November 2011 | Eric Rasmussen, Financial Advisor Magazine
Financial advisors discuss their strategies for retirement withdrawals in an era where every day in the markets is a new roll of the die.
What’s so funny about peace, love and the 4% withdrawal rule?
It’s easy to knock beloved institutions and ideals in tumultuous times. As protestors across the country rage about Wall Street excesses from the streets, academics are also questioning financial orthodoxy behind red brick walls covered with ivy. Since the economic maelstrom of 2008, such sacred cows as the efficient market hypothesis and the reliability of mean reversion for returns have come under attack.
Some academics have even started to question the 4% rule—which hits financial advisors where they live. This thumbnail withdrawal strategy allows retirees to take 4% of their pretax money out in the first year of retirement and then continue to take that out plus inflation (adjusting up by 3%, or some other inflation rate, each year). The 4% rule stresses capital preservation so people can keep their money at play in the market for long-term growth but still unwind enough to live comfortably. If a client is older, the withdrawal can rise to 5% or 6%.
But like a lot of dearly held beliefs in the recession, it’s being re-evaluated. Given that 2009 saw a decade of lost returns, clients likely think that taking out 4% every year will leave them broke before they die. Indeed, according to a recent study by the Employee Benefit Research Institute, 70% of workers say they are not on track for retirement.
William Sharpe, the Nobel prize laureate in economics, chimed in when he co-wrote a paper in 2008 called “The 4% Rule—At What Price?” Sharpe and co-authors Jason Scott and John Watson, suggested that the 4% rule tries to tackle fixed spending but doesn’t know what to do with volatility. They wrote, “This rule and its variants finance a constant, non-volatile spending plan using a risky, volatile investment strategy. As a result, retirees accumulate unspent surpluses when markets outperform and face spending shortfalls when markets underperform.”
In effect, Sharpe says that a retiree who uses the 4% rule is paying too much for the surplus he won’t use in good times. (Imagine a dart-throwing game at Coney Island. You’ve won a prize ham after throwing $50 worth of darts, but you’ve overpaid anyway by buying $100 worth of darts.) And yet you can still come up short when the market plunges into the toilet.
In 2010, Sharpe told members of the National Association of Personal Financial Advisors at their annual conference in San Diego that clients are now facing new risks never before addressed by steady withdrawal rates. People are living longer, facing higher health-care costs and the possible shrinking of government programs such as Social Security and Medicare. There is also, of course, the specter of inflation. To those, Sharpe added another fear to make the blood turn cold: counterparty risk. What if more companies you’ve trusted your life savings with go the way of Lehman Brothers?
The changes in thinking have led many advisors to come up with new solutions and innovate new ways to juice yields for their retiree clients.
With short-term interest rates near zero, few people are extolling the virtues of bonds, which are facing a prolonged bear market if interest rates rise. But some fight that orthodoxy, saying that bonds are still the best way to preserve wealth when it’s needed, and that bond ladders are still great ways to generate income.
Joseph Alfonso, a solo practitioner RIA based in Lake Oswego, Ore., and Santa Clara, Calif., has devised a strategy of building a 15-year ladder of U.S. Treasury “strip” bonds to match his clients’ cash flow needs and beyond that budgets an annual 10% savings rate in retirement. He says that this strategy makes a priori withdrawal rate calculations unnecessary.
“What I do is eliminate the need at the outset to figure out what percentage of fixed withdrawal rates is safe because I believe that even when you’re trying to calculate that percentage, there are so many assumptions that go into it that it’s hard to get the number right, and given what’s at stake, I think my approach is a better approach.”
Alfonso says that five years before his clients retire, he knows what kind of lifestyle they’re comfortable with and wants to maintain throughout retirement. So he looks at required cash flow and builds a bond ladder that begins in the first year of retirement and gets replenished each year as bonds come off the ladder.
“The strategy is to make sure the face value of those maturing bonds add up to what we need in terms of ongoing cash flow. We know up to the penny what will be available in terms of reliable cash flow off the bond ladder, and in the years that stocks outperform relative to bonds, we have the option of not even taking advantage of the cash flow from the bond ladder.”
Alfonso buys the bonds discounted, so he is looking for an internal rate of return and is not so much concerned with yield.
Fred Amrein, an advisor with Amrein Financial in Wynnewood, Pa., says that one of his firm’s retirement withdrawal strategies is to control required minimum distributions. If the client has a lot of money amassed in qualified accounts, he is already thinking ahead to manage the withdrawals more efficiently before they retire, since the future tax code is uncertain.
“Their RMD at age 70½ could be a shock and will minimize the client’s ability to control their tax bracket and other retirement costs,” Amrein says. “One of our strategies is to withdraw income up to your current tax bracket limit and move it to a Roth IRA. This is a subset of a Roth conversion.” He says it’s not just a one-time expense but a process managed over time that allows the client to control his or her current and future tax brackets. He says it may also lower the client’s contributions to Medicare, which is based on income and the tax on Social Security.
Mitchell Reiner, a managing partner of Wela Strategies in Atlanta, says that his firm has an income portfolio focuses on unique income opportunities such as closed-end funds, master-limited partnerships, energy royalty trusts, REITs, preferred stocks, convertible bonds and fixed-income ETFs. The strategy looks at macroeconomic factors to determine equity valuations and the interest rate environment and then allocates into sleeves: fixed income (through individual bonds and funds); closed-end funds; and alternative investments (comprising MLPs, preferreds, convertibles and REITs). These individual components are even further drilled down as the firm looks for the best premiums, discounts, spreads, international opportunities, etc.
“Typically these assets are not perfectly correlated with each other or the equity markets,” says Reiner. “We focus on consistency of income above most else. For clients, we communicate that although we want to minimize fluctuations in principal, we are focused on getting a yield that is consistent and can potentially grow over time with equity prices and inflation. We still maintain a target yield of under 5%, but often times generate more than that.”
Reiner says the firm has packaged this strategy into a model ETF called the “Aggressive Yield” portfolio that is available on multiple platforms. These models are run out of Wela, a firm he founded from his primary firm, Atlanta’s Capital Investment Advisors.
What’s Wrong With 4%?
Of course, there are other advisors who say that if you question the efficacy of the 4% rule because of the volatile market, you are, as the actress said to the bishop, doing it wrong.
Lee Munson, the chief investment officer of Portfolio LLC in Albuquerque, N.M., and author of Rigged Money, which will be out in December, asks simply, “What’s wrong with 4%?” Instead, he rails against one of the medicines advisors have come up with to deal with uncertainty: Monte Carlo simulations that use historical returns and thus, he says, improperly frame the numbers. Such numbers can only pretend to be forward looking when they are in fact measuring the past, he asserts.
“I think the profession has gotten worse because of Monte Carlo simulations,” he says. “I don’t think Monte Carlo simulators work. Because all they really do is [use] expected returns … basically, they just take some daily, monthly returns on stocks and just randomize them.”
He says that, to paraphrase Vanguard founder John Bogle, all Monte Carlo does is put these questionable expected returns in a blender “and they give you all these infinite things that could happen based on Gaussian, standard distribution bell curves. My issue with them is that it always goes back to garbage in, garbage out.”
Munson says that the problem with the 4% rule is not that it doesn’t work, but that it’s not used properly, and by that he means risk is not properly factored into the equation. “The reason 4% has always been a golden rule is because it’s so low and because it can sustain quite a bit,” he says. “Over a 25-year period of time, there is the opportunity to retrench. That’s something financial advisors never want to tell their clients. They want the arrogance of certainty. … But you may have to retrench if you have global catastrophe.” Still, he adds, “We just don’t see that at 4% withdrawal rates if people are managing risk properly.”
What Munson says that he practices at his firm is risk budgeting, which he says is not yet a popular practice “in the pie chart world.” He suggests that a pie chart with 60% equities and 40% bonds starts to look different if risk is factored in. It may have the risk of 80% equities and 20% bonds depending on the market volatility.
“If people start risk-budgeting, they’ll have less problems with the 4% rule.”
As of October 1, 2011, he says, to reflect the real risk of a 60/40 portfolio meant that he had to be 30% in cash, which was what he was in. (His current moderate portfolio is 36.14% equity, 30.39% bonds and 33.47% in cash.) He says he does not do this to time the market but for the simple reason that the volatility index (VIX) is at a high level of 40. And that means the rest of the portfolio of stocks and bonds is too risky. In January, on the other hand, when volatility was much lower, the firm’s moderate portfolio was 73.82% in equity, 28.07% in bonds and 0% in cash.
“If you have a portfolio today, you have to keep adjusting it to whatever that long-term historical risk is. That’s just building on the pie chart.” To this end, he uses mainly passive ETFs.
Graydon Coghlan, a San Diego-based advisor with 11 offices in California, says that his approach is to take out 4% to 6% a year depending on the client and then give a cost of living adjustment of 3% per year. The investments are determined by the clients’ age, income need and the amount of risk they’re willing to take.
“Depending on that, we will invest in ETFs, mutual funds, dividend-paying stocks and individual stocks and annuities,” he says. “We will invest in all types of things, including any fixed-income vehicles and REITs. These have good yields right now so if [the clients] are willing to lock up their money for there to five years, they can get a nice 6% yield on that.” He will also do indexed annuities.
The reason sometimes strategies can get harmed, he says, is that clients’ comfort level is much lower, and that steers them to investments that won’t grow as much and won’t allow Coghlan to pay them a cost-of-living adjustment. “If they have all REITs and fixed-income vehicles and dividend-paying stocks and they’re using that full amount of the yield, there is no growth, so that means there’s no COLA,” he says. “So that’s the tough part.”
Christiane Delessert, a CFP licensee at Delessert Financial Services Inc. in Waltham, Mass., says that the 4% rule might still be applicable at some point five years from now when the world has gone through the deleveraging process. But the current market has forced advisors to rethink strategies. In the meantime, she is meeting with clients three times a year to monitor cash reserves and keeping two years of living expenses in cash or short-term bonds. She looks at refinancing debt rather than retiring it because of the current low interest rates, and she says that her clients are more receptive to dividend strategies than annuities, which give them less control. Some of her clients are even talking about continuing work.
And don’t forget the old standby.
“Social Security is more important than ever,” she says. “We make sure that the clients understand how meaningful that annual payout is. To receive $25,000 per year, at 4%, would require putting aside $625,000 of their own funds. “When you explain it that way, the client is much more humbled about the value of that Social Security payment.”