“Often when you think you’re at the end of something, you’re at the beginning of something else.” – Fred Rogers
The first quarter of a new year is a popular time to reassess one’s life situation. Health goals, career changes, and financial standing all tend to be top of mind. As an investment adviser my focus is directed towards my client’s financial well-being.
The combination of recent positive investment performance, along with the higher cost of living post COVID has some clients wondering about increasing portfolio distributions. Let’s face it, the cost of things that matter – shelter, food, energy, and education have all jumped higher and appear to be permanently stuck at a higher plateau.
Our rule of thumb for most clients regarding portfolio distributions has been a 5% annual withdrawal rate. However, one’s distribution rate is not set in stone and evolves as time passes and financial conditions change.
The below article published in Barron’s, dives into sensible portfolio distribution rates, which I thought could be of interest to those who are in or are approaching retirement.
*****
Does the 4% Withdrawal Rule for Retirees Still Make Sense?
By Elizabeth O'Brien
February 9, 2024
The 4% rule, a mathematically derived annual withdrawal rate that retirees can use to avoid running out of money, is the Barbour jacket of retirement planning. It’s a classic strategy that provides protection in changing weather.
That doesn’t mean you should wear it right off the rack, though: Retirees can tailor the 4% rule to their particular needs and the prevailing market environment.
In its original form, the rule holds that retirees can safely withdraw 4% of their portfolio in the first year of retirement and then continue to withdraw that same amount each year, adjusted for inflation, with a very high probability of having their money last for 30 years.
When bond yields were essentially zero accounting for inflation, the safe withdrawal rate decreased, but now that bond yields have risen for nearly two years, it is back to its baseline level. Late last year, research firm Morningstar affirmed 4% as the safe withdrawal rate, up from 3.8% in 2022 and 3.3% in 2021.
The rule was developed in 1994 by financial planner Bill Bengen, who researched historical market conditions and found that a 4% withdrawal rate worked across all of them. Bengen has since raised the rate to 4.7%, in light of today’s high stock valuations and moderate inflation, he told Barron’s.
Although market conditions have put the “four” back in the 4% rule, that’s just the starting point for retirees crafting their withdrawal strategies. “The 4% rule is meant to be a rule of thumb and not a financial plan,” says Brendan McCarthy, head of retirement investing for Nuveen.
Here are some ways retirees can tweak the rule as they develop their financial plan:
Use a Less-Conservative Rate
One criticism of the 4% rule is that, in the vast majority of market conditions, it leaves too much money in a portfolio at the end of a retiree’s life. Four percent is a conservative rate that’s meant to hold up in even the worst environments.
Preparing for a catastrophic scenario may require you to curtail your lifestyle more than you’d like, says Omar Qureshi, managing partner at Hightower Wealth Advisors in St. Louis. Knowing you have a good likelihood of leaving money behind, you may prefer to take a big trip or gift money to heirs instead of sticking with the most conservative withdrawal strategy.
Evan Potash, a Certified Financial Planner and executive wealth management advisor for TIAA in Bucks County, Pa., says many of his clients want to give money to loved ones and charity while they’re still alive. In some cases, this could lead to withdrawal rates of around 6%, he says. Careful annual monitoring helps ensure this level of withdrawals is sustainable.
In addition to seeing recipients enjoy their money, Potash’s local clients reap a tax benefit from gifting while they’re still alive: They reduce the amount of money that will be subject to Pennsylvania’s 4.5% inheritance tax (on direct descendants) when they die.
Adjust Annually Based on Markets
Just as you might modify the 4% rule according to your goals, you might also adjust it according to market fluctuations. One such approach involves forgoing an inflation adjustment and taking 4% of the current account balance every year, Qureshi says.
Say you start retirement with a $2 million portfolio. Under the original 4% rule, you would withdraw $80,000 the first year and $82,400 the following year, assuming a 3% inflation adjustment. But say your portfolio earned 20% that first year in a strong market, for a year-end balance of around $2.4 million. Four percent of that is $96,000.
The flip side of this strategy is that if the market has a negative year, you would have to take a pay cut. This approach ameliorates what is known as sequence-of-return risk, or the bad luck of retiring into a bear market. Negative returns early in retirement—assuming you continue to withdraw money from your declining balance—will cause your portfolio to run dry much more quickly than taking withdrawals during a period of negative returns later in retirement.
Give Yourself a Paycheck
Many retirees don’t want to see their income go down. Instead, they prefer to receive a steady amount adjusted upward for inflation, even if that means initially setting a lower withdrawal amount than if they were willing to tolerate income fluctuations.
If you’re in that boat, one option is buying a simple, fixed-income annuity. It can help set a floor under monthly income and ensure that essential expenses are covered by the annuity payments and Social Security. That way, any variability can be reserved for discretionary income.
Take Steps to Reduce Your RMDs
No matter how much you want to withdraw, keep in mind that the Internal Revenue Service will eventually make you withdraw more than 4% from your tax-deferred retirement accounts.
Required minimum distributions start at a rate of around 3.7% at age 73, then rise to about 6.3% at 85 and 11.2% at 95. Although the IRS expresses your RMD in terms of a “life expectancy factor” attached to your age, you can do some simple math to calculate your RMD as a percentage by dividing your required withdrawal by your account balance and multiplying by 100.
One way to lower your RMD amount is to reduce the assets you have in your retirement accounts before the withdrawal requirement kicks in—currently at age 73. To do this, you could convert some of your traditional retirement account into a Roth account. Roth IRAs aren’t subject to RMD requirements while the original owner is alive.
The sweet spot for Roth conversions is between the time you retire and the time your RMDs start. Typically during this period, your income will be lower than when you were working, so you will dip into a lower tax bracket. Your income will rise again once you start taking RMDs. When you do a Roth conversion, you will owe income taxes on any amount converted, but you’ll reduce the tax bill if you make the conversion while you are in a lower tax bracket.
Put Your Assets in the Right Accounts
Another move to lower RMDs and future taxes is to pay attention to what financial advisors call your “asset location.” Say your financial plan calls for a 50% equity allocation overall. You might decide to split that between 30% stock in your retirement account and 70% stock in your taxable brokerage account. The taxable account won’t be subject to RMDs, and sales of stock from it will be taxed at a capital-gains rate, which likely will be lower than the rate you pay on income.
For these reasons, it could be advantageous to front-load your taxable accounts with higher-growth assets like stocks, Potash says. An added benefit is that, if there’s any money leftover, your heirs will receive a step-up in cost basis on the accounts’ assets.
Whatever you decide, your strategy needn’t be set in stone. Goals can change, as can market conditions and your health status—and withdrawal rates can be adjusted accordingly. Rather than adopt a rigid 4% rule, “the ideal strategy is one of flexibility,” Qureshi says.
*****
Sincerely,
Justin Kobe, CFA
Founder, Portfolio Manager & Adviser
Pacificus Capital Management
A referral is the best compliment.
Feel free to forward this email to family and friends.
*****
Advisory services through Cambridge Investment Research Advisors, Inc., a Registered Investment Adviser. Securities offered through Registered Representatives of Cambridge Investment Research, Inc., a broker-dealer, member FINRA/SIPC. Cambridge and Pacificus Capital Management are not affiliated. Material discussed is meant for general illustration and/or informational purposes only, and it is not to be construed as investment, tax, or legal advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon when coordinated with individual professional advice. These are the opinions of Justin Kobe and not necessarily those of Cambridge Investment Research, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Investing in the bond market is subject to risks, including market, interest rate, issuer credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies is impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counter-party capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Diversification and asset allocation strategies do not assure profit or protect against loss.