The goal of the New Three-Legged Stool™ strategy for retirement planning is to increase the probability of your assets providing a lifetime of sustainable income. Minimizing taxes on your retirement distributions means you can take smaller withdrawals for spendable income. Thus your wealth lasts longer allowing you to better maintain your lifestyle throughout retirement.
The challenge of preserving an income stream throughout retirement has never been more difficult. One factor impacting this is that employers have been dropping defined benefit pension plans that guaranteed income. The U.S. Department of Labor estimates roughly 15% of private-sector workers are covered by defined-benefit plans. Of those companies with a plan, 35% were frozen and 2% were in the process of terminating the plan.
Another factor is the current investment climate. Interest rates on fixed income are currently below the rate of inflation. A retiree with 100% of their savings invested in fixed income is virtually guaranteed a declining lifestyle as inflation erodes their purchasing power. The equity markets have scared many retirees into reducing their exposure to the stock market or getting out of stocks all together.
However, the biggest factor contributing to this challenge is the life expectancy of a retired couple today. Statistics tell us that a healthy 65-year old couple that doesn’t smoke has a 25% chance of one of them reaching age 95. After a forty year career of saving and investing, this couple’s nest egg now has to last thirty years. Even a mild inflation rate of 3% would cause the prices of goods and services to increase 250% over retirement. A sound investment strategy that provides growth to battle inflation and a tax-efficient distribution plan to minimize expenses is required to meet this challenge.
There are several fundamentals to building a retirement strategy that, if properly implemented, will increase your probability of success:
- You must have equities in your portfolio to provide growth. Most retirees are still listening to the myth put out by the financial press that tells you to reduce your equity exposure during retirement. They often bring up a formula that subtracts your age from 100 to determine the percentage you should have in equities. This formula was started 50 years ago when the length of retirement was only 10 years. Faced with the need to generate an increasing income stream for 30 years or more, it becomes clear that you will need at least half your savings invested in equities to reach this goal. Please keep in mind that equities are subject to market risk.
- Establish an asset allocation strategy that allows you to take advantage of the volatility in the financial markets without affecting your retirement income. A proper asset allocation should include equities, fixed income and cash. Diversify the equity portion of the allocation between growth and value stocks, domestic and foreign, and large companies and small to increase the probability that at least part of your portfolio is performing well. Use your asset allocation strategy to determine where to draw income from in order to maintain balance. In years when the stock market is going up, your income will come from stocks. When the market is doing poorly the fixed income assets will provide your income. Remember that diversification does not assure a profit or protect against loss and it is possible to lose money.
- Select a withdrawal rate that can be sustained over a long period of time. Research on a sustainable withdrawal rate suggests that a 4 to 4 ½% distribution can be maintained and increased each year with inflation. We suggest the distribution rate be established at 4% to start and the amount reduced if the rate exceeds 6% in a down market. This allows for principal volatility without the need to frequently change distribution amounts. In years the market performs poorly you may not want to take a cost-of-living increase. We also recommend delaying large purchases such as a car replacement until a good market provides excess earnings.
These are the three fundamentals for the investment side to establishing a retirement income strategy. Next week we’ll look at the fundamentals of incorporating tax-efficiency in the portfolio.
- Your asset allocation strategy should not change once you retire. Reducing your stock exposure in retirement is a myth.
- Growth is just as important as income in retirement because inflation is likely to more than double the cost of goods and services over life expectancy.
- Retirement income strategies need to be tax-efficient to minimize the draw you need to reach your spendable income goal.