Retirement Planning is by far one of the most important areas of financial planning and one that we allocate a good portion of our time and resources to address. We break retirement planning up into two distinct phases:

  1. Accumulation Phase
  2. Distribution Phase

The accumulation phase is simply the phase in which you are still working and gathering assets to fund the second phase, which is the distribution phase. Clients in the distribution phase are typically either retired or semi-retired and are supplementing their pre-retirement income with distributions from their portfolios. In the last newsletter we addressed the accumulation phase. This article is part two of our two-part series on retirement planning and will address the distribution phase.
There are two common misconceptions that cause many retirement plans to fail. The first is the estimate of how much income will be needed in retirement. Too often people underestimate how much income they will need to live comfortably in retirement. According to a MetLife Retirement Income IQ poll, 49% of people surveyed felt they could live on 50% or less of their pre-retirement income, even though most experts recommend 80 to 90 percent. The second misconception is the level of withdrawals their portfolios could handle and not run out of money. Interestingly, in the same poll 43% of the people surveyed assumed they could withdraw 10% or more per year while preserving their principal. A Monte Carlo simulation is useful in calculating the probability of success for a distribution strategy. It runs through hundreds of simulated market scenarios based on historical return and risk characteristics. The results show that when there is a 10% withdrawal rate from a portfolio allocation of 50% equity and 50% fixed income, there is only a 1% chance of success. How can so many people be that wrong about their retirement plans? The answer is a lack of financial education, which highlights the need to either educate yourself financially or work with a financial planner. Your entire economic future is at stake.
Though we structure each of our client’s withdrawal rates on an individual basis, in general we recommend that our clients do not go higher than 4-4½% of their nest eggs per year. Most planners agree that a withdrawal rate in this range should generally allow the assets to last throughout the client’s lifetime. Often when reviewing a retirement plan with a client we’re asked why we only use a 4 or 4½% withdrawal rate when we are estimating a 6-9% average return (depending upon the asset allocation) based on historical performance of the markets over a 25-30 year period. There are two very important reasons for this:

  1. Inflation: By having a withdrawal rate less than our expected rate of return, we can allow for an inflation adjustment in the retirement plan. For example, if a client has a $1,000,000 nest-egg and he or she withdraws 4% ($40,000) in the first year and the portfolio makes 6% that year, in year 2 the principal is now $1,020,000. Therefore, the withdrawals in year 2 would total $40,800. According to Smart Money magazine, the average retirement is now in excess of 20 years (in 1950 the average was 8.1 years). Because most Americans enjoy two decades of retirement, an inflation adjustment is essential to a retirement plan’s success.
  2. Unpredictability of capital markets: Unfortunately, one of the things that can have a huge impact on the success of a retirement plan is how the markets perform in the first few years of retirement. Obviously this is something that the retiree has absolutely no control over. Therefore, we try to offset some of this uncertainty by being conservative in our estimates.

Finally, it may be necessary to adjust your plan from time to time. A retirement plan is not meant to be set in stone from the day you retire until the day you die. Plans must be adjusted for the unexpected: a family member in desperate need, extended health crisis, inheritance, or a year like 2008. Events like these will have an impact on a plan and the plan must be adjusted accordingly. For example, we have several clients in retirement who reduced their distributions in 2009 to try to recoup some of the losses resulting from the 2008 economic crisis. Conversely, if a client inherits $500,000 in retirement, the unexpected good fortune could mean less would need be withdrawn from the retirement plan in that year. In conclusion, a final key ingredient to any successful plan is the ability to be proactive when faced with unexpected occurrences and make changes necessary to insure the ultimate success of the plan.
Matt & Tom Reynolds