Archives for February 2017

While reading Wade Pfau’s recent paper “Retirement Income Showdown: Risk Pooling Versus Risk Premium,” I came across a topic I wanted to share with you. (For reference, this is not the main point of the paper but rather one of a handful of points discussed in a comparison of partially-annuitized portfolios to regular “investments-only” portfolios.)

I think the concept is best explained with an example.

Imagine that you retire at age 65, and you decide on the date of your retirement to use all of your retirement savings to purchase a Treasury bond ladder extending 30 years into the future. That is, you plan to have Treasury bonds maturing each year for the next 30 years, and you plan to use those bonds to fund your retirement spending.

In this example, how liquid is your portfolio?

In one sense, it’s super liquid, given that Treasury bonds are one of the most liquid assets in the world. At any given moment, there are countless parties who would be willing to buy your Treasury bonds.

But from the perspective of your own personal retirement, your portfolio is not nearly so liquid. For example, in Year 1 of retirement, you can really only afford to spend the money from Year 1’s Treasury bonds. If you find yourself liquidating Year 2’s bonds and spending that money prior to Year 2, you have a problem.

Pfau explains it this way (while referencing another article by Curtis Cloke):

“In a sense, an investment portfolio is a liquid asset, but some of its liquidity may be only an illusion. Assets must be matched to liabilities. Some, or even all, of the investment portfolio may be earmarked to meet future lifestyle spending goals. In Cloke’s language, the portfolio is held ‘hostage to income needs.’ A retiree is free to reallocate her assets in any way she wishes, but the assets are not truly liquid because they must be preserved to meet the spending goal. While a retiree could decide to use these assets for another purpose, doing so would jeopardize the ability to fund future spending.

This is different from ‘true liquidity,’ in which assets could be spent in any desired way because they are not earmarked to cover other liabilities. True liquidity emerges when excess assets remain after specifically accounting for ongoing lifestyle spending goals. This distinction is important because there could be cases when tying up part of one’s assets in something illiquid, such as an income annuity, may allow for the spending goal to be covered more cheaply than could be done when all assets are positioned in an investment portfolio.”

In other words, a typical “investments-only” portfolio of stocks/bonds/mutual funds is liquid in the sense that you can sell your holdings at any time. But if the portfolio is just barely large enough to be expected to satisfy your lifetime spending, it’s illiquid in the sense that you have no flexibility in terms of how much you can safely spend per year. You can’t really afford to spend a higher-than-planned amount in a particular year.

Conversely, if you took part of the portfolio and used it to purchase a lifetime annuity, your remaining portfolio would be smaller, but because of the relatively high payout on such annuities, you would have more flexibility with your remaining portfolio — more “true liquidity” in Pfau’s terms.

How About an Example?

For those of us here in the U.S., the best deal we can find on an annuity purchase is from delaying Social Security.

Imagine you have a retirement portfolio of $800,000, and you estimate your annual expenses to be $50,000. With regard to Social Security, you have a full retirement age of 67, and your primary insurance amount (i.e., your Social Security benefit at full retirement age) is $2,000 per month, meaning that you would get:

• $1,400 per month ($16,800 per year) if you file ASAP at age 62, or
• $2,480 per month ($29,760 per year) if you wait until age 70.

If you file at age 62 your portfolio will have to satisfy $33,200 of expenses per year (that is, $50,000 of total expenses minus $16,800 of Social Security income). With an $800,000 portfolio, that’s a 4.15% initial withdrawal rate — putting you squarely in the “probably fine, but who really knows?” zone. (That is, you’re in the zone where you likely can’t afford to have a big spending shock, especially not in early retirement.)

Conversely, if the plan is to wait until age 70, the portfolio can be split into two sub-portfolios:

1. One portfolio that will have to satisfy $20,240 of annual expenses every year, starting at age 62, and
2. One portfolio that will have to satisfy the remaining $29,760 of annual expenses from 62 until 70 (at which point Social Security will kick in).

The second portfolio will have to be $238,080 (i.e., $29,760 per year for 8 years), and it should be put in something very safe (e.g., money market account, an 8-year CD ladder, etc.). That leaves $561,920 for the first part of the portfolio, resulting in a spending rate of 3.6%.

In other words, the portion of the portfolio that is intended to last throughout retirement now has a spending rate of 3.6% rather than 4.15%, meaning that there’s more flexibility to handle unexpected spending shocks.

To be clear, this is a simplified example, in that it ignores investment returns, taxes, and the complexity that arises with regard to Social Security benefits for married couples. But even when you build out a more detailed analysis, the same overall concept holds true. Delaying Social Security means you’ll have a smaller portfolio, but you will have greater flexibility in terms of what you can do with that portfolio — more “true liquidity.”

The same concept holds true with purchasing lifetime annuities from insurance companies, though the effect is not as powerful, given that the payout per dollar spent on premiums is not as high as the payout per dollar spent to delay Social Security.

I was recently asked to share my thoughts on how to spend from a portfolio in retirement. In my view (without getting into the topic of whether part of the portfolio should be annuitized) there are three broad questions you have to answer:

1. Which account(s) to spend from each year (i.e., Roth, tax-deferred, taxable),
2. Which assets to spend from (i.e., stocks first, bonds first, or both at the same time), and
3. How much to spend per year.

Which Account(s) to Spend From?

While tax planning is very case-by-case, there is broad consensus on the strategy that most often makes sense. (See this paper or this article from Colleen Jaconetti and Maria Bruno of Vanguard, or my book Can I Retire, for a more thorough discussion of this topic.)

Most often, the overall strategy is to spend in the following order:

1. Spend RMDs,
2. Spend from taxable accounts,
3. Spend from Roth accounts if your current marginal tax rate exceeds the marginal tax rate you expect to face in the future, or spend from tax-deferred accounts if your current marginal tax rate is lower than the marginal tax rate you expect to face in the future.

Of note, #3 isn’t just about tax brackets. It’s about marginal tax rates, which include the effect of various tax breaks phasing out over specific income levels or various taxes kicking in at specific income levels. Also, it’s a dollar-by-dollar decision. For example, in a given year it may make sense to spend from tax-deferred up to a certain point, then switch to Roth spending once, for example, you reach the point where additional income would be taxed at a higher rate (e.g., because you’ve hit the top of your tax bracket).

A tax professional can be very helpful here. Alternatively, if you’re doing the analysis yourself, software such as TurboTax can be useful for running “what if” scenarios (e.g., how much would my overall tax bill go up if I took out an additional $1,000 from my traditional IRA this year?).

Which Assets to Spend From?

With regard to which assets to spend from first, there’s still ongoing debate on the topic.

Most target-date fund providers assume that stock allocation should decline in early retirement, then stay level for the rest of retirement (i.e., spend first from stocks, then spend from both stocks and bonds).

But Michael Kitces and Wade Pfau made an interesting case a few years back that retirees’ stock allocation should actually be lowest in the years immediately before and after retiring, when their finances are most exposed to years of bad returns. That is, your bond allocation should be at its highest point when you retire, and you should be reducing your allocation to bonds gradually from there.

How Much to Spend Each Year?

As far as how much to spend per year, that’s also a topic where there’s a lot of discussion/debate. It mostly centers around whether or not the “4% rule” — in which you spend 4% of your portfolio in the first year of retirement, then increase that level of spending each year in keeping with inflation, regardless of how your portfolio performs — is actually safe.

For instance, Wade Pfau took a look at how a 4% inflation-adjusted withdrawal rate would have worked if used in other countries, and the answer is that it would have been quite risky. That is, it may just be a historical fluke that such a strategy happened to be pretty safe in the U.S. in the 20th century.

In addition, the low interest rates we face today strongly suggest that a 4% withdrawal rate is riskier today than it would have been in the past (in the U.S.), because we can be pretty confident that the bond portion of the portfolio will provide less total return than in most historical cases in the U.S.

A counterpoint, however, is that if you are flexible with how much you spend (i.e., you could easily cut spending if your portfolio experiences poor returns early in retirement), you can start with a higher withdrawal rate. (For a good discussion of this topic, see the second video in this article in which financial planner Jonathan Guyton explains his applicable research.)