST OF TIME AND RESOURCES

Is this approach to retirement spending a radical departure from the traditional view? If that traditional approach sees the investment process and client goals only as a set of statistics… then we would answer with a resounding “Yes!”

We believe that within the context of true goals-based investing, we are “in good company” because we recognize that people have real-life, tangible goals that must be funded – and this approach helps us create a monetary version of their goals. Our process acknowledges changing life cycles, and it creates a plan to fund the expenditures that allow clients to follow their own path and achieve their individual goals.

We also recognize the uncertainties facing every investor, and we approach these with a standard of care that provides the confidence needed to pursue and maintain the prudent plan we develop with our client. This collaborative effort takes a holistic approach to retirement planning, bringing the unique client perspective into the investment process.

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Written in partnership with Stephen Campisi