One of the most persistent analogies I have heard in my
career as a financial adviser is the story of climbing and descending Mount
Everest. As the story goes, more climbers perish on the way down the mountain
than do climbing up it. We then equate our clients’ wealth journey with that of
climbing Mount Everest – spending lots of time and effort to get to the summit
of peak financial wealth (i.e., retirement) only to be left with the question,
“How am I to descend the mountain safely?”
While many analogies are tired and overdone, this is
actually not a bad one. The problem is this: We as an industry have done an
awful job at guiding our clients down the mountain with the same degree of care
that we provide on the way up.
Until just within the last decade or so, our standard answer
for descending the retirement mount has been the venerated “4% Withdrawal
Rule,” popularized in the mid-’90s by historical study of withdrawal rates by William
Bengen. Although this rule has been regarded as relatively failsafe, many of
the assumptions used in its origination are incongruent with many of the
assumptions we make for our clients’ retirement roadmap today.
There is a better way to help clients build an income
strategy for retirement, and our clients deserve just that.
3 Alternatives to the 4% Rule for Your Income Plan
Most advisers are already familiar with the concept of
probability-based planning using Monte Carlo analysis. The same concept holds
true for distribution planning. Although we cannot ensure a given level of
income from the portfolio over time, we can reasonably expect the portfolio to
provide it in most scenarios.
The task becomes how to actually structure the withdrawals
to stay within the acceptable probability of success range. Within this
category there are two similar but distinct ways to converting a portfolio into
income throughout retirement.
Income Approach No. 1: Dynamic Systematic Withdrawals
The first approach is what is called dynamic systematic
withdrawals, or systematic withdrawals with guardrails.
This approach modifies the traditional systematic withdrawal
approach by introducing decision rules, or “guardrails,” to determine when and
how distributions may increase or decrease over time. These decision rules are
set forth at the creation of the plan and inform the decision to reduce
withdrawals to accommodate increased risks related to the markets, longevity,
inflation or sequence risk.
Some examples of these rules inlcude Jonathan Guyton’s and
William Klinger’s decision rules, floor and ceiling rules, and targeted
portfolio adjustments. In their study, Guyton and Klinger found that a sound
set of decision rules could potentially increase the initial withdrawal rate by
as much as 100 basis points.
Who may want to use this method: This approach may be the
most appropriate for retirees who are willing to tolerate some fluctuation in
their retirement paychecks (subject to some limits, of course) but who want to
start out with as high an income as possible.
Income Approach No. 2: Bucketing
The second probability-based philosophy of converting a
portfolio into retirement income is called time-segmentation or, more commonly,
bucketing. The term “bucketing” has been used and reused to fit a wide set of
applications. Within the context of retirement income planning, bucketing
refers to the breaking up of retirement into distinct time increments and
investing for specific outcomes at specific times. The idea is, if I know I
won’t need to touch a sum of money until some specified date in the future, I
will be more comfortable riding out fluctuations in the value of that bucket.
A simple way to set up buckets is to separate the portfolio
into time segments corresponding with the “Go-Go” years, the “Slow-Go” years,
and the No-Go” years of retirement, although there are many ways to achieve the
same end using other methods of segmentation. These different time periods in
retirement typically represent different spending patterns.
Who may want to use this method: This second approach to
retirement income planning may be the most appropriate for retirees who desire
more structure in their plan and who would typically need more behavioral
coaching along the way using systematic withdrawals. These clients may have a
lower-than-average risk tolerance for their age, and they are likely to be more
Income Approach No. 3: Safety-First Planning
Our third approach to retirement income planning has wide
acceptance in the academic community, garnering support from multiple Nobel
laureates and a wide array of academic thought leaders. The safety-first
approach, also known as the flooring approach, is tied to the academic theory
of life-cycle finance. This theory seeks to address the question of how to
allocate resources over one’s lifetime so as to maximize lifetime satisfaction,
given existing spending constraints.
Put simply, in the safety-first approach you help the client
categorize their expenses into needs, wants and wishes. You then create a floor
for their needs using pensions, Social Security, bond ladders and income
annuities. In this process, it is essential that the financial adviser does not
project their own perception of what should be considered needs and/or wants.
This should be left entirely up to the client(s), with the adviser as a guide.
Who may want to use this method: This approach lends itself
more to individuals and couples who focus more on their cash flow than their
wealth and to those couples who are relatively healthy with long expected
The Bottom Line on Income Planning
Whichever approach you and your client ultimately decide
upon, one thing is inevitable: You will have presented your client with a
thoughtful and methodical approach to designing their plan, their way. After
all, what good is a Sherpa who guided you all the way to the top of Mount
Everest only to tell you he didn’t know how to safely get back down?
Click here for the