Of the many challenges facing retirees, establishing an investment portfolio that yields enough income you won’t outlive is paramount.
Retirees are living longer today. According to the United States Social Security Administration, the average life expectancy at age 65 is 85.7 for women and 83.2 for men. The Society of Actuaries cites that, for a couple 65 years of age, there is a 72% chance one of the pair will live to 85; and, for the other, there’s a 45% chance they will live to 90.
These vital statistics are indispensable when formulating an appropriate retirement spending strategy.
The 4 Percent Rule
A well-known retirement spending strategy is the “4 percent rule.” It was introduced in the 1990s by now-retired financial planner William P. Bengen. The author of “Conserving Client Portfolios During Retirement” calculated a sustainable withdrawal rate that can be maintained for 30 years in retirement (adjusted for inflation).
For example, a retiree with a $1 million portfolio would calculate the first-year withdrawal as $1 million x 4% = $40,000; assuming an inflation rate of 2.5%, the second-year withdrawal would be $40,000 x 1.025 = $41,000 (and so forth).
This simple rule of thumb, however, is not without its shortcomings. First, Bengen’s research looked at historical market returns dating back to the 1920s. Today, experts note, returns aren’t likely to be as robust as in the past. As a result, a lower, more conservative spending rate (such as 3%) may be more appropriate. Second, the rule was calculated on spending 30 years in retirement. As increasing numbers of retirees are living longer, that 30-year yardstick may no longer be prudent. Third, the “4 percent rule” does not take into account the sequencing of market returns. So, those who experience negative portfolio returns early in retirement may have to adjust their spending to avoid prematurely depleting their portfolio’s assets.
Dynamic Spending
For some retirees, employing a dynamic spending strategy can be helpful. Utilizing this strategy, retirees set a target annual spending amount, establishing a ceiling percentage to increase spending after a year of notable portfolio returns and a floor percentage to decrease spending after a year of poor/negative portfolio returns.
Employing this approach, retirees can adjust portfolio withdrawals (higher or lower) based on performance, which may help preserve the portfolio’s assets compared to a fixed withdrawal rate. Among the drawbacks of this strategy are the retiree being able to calculate a reasonable spending range and variable spending over time based on market/portfolio performance. Behavioral finance suggests a retiree would increase spending following positive returns, but be reluctant to reduce spending after negative returns.
The Bucket Approach
In recent years, the “bucket approach” has grown in popularity among financial planners. Engaging the “bucket approach”, a retiree designates a pool of assets (the bucket) to help achieve their retirement income goals within a defined period of time. For example, the first bucket could be for short-term needs (less than 3 years), with the pool of assets allocated very conservatively among cash and bonds. A second bucket, for intermediate needs (3 to 10 years), has a longer time horizon. That bucket would be invested among bonds, stocks, and real assets. The third bucket would be for long-term needs (10-plus years) and have a smaller allocation to bonds with a larger allocation to high-growth assets, including stocks, real assets, and alternative investments. Over time, as assets in the first bucket are depleted, they are replenished with a transfer from the second bucket, which is replenished with a transfer from the third bucket.
From a behavioral finance perspective, retirees may be better equipped to handle market volatility with their assets segregated. In the event of a prolonged market pullback, a retiree’s near-term cash needs are covered with the first (short-term) bucket. The drawback of this strategy is that it can complicate a thoughtfully constructed portfolio. Also, many retirees have multiple investment accounts (both taxable and tax-deferred), and monitoring and evaluating each bucket could be viewed as unwieldy.
Monte Carlo Simulations
Named for Monte Carlo and modeled after the chance and random outcomes associated with the gaming destination, Monte Carlo simulations were developed in the 1940s by mathematician Stanislaw Ulam.
A Monte Carlo simulation incorporates a number of variables (savings, spending, asset allocation, market returns, taxes, etc.) to project the probability a retiree will have sufficient assets throughout retirement. Ideally, the Monte Carlo simulation shows a high projected probability of success (such as 80% or more), which will provide some cushion should future results vary from initial inputs. If the Monte Carlo simulation projects close to 100%, the retiree could reassess the analysis and use a higher spending rate; conversely, if the projected probability is too low, the retiree would need to adopt a lower spending rate.
The simulations have advantages, most notably that the analysis can incorporate a wide range of variables to determine if there are enough assets for a given spending level. The Monte Carlo simulations have great flexibility in assessing how changes to selected variables (savings, spending, returns, etc.) affect the distribution of retirement outcomes. As for its potential limitations, if the simulation model’s annual spend rate is too low or future asset returns are too high, the analysis's usefulness could be limited.
Retirement is a process, not an event or a destination. Thoughtful preparation must be exhibited to determine the appropriate annual spend. Equally important is an ongoing discussion of the retiree’s long-term needs and goals. Each should be revisited periodically and reassessed to provide a successful retirement. At MBE Wealth, our team of trusted advisors is here to help you navigate your options with clarity and confidence. We take the time to understand what matters most to you and build a strategy designed to support your goals today and into the future.
Ready to take the next step? Reach out to MBE Wealth and let’s start the conversation.
Disclosure
The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your financial advisor, attorney, or tax advisor. For additional information and disclosures, please visit our website at www.mbewealth.com. MBE Wealth Management, LLC is a registered investment advisor.
This content is developed from sources believed to be providing accurate information, and provided by Fiducient Advisors. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.