Protecting and Sustaining your Retirement Income

As clients age, they begin to focus on retirement. I am constantly asked about how much money is necessary to retire. Some quantifiable information must be addressed and ascertained before this question can be answered.

The starting point in this process is to determine the amount of living expenses one requires during retirement. The majority of studies indicate that this range is between 65-70% of current annual living expenses. Typically, all or most children are somewhat financially independent, the mortgage is nearly or fully paid off, and other types of large expenses, such as weddings, have been largely met. Of course, every situation is different as some individuals continue to support their children in or out of college or provide financial assistance to elderly parents but, generally, living expenses do decline in retirement.

The first source of retirement income is social security. While many taxpayers are worried about the long term sustainability of social security benefits, clearly for those boomers near or at retirement, this concern should not be an issue. I will not re-visit strategies to maximize social security benefits as I wrote a newsletter on this topic last year, but it often makes a great deal of sense to delay the onset of social security benefits from normal retirement at age 66 to age 70. If you can afford to wait four extra years, annual benefits increase by 8% resulting in a total increase of 32%.

After determining the shortfall between living expenses and social security benefits, the most important decision to be made is the distribution rate on investment assets necessary to maintain income for your entire life. In 1993, Bill Bengen, a financial advisor, conducted a study based on the classic 60/40 stock/bond mix for a portfolio at retirement. Bengen calculated that a distribution rate of 4% would be sufficient to sustain income for 30 years. Later, Bengen adjusted his investment mix to include small cap stocks and raised this rate to 4.5%. Since Bengen’s study, the increased availability of hedging strategies has enhanced our ability to limit downside risk. As a result, my experience suggests that a 5% distribution rate is reasonable.

Two significant market meltdowns have occurred subsequent to Bengen’s study, the tech meltdown in 2000 and the financial crisis of 2008 that has revised this thinking. Led by Moshe Milevsky, a finance professor at York University in Toronto, additional studies were undertaken to incorporate several issues not addressed in Bengen’s study, mainly increased longevity, rising health care costs and, perhaps most significantly, the impact of the sequence

of returns on distribution rates. It has been clearly demonstrated that significant portfolio declines during the first few years of retirement has a deleterious effect on the long term sustainability of retirement income. Even if the portfolio subsequently rebounds, distributed income cannot benefit from a market recovery since it has been removed as an asset.

Additionally, the classic 60/40 stock bond mix may no longer be appropriate in the current investment climate. With interest rates continuing to hover near historical lows, allocations to bonds generate insufficient interest to attain investment objectives and bond prices may be subject to precipitous declines if and when the long anticipated rise in rates begins. This new investment landscape may necessitate increasing the allocation to stocks.

One approach uses different buckets for retirement assets that include a single premium immediate annuity (SPIA), an account designed to begin distributions when the SPIA is exhausted and a growth portfolio that remains intact for the long term and can thus rebound from significant market declines. While this three pronged strategy has its own drawbacks, it does represent a viable strategy designed specifically to mitigate the negative effect of significant market declines.

Another strategy manages the various tax characteristics of different buckets of retirement assets to maximize after-tax distributions. A combination of taxable accounts that may benefit from favorable capital gains and dividend tax treatment, qualified retirement plans (IRAs, 401(k), 403(b), etc.) and tax free accounts creates the flexibility desired to manage income taxes. As most of you are aware, I am a big promoter of Roth IRAs and Roth 401(k) accounts. Of course, the main benefit of the Roth is the tax free nature of distributions. With the likelihood that income taxes will rise in the future, the advantages of a tax free account as a tool to manage your tax liability during retirement cannot be under-estimated. Distribution planning cannot effectively be implemented without analyzing the impact of taxes.

With the possibility that in this current investment environment, growth is challenging, the global economy is fragile, and taxes are likely to increase, strategizing to protect and grow the retirement nest egg is as crucial as ever. A careful analysis of specific liquidity and income needs and the associated taxes is essential to determining the most appropriate strategy for you.


Clifford L. Caplan, CFP®, AIF®

In the News: In an article in the April 6th edition of the Wall Street Journal, titled “Closed End Funds Look Appealing, but Weigh the Risks”, I was quoted on the investment opportunities in various closed end municipal bond funds.