Creating a Withdrawal Strategy for Your Retirement Portfolio: Understand Your Unique Situation

By on July 9, 2015
Categories: D&Y UPDATES
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Another quarter has passed with the Federal Reserve maintaining its Zero Interest Rate Policy (ZIRP) with regard to short-term interest rates.  Despite public statements suggesting that the Fed is anxious to begin normalizing its monetary policy, it has once again postponed the first rate hike due to somewhat disappointing recent economic data.  Most Fed watchers believe the first move by the Fed—probably a quarter-point raise—will occur in September or December.  While the anticipation surrounding the amount and timing of the first interest rate increase will undoubtedly generate much debate and market speculation, the initial phase of interest rate hikes has historically not detrimentally impacted stock prices.

Asset class returns for the second quarter of 2015 were as follows:

 Index  Asset Class   Second Quarter 2015   Year-to-Date 2015
 Barclays U.S. Govt./Credit – Int.  Fixed Income               -0.6%              0.8%
 S&P 500  Large U.S. Stock                0.3%              1.2%
 Russell 2000  Small U.S. Stock                0.4%              4.8%
 MSCI ACWI ex-USA  Foreign Stock                0.5%              4.0%
 S&P Global REIT  Real Estate  Securities               -7.9%             -4.6%


Greece and Puerto Rico headlined world economic news during the last few days of the second quarter.  On June 27th, Greece’s Prime Minister, Alexis Tsipras, announced that Greek banks would close until a referendum could be held to determine whether the country would accede to the European Central Bank’s conditions for further loans, dramatically increasing the uncertainty around Greece’s future in the Eurozone.  Then, on June 30th, Greece missed a scheduled loan repayment to the International Monetary Fund (IMF) of $1.73 billion, becoming the first advanced economy to default on loans from the IMF.  In the case of Puerto Rico, a U.S. territory, the commonwealth’s governor, Alejandro Garcia Padilla, called Puerto Rico’s debts “unpayable,” and stated that the only path forward would have to include bondholder concessions (losses).  Neither of these situations should have come as a big surprise.

Both Greece and Puerto Rico have relied on external funding of their sizeable budget deficits for many years and have neglected to adopt the necessary economic reforms to generate sustainable growth and to foster fiscal discipline.  Despite both Greece and Puerto Rico long being recognized as financially troubled, the higher yields they offered seduced many investors—both institutional and individual—into making questionable investments in their bonds.  Our clients’ bond portfolios are not directly affected by the recent developments in either Greece or Puerto Rico.  We have always believed that our clients’ bond allocation—whether municipal or taxable—is the ballast of their portfolios, and should consist primarily of high-quality, low-risk securities to offset the inevitable ups and downs of equity markets.  Our bond portfolios continue to prioritize principal preservation over income maximization.

With the understanding that both risk and uncertainty are ever-present within financial markets, we would like to use this quarter’s letter to shed some light on considerations for systematic withdrawals from retirement portfolios.

The longstanding rule-of-thumb is that a well-balanced portfolio, split between high-quality stocks and bonds, should be able to sustain an initial 4% withdrawal, increased thereafter at the annual rate of inflation.  Bill Bengen wrote a seminal paper on what a reasonable withdrawal rate should be on a portfolio in retirement.  After Bengen closely examined market conditions and inflation within every 30 year retirement period from 1926 to 1993, his findings resulted in publishing the “4% Rule.”  Within this timeframe, Bengen specifically identified 1969 as the worst year to retire based on the combination of low returns and high inflation that immediately followed and severely eroded the value of savings.  Using this as the worst-case scenario, Bengen tested numerous withdrawal percentages before determining that retirement spending could be sustained for 30 years by utilizing a 4% rate of withdrawal from a portfolio consisting of 60% large-cap stocks and 40% intermediate-term government bonds.

Numerous academics and investors alike extended Bengen’s original model to add both practicality and flexibility to retirement planning.  Advisor Jonathan Guyton, for example, applied a rules-based technique that increased the portfolio withdrawal each year to match inflation, except in years when the portfolio loses money.  If the withdrawal rate ever rises to more than 120% of the initial rate, that year’s withdrawal is cut by 10%.  In good years, withdrawals may increase by 10%.  These modifications allowed for higher initial withdrawal rates.  Financial planner Michael Kitces further evaluated safe retirement withdrawal rates in the context of broader diversification among additional asset classes, the use of current market valuations in guiding the initial withdrawal rate, and the impact of variable spending on the safe withdrawal rate.  All of these factors suggest that spending could theoretically be higher than Bengen’s original 4%.

It is important to realize that the 4% Rule has been used and validated solely in an era of attractive financial market returns.  For the 30 years ending in December 2014, Bengen’s hypothetical 60/40 provided an annual return of 9.9%.  Today, given the significantly higher starting prices of both stocks and bonds, we estimate the future return on a diversified 60/40 portfolios to be in the range of 5.5% to 7.0%.  While the 4% Rule remains a good starting point for retirement portfolio withdrawal discussions, investors must weigh many factors when determining the annual rate of withdrawal from retirement portfolios:

Set reasonable expectations about the size of portfolio withdrawals given your age, health and life expectancy, and sources of additional income.  Social Security and pension benefits are a significant source of retirement income for most Americans.  A number of strategies are available to optimize these benefits, including deferral of benefits to full retirement age or later, to significantly increase future income and protect against longevity risk.  A generation ago, a 15 to 20-year retirement was seen as normal.  Today, with earlier retirements and longer life expectancies, many people must plan to sustain their savings for 30+ years.  The longer the timeframe, the more serious consideration must be given to a lower initial withdrawal rate.

Do not invest too conservatively.  Retirees not only require income-producing assets to provide for near-term withdrawals, but also growth assets to ensure that their portfolio outpaces inflation and can provide them with cash flow decades in the future.  While bonds serve an important purpose in reducing overall portfolio volatility, yields are strikingly lower than they were 35 years ago and therefore must be used in combination with equities to realize retirement goals for most investors.

Be mindful of the tax implications of your mix of retirement assets.  Some retirees have the majority of their retirement savings in IRAs, 401(k)s, and other tax-deferred retirement accounts.  In most cases, every dollar distributed from these accounts will be taxed as ordinary income.  Conversely, retirees who have significant assets in taxable accounts–or even better, Roth IRAs–have more flexibility to control taxation by first liquidating unappreciated assets from taxable accounts, then perhaps tapping Roth IRA assets, followed by selling appreciated assets (paying the lower capital gains tax rate on gains), and finally taking taxable distributions from IRAs/401(k)s once they are required at age 70½.

The recommendations outlined above seem simple; however, no two situations are alike.  Every retirement discussion requires an individually-tailored plan that can be consistently executed in both strong and weak market conditions.  Please feel free to contact us with questions about your particular situation.

Speaking of retirement, as of this letter’s publication, our co-founder Mark Dowling has officially retired.  We would like to take this opportunity to formally thank our long-time Partner, mentor, and friend for his stellar example and lifetime commitment to serving clients with excellence and integrity.

When Mark Dowling and Dale Yahnke founded Dowling & Yahnke almost 25 years ago, they did so with the sincere belief that investors deserved the opportunity to work with a fiduciary, someone who placed the client’s interest ahead of his own.  The exceptional academic credentials and high level of community involvement that have become trademarks of Dowling & Yahnke were demonstrated by Mark at the Firm’s founding.  In addition to graduating from San Diego State University with a Master of Business Administration, Finance (MBA) and holding the designations of Chartered Financial Analyst (CFA) and CERTIFIED FINANCIAL PLANNER™ (CFP®), Mark taught financial planning and investments at the adult education, community college, and university levels.  He has also been instrumental in the development and review of competency tests for financial planning professional organizations.  Mark has worked on committees for the Board of Examiners of the Certified Financial Planner Board of Standards to develop and maintain the comprehensive examination required of all CFP® candidates.

To say that Mark has been anything short of a gifted financial adviser and consummate professional would be an understatement.  We could not be more grateful for the example he set and the legacy he leaves behind.  We collectively wish Mark and his lovely wife, Jenny, all the best in retirement.

We appreciate our clients’ trust and confidence in Dowling & Yahnke and invite you to contact us with any questions regarding your finances.  Have a wonderful and safe summer!


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