Most people have a basic misconception about how to invest after they retire, thinking that a conservative portfolio is the best protection against the risk of running out of money.
In reality, financial advisers say, the key to making a client’s money last as long as they do is the annual rate at which they tap the portfolio.
The importance of the annual-withdrawal rate is the big difference between building a nest egg and emptying it, said Christine Fahlund, a senior financial planner and vice president at T. Rowe Price Investment Services Inc. in Baltimore.
Often, new retirees are shocked to learn how little they can safely withdraw each year from a portfolio that must last two or three decades.
Since the late 1990s, independent studies using both historical market data and Monte Carlo projections of future market scenarios have shown that even with optimal investment returns, retirees who take more than 6% a year from their portfolio over a 30-year period run a significant risk of running out of money. The studies consistently have shown that the most prudent withdrawal rate in retirement is 4% of the initial portfolio, plus inflation.
For example: If you have a $500,000 portfolio, you withdraw $20,000 the first year.
If the consumer price index rises 4% that year, you withdraw $20,800 ($20,000 plus 4%) in year two. If the CPI rises 2% the following year, your next withdrawal is $21,216 ($20,800 plus 2%) and so on.
“New retirees always come in thinking they should change their allocation,” said Ross Levin, a certified financial planner and president of Accredited Investors Inc. in Edina, Minn. Often, they don’t realize how much of their portfolio is already in fixed-income equivalents, he said.
“Social Security, a defined benefit pension and a paid-off house are all bondlike instruments,” Mr. Levin said. And they want to protect themselves against the loss of principal, even if it means losing purchasing power, he said.
Like most advisers, Mr. Levin thinks that that is a fundamental error. Healthy retirees need to invest for total return, just as they did when they were working, because they face decades of inflation.
“In today’s environment, a ‘riskless’ 10-year Treasury yields 3.5% — a virtual guarantee to lose money on an after-inflation, after-tax basis,” Mr. Levin said.
The upside of a portfolio with a 40% to 60% stock allocation is its potential growth; the downside, of course, is potentially stomach-churning losses.
In volatile times like these, a retiree’s wisest course isn’t to change his or her allocation but to reduce the annual-withdrawal rate, Ms. Fahlund said. And that isn’t easy to explain, she said.
“If you don’t have ultrawealthy clients, you have to repeat the spending discussion a million times. It’s very hard,” Ms. Fahlund said.
“You’ve created a relationship with the client; there’s empathy, understanding, rapport,” she said. “It’s hard to say you can’t spend that much.”
Still, Ms. Fahlund said, the solution isn’t to avoid market volatility but to create a long-term strategy that recognizes the inevitable bumps in the road.
One very popular approach is the two-bucket portfolio: The first bucket is a cash flow reserve account funded with two years’ worth of living expenses; the second bucket is invested for total return.
You take pro-rata annual withdrawals from the cash flow bucket, refilling it as you re-balance the total-return bucket, said Harold Evensky, a certified financial planner and the president of Evensky & Katz Welath Management in Coral Gables, Fla.
With this strategy, you hope to avoid having to tap the total-return bucket in a bear market, thus giving your stock holdings a chance to recover. After the recovery, you refill the liquidity bucket.
“It’s much easier for a client to take market volatility in stride when he can see a couple of years of cash flow on his account statement,” Mr. Evensky said.
