Tuesday, September 14, 2010

Tuesday Q&A Series – Retirement Income

This week’s questions come from Ken, a client who is concerned about how much of his portfolio he can afford to live on in retirement and how long that portfolio will last.

Q. I want to ensure adequate income for living expenses in the future. What percentage of my assets can I plan on using each year? How long will my money last?

This is a great question and continues to be a debatable concept within the financial planning community as well as among investors.

There are several questions to consider before embarking on the appropriate strategy for your situation: Do you prefer a higher level of income in the early years of retirement or do you prefer more certainty of your assets lasting your entire life? Can you sustain your lifestyle if you choose a lesser amount of income from your retirement assets initially? Do you want to leave your heirs a significant inheritance?

“Longevity Risk” can be described as the risk of living longer than your retirement assets can sustain. Cultural shifts in longevity risk can put strains on social security, public and private pensions and personal retirement assets. This concept is gaining some more attention, especially considering the funding status of Medicare and social security, but is probably under-discussed by the financial media and planners alike.

The upside to employing a spending plan that allows your portfolio to last forever is that you will likely never fear or experience a complete drawdown of your retirement assets. The obvious problem with this approach is that many savers are not able to employ this strategy without seriously affecting their current standard of living. Accepting less income early on in retirement, when most are healthier and able in exchange for a substantial income after the age of 90 is not the tradeoff everyone is willing to make.

Let’s consider three examples all with different withdrawal rates and investment strategies and the advantages and the risks associated with each. We will assume Ken has a $1 million dollar portfolio and wants to see how long those funds will last under a few different assumptions. We will also assume that Ken is retiring at age 65 in each scenario. For retired couples, keep in mind that there is about a 50% chance that at least one of you will survive into your 90’s.

Scenario 1

Starting Annual Income: $40,000
Annual Return Requirement: 6%
Portfolio Characterization: Moderately Conservative
Annual Income at Age 90: $61,000
Portfolio Value at Age 90: $1,573,000

This first scenario is the most conservative on two fronts: First, Ken is taking a modest annual distribution calculated at 4% or the prior year end balance; Second, because of the relatively low distribution requirement, he can afford to invest more conservatively. This less risky portfolio has a greater chance of performing to the stated expectations. This portfolio supports a nearly 2% annual distribution increase, while the portfolio value is also able to grow, keeping pace with some inflation. This expected increase in value over time will provide financial security and flexibility should unforeseen spending requirements arise.

Scenario 2

Starting Annual Income: $60,000
Annual Return Requirement: 7%
Portfolio Characterization: Moderately Aggressive
Annual Income at Age 90: $69,000
Portfolio Value at Age 90: $1,162,000

Ken has a higher income requirement of $60,000 per year, or a 6% withdrawal rate, in this scenario. This spending and investment plan can support a smaller annual increase in spending of only 0.5% annually. The investment allocation is going to have to take a slightly more aggressive bent to achieve a 7% annualized return, which increases the chances of falling short of those expectations. But significantly higher income in the early years will help maintain the desired standard of living. The account value is basically being maintained on a nominal basis, but not maintaining value on an inflation adjusted basis.

Scenario 3

Starting Annual Income: $90,000
Annual Return Requirement: 8%
Portfolio Characterization: Aggressive
Annual Income at Age 90: $0.00
Portfolio Value at Age 90: $0.00
Note: Portfolio likely exhausted by age 86

Clearly, Scenario 3 is the most aggressive option. Ken is starting with significantly higher distributions which will almost certainly exhaust the accounts within a 20 year period. In this scenario, his spending requirement had not been adjusted to compensate for inflation and continues at $90,000 annually until the account is exhausted. Given the increased volatility with an aggressively invested account, the funds under this scenario have a relatively high probability of providing income for fewer years than we expect.

Each of the foregoing scenarios has its own distinctive advantages and weaknesses. Each investor will have their own unique objectives and risk tolerances that need to be considered in order to find the right solution. Some may prefer a more or less aggressive investment allocation based on some of the factors discussed above or other factors specific to their situation.

Ken, I hope my answers above have given you a better understanding of our thoughts about withdrawal rates and some considerations for various scenarios.

We encourage our clients and readers to send us questions for our Tuesday Q&A series at contact@rollinsfinancial.com. And as always, we hope you will keep Rollins Financial in mind when seeking professional advice on financial planning and investing.

Best regards,
Eddie Wilcox

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