retirement buckets

Retirement Buckets

Our fifth and final installment of our series on retirement income will cover the strategy of five-year retirement buckets. It is a very simple approach: you maintain two buckets within your portfolio. Bucket 1 consists of cash and bonds sufficient for five years of income needs. Bucket 2 is a long-term growth portfolio (stocks).

We could start with up to a 5% withdrawal rate. Let’s consider an example. On a $1 million portfolio, we would place $250,000 in Bucket 1. That is enough to cover $50,000 in withdrawals for five years. Bucket 1 would be kept in cash and bonds, for safety and income. Each year, you would take withdrawals from Bucket 1.

Bucket 2, with $750,000, is your stock portfolio. The goal is to let this money grow so that it can refill Bucket 1 over time. In years when Bucket 2 is up, we can refill Bucket 1 and bring it back up to five years worth of money. At $750,000, a 6 2/3% annual return would provide the $50,000 a year needed to refill Bucket 1.

Addressing Market Volatility

When the market is flat or down, we do not take a withdrawal from Bucket 2. This addresses the big risk of retirement income, having to sell your stocks when they are down. Instead, by having five years of cash in Bucket 1, we can wait until the market recovers before having to sell stocks. That way, you are not selling stocks during a time like March of 2020, or March of 2009! Instead, we hold on and wait for better times to sell.

Historically, most Bear Markets are just for a year or two, and then the market begins to recover. Sometimes, like this year, the recovery is quite fast. The goal with our Retirement Buckets is to never have to sell during a down year. And while it is always possible that the stock market could be down five years in a row, that has never happened historically.

Retirement Buckets is different from our other withdrawal strategies, such as the 4% rule or the Guardrails strategy. Those strategies tend to have a fixed asset allocation and rebalance annually. The Retirement Buckets Strategy starts with a 75/25 allocation, but that allocation will change over time. Our goal is not to maintain exactly 25% in the cash/bonds bucket, but rather to target the fixed amount of $250,000. If the market is down for two years, we may spend Bucket 1 down to $150,000.

Stocks for Growth

For most people, having five years of cash and bonds in reserve should be sufficiently comfortable. However, if you wanted to increase this to 7 years, a 65/35 initial allocation, that would also work. But, I would suggest starting with at least a 60% allocation to stocks. That’s because when Bucket 2 is smaller, you need an even higher return to refill the $50,000 a year. If you started with 60/40 ($600,000 in Bucket 2), for example, you’d need a return of 8 1/3%.

Retirement Buckets can work because you are creating flexibility around when you are going to sell stocks. When you maintain any fixed allocation, you run into the problem of selling stocks when they are down. Rebalancing is good when you are in accumulation – it means you are buying stocks when they are low. But for retirement income strategies, selling stocks when they are down is likely going to be a bad idea.

Selling Bonds First

Somewhat related to a Buckets Strategy is another income strategy, the Rising Equity Glidepath. In this approach, you sell your bonds first. So, if you started with a 60/40 allocation at retirement and withdraw 4% a year, your bonds would last you 10 years (actually a little longer, with interest). If you avoid touching your stocks for 10 years, they are likely to have doubled in value, historically, with just a 7% annual return. I see the Rising Equity Glidepath as being related to the buckets strategy because both approaches focus on not selling stocks. This reduces the Sequence of Returns risk that market losses impact your initial retirement years.

However, most investors become more conservative as they age, so they aren’t going to like the Rising Equity Glidepath. If they retire at 65, that puts them on track to be at 100% equities at age 75. That’s not what most want. So, even though the strategy looks good in theory, it’s not going to make sense in practice.

What’s Your Plan?

The Retirement Buckets approach can provide a strategy that is logical and easily understood by investors. We maintain five years of cash and bonds, and can replenish the cash bucket when the market is up. This gives you a flexible process for how you are going to fund your retirement and respond to market volatility.

I hope you’ve enjoyed our series on retirement income approaches. It is so important to understand how to create sustainable withdrawals from your portfolio. Whether you are already retired or have many years to go, we are here to help you find the right strategy for you.

guardrails withdrawal strategy

Guardrails Withdrawal Strategy

After looking at Bengen’s 4% Withdrawal Rule last week, today we turn to the Guardrails Withdrawal Strategy created by Guyton and Klinger in 2006. Bengen’s 4% Rule is a static withdrawal strategy – he tested various fixed withdrawal rates over 30-year periods to calculate a safe withdrawal rate for retirement income. This is a static approach because he did not attempt to adjust withdrawals based on market performance.

As a result, one criticism of the 4% Rule is that it is too conservative and is based on the historical worst case scenario. In many scenarios, retirees could have taken much more income than 4%. Or they could have retired years earlier! In bad market scenarios, it also seems unlikely that a retiree would continue to increase their withdrawals every year for inflation if it risked depleting their assets.

A Dynamic Withdrawal Strategy is one which adjusts retirement income up or down based on market performance. Guyton’s Guardrail approach establishes a framework for retirees to adjust their income if necessary. The benefit is that you could increase your withdrawals if performance is above average. It also means you may need to reduce withdrawals during a bad stretch. A dynamic approach means you could start with a much higher withdrawal than just 4%. The guardrails creates an ongoing process to know if your withdrawal rate is in the safe zone or needs to change.

Guyton’s Guardrail Rules

Like Bengen’s framwork, Guyton looked at historical market performance over a 30-year retirement. Here are the main points of his Guardrails Withdrawal Strategy:

  • Your initial withdrawal rate could be 5.4%.
  • You increase withdrawals for inflation annually, EXCEPT in years when the portfolio has fallen in value, OR if your withdrawal percentage exceeds the original rate of 5.4%. In those years, you keep the same withdrawal amount as the previous year.
  • If a market drop causes your current withdrawal rate to exceed 6.48%, then you need to cut your withdrawal dollars by 10%.
  • If market gains cause your withdrawal rate to fall below 4.32%, then you can increase your withdrawal dollars by 10%.
  • This strategy worked with allocations of 65/35 and 80/20. With a 50/50 portfolio, the safe withdrawal rate drops from 5.4% to 4.6%.
  • After a year when stocks were down, withdrawals should only come from cash or bonds. On years when the market is up, he would trim stocks and add to cash to meet future withdrawals.

On a $1 million portfolio, the Guardrails approach suggests you could safely withdraw $54,000 in year 1. That’s significantly higher than the $40,000 under Bengen’s static 4% rule. And while you might forgo annual inflation increases if the market does poorly, you were already starting at a much higher income level. Even if you had a 10% cut in income, from $54,000 to $48,600, you are still getting more income than if you were using the 4% Rule.

Dynamic Withdrawal Range

The Guardrails approach establishes an ongoing withdrawal range of 4.32% to 6.48%. That is a 20% buffer from your original 5.4%. If your withdrawal rate goes outside of this range, you should decrease (or can increase) your withdrawals. The static 4% rule only focused on your initial withdrawal rate and then just assumes you make no changes regardless of whether your future withdrawals are high or low. The 4% rule is an interesting study of market history, but I think retirees want to have a more strategic approach to managing market risk.

The benefit to a retiree for implementing a Guardrails approach is significant. If you need $40,000 a year, you would only need an initial nest egg of $740,740 with the guardrails, versus $1 million under the 4% rule. And you now have a clear process each year to evaluate the sustainability of your current withdrawals. You are responding to markets to aim for an effective retirement strategy.

Calculating a sustainable withdrawal rate for retirement income will always be an unknown. We’ve talked about the challenges of sequence of returns risk, inflation, and longevity. While we can’t predict the future, having a dynamic approach to retirement withdrawals is appealing and intuitive. Is a Guardrails Withdrawal Strategy right for you? Along with portfolio management, our retirement planning process can offer great peace of mind that you are taking a prudent, well-thought approach to managing your wealth.

The 4% Withdrawal Rule

The 4% Withdrawal Rule

Many retirement income projections are based on the work of William Bengen, a financial advisor who created the 4% withdrawal rule. Today, in part three of our five-part series on creating retirement income, we look at Bengen’s 4% Rule and what it can mean for your retirement.

Bengen’s Research

Twenty-five years ago, there had been little research done on how to create retirement income from a portfolio. Thankfully, most people had pensions which guaranteed their payments. However, with the rise of 401(k) plans, the responsibility for retirement income shifted from the employer to the employee and their investment portfolio. We needed a more rigorous framework for retirement planning.

Bengen looked back at the history of the stock and bond returns and considered a 30-year retirement period. Since inflation increases your cost of living, he assumed that retirees would need to increase their retirement withdrawals annually. He then calculated, for every period, the maximum withdrawal rate that would have lasted for the full 30 years, adjusting for inflation.

He examined this for every 30 year period with available data. For example, 1930-1960, and then 1931-1961, 1932-1962, etc. all the way up to the present. In the all 30-year periods, retirees were able to withdraw at least 4% of their initial sum. In the worst case scenario, retirees with a $1 million portfolio could withdraw $40,000 in year 1, and increase it every year with inflation. This is the Safe Withdrawal Rate, or SAFEMAX as Bengen called it.

Interestingly, Bengen did not name this the 4% Rule. In interviews with reporters, they started calling it the 4% Rule and the name stuck.

Portfolio Implications

Bengen originally used a simple two asset portfolio using one-half US Large Cap Stocks and one-half US Intermediate Treasury Bonds. He assumed annual rebalancing, which helped with stock market volatility. He found that the 4% Rule would work with about one-half to three-quarters invested in stocks. With higher allocations to stocks, the portfolio became more likely to implode during bear markets. And with higher allocations to bonds, the portfolio could not keep up with the inflation-adjusted withdrawals. So, the sweet spot for a retirement allocation seemed to be from 50/50 to 75/25.

In the majority of 30-year periods, the potential withdrawal rate was much higher than 4%. In a few periods, it even exceeded 10%. The 4% rate was the worst case scenario. 4% worked for all of the 51 different 30-year periods starting in 1926 that Bengen considered in his original paper. At a 4% withdrawal rate, your money actually grew in most of the periods. If you started with a $1 million portfolio and took 4% withdrawals, your portfolio would have actually exceeded $1 million, 30 years later, in the majority of cases.

Later, Bengen added Small Cap stocks to the mix, with a portfolio of 30% large cap, 20% small cap, and 50% bonds. With this portfolio mix, he found that the safe withdrawal rate increased to 4.5%. Bengen considers this work to replace his initial 4% Rule. Unfortunately, the name had already caught on and Bengen will forever be known as the creator of “The 4% Rule”, but he would rather it was called “The 4.5% Rule”.

There is definitely room for higher withdrawals than 4%. The problem is that we don’t know what future returns will be and we don’t know the sequence of returns. So, the safest bet remains to start at only a 4% withdrawal. For people who retire before age 65, we may want to plan for a longer potential horizon than Bengen’s 30 year assumption. A longer retirement might require a lower rate than 4%.

Summary

The 4% Withdrawal Rule is a good rule of thumb for retirement income. When we use other analytical tools, such as a Monte Carlo evaluation, it often generates results similar to Bengen’s rule. If you want to use a 4% rate, your nest egg needs to be 25-times your annual needs. This is a very high hurdle for most people. It’s incredibly challenging for most Americans to save 25 times their annual expenses during their working years.

So while it is a conservative way to calculate retirement income, the 4% rule may make people over-prepared in most periods. As a result, people could have spent more money in retirement. Or they could have retired years earlier, but waited to accumulate enough assets to meet the 4% Rule. That’s a flaw with the 4% Rule.

The other weakness is that it is based on history. Just because it worked in the past century is no guarantee that it will work in the future. For example, if we have very low bond yields, poor stock returns, or higher inflation, it’s possible that a 4% withdrawal fails. One researcher, Wade Pfau, tried to apply the 4% Rule to investors in other countries. He found that it didn’t work for every country. We have had a really good stock market, and low inflation, here in the US and that’s why it worked historically.

Bottom line: the 4% Withdrawal Rule is a good starting place to understand retirement income. But we can do better by having a more dynamic process. We can adjust withdrawals based on market performance. Or you can delay or reduce inflation adjustments. We can avoid selling stocks in down years. All of these strategies can enhance the 4% rule and potentially enable you to start with a higher withdrawal rate. We will consider two such strategies in the next articles, considering Guardrails and a 5-year Bucket Approach.

Bengen is retired now, but still writing and continuing his research. He realized that his initial research left a lot of money on the table for retirees. Two months ago, he produced a new article looking at stock market valuations and inflation to refine the initial withdrawal rate. If you are retiring when stocks are expensive, future returns are likely to be lower, and you should start with a lower withdrawal rate. If stocks are cheap, you might be able to start with a higher withdrawals than 4%. Bengen believes this new process could calculate a safe-withdrawal rate of 4.5% to 13%. (The present calculation using his new method is 5.0%.) Time will tell if his new research gains wider acceptance, but for now, he will be best known as the father of the 4% withdrawal rule.

Guaranteed Retirement Income

Guaranteed Retirement Income

Guaranteed Retirement Income increases satisfaction. When you receive Social Security, a Pension, or other monthly payment, you don’t have to worry about market volatility or if you will run out of money. You’re guaranteed to receive the payment for as long as you live. That is peace of mind.

Research shows that people prefer pension payments versus taking withdrawals from an investment portfolio. When you were working, you had a paycheck show up every month and you didn’t feel bad about spending it. There would be another paycheck next month. Unfortunately, with an investment portfolio, retirees dislike spending that money. There is “range anxiety” that their 401(k) or IRA will run out of money. There is fear that a market drop will ruin their plans. After spending 40 years building up an account and it’s not easy to reverse course and start to spend that nest egg and see it go down.

Corporate and Municipal pensions have been in decline for decades. As a result, most of us have only a Social Security benefit as guaranteed income. That’s too bad. 401(k) plans are a poor substitute for a good pension. You need to accumulate a million bucks just to get $40,000 a year at a 4% withdrawal rate. It places all the responsibility on American workers to fund their own retirement, and this has led to wildly disparate retirement readiness between people. Even those who accumulate significant retirement accounts still have the worries about running out of money. Sequence of Returns, poor performance or mismanagement, cognitive decline, or longevity are all risks.

The solution to create guaranteed lifetime income is a Single Premium Immediate Annuity, or SPIA. A SPIA is a contract with a life insurance company in which you trade a lump sum in exchange for a monthly payment for life. For as long as you live, you will get that monthly check, just like a Pension or Social Security. When you pass away, the payments stop. For married couples, we can establish a Survivor’s Benefit that will continue the payout (sometimes reduced at 50% or 75%) for the rest of the survivor’s life, if the owner should pass away.

How much would it cost? For a 65-year old man, a $100,000 premium would establish a $537/month payment for life. That is $6,444 a year, or a 6.4% rate on your premium. For a 65-year old woman, it would be $487, a month, or $5,844 a year (5.8%) For a couple, if the wife was also 65, that same premium would offer $425/month for both lives (100% survivors benefit). That’s $5,100 a year, or 5.1%. The greater the expected longevity, the lower the monthly payment.

There are some fairly obvious advantages and disadvantages of a SPIA.

Pros

  • Lifetime income, fixed, predictable, and guaranteed
  • No stock market risk, no performance concerns, no Sequence of Returns risk

Cons

  • Permanent decision – cannot reverse later
  • Some people will not live for very long and will get only a handful or payments back
  • No money leftover for your heirs
  • No inflation protection – monthly payout is fixed

I’ve been a financial advisor since 2004 and I have yet to have a client who wants to buy a SPIA. For some, the thought of spending a big chunk of money and the risk that they die in a year or two, is unbearable. However, the payout is fair, because some people will live for much longer than the average. The way insurance works is by The Law of Large Numbers. An insurance company is willing to take the risk that someone will live for 40 or 50 years because they know that if they sell thousands of annuities, it will work out to an average lifespan across the group. Some people live longer than average and some live less than average.

Two Ways to Use a SPIA

Although they remain unpopular, SPIAs deserve a closer look. Let’s immediately throw away the idea that you should put all your money into a SPIA. But there are two ways that a SPIA might make sense as part of your retirement income plan.

  1. Use a SPIA to cover your basic expenses. Look at your monthly budget. Assume you need $3,000 a month to cover all your expenses. If you have $2,200 in Social Security benefits, buy a SPIA that would cover the remaining $800 shortfall. For the 65-year old couple above, this $800/month joint SPIA would cost $188,235. Now you have $3,000 a month in guaranteed lifetime income to cover 100% of your basic expenses. Hopefully, you still have a large investment portfolio that can grow and supplement your income if needed.

The nice thing about this approach is that it takes a bit less cash than if you follow the 4% rule. If you needed $800 a month ($9,600 a year), a 4% withdrawal rate would require you have a portfolio of $240,000. The SPIA only requires $188,235.

Let’s say you have a $1 million portfolio. You could (a) put it all in the portfolio and start a 4% withdrawal rate, or (b) put $188,235 into the SPIA and keep the remainder in the portfolio. Here’s what that would look like for year one:

  • a. $1 million at 4% = $40,000 potential income
  • b. $188,235 SPIA = $9,600, PLUS $811,765 portfolio at 4% = $32,470. The combined income from the SPIA and portfolio is now $42,070

You have increased your income by $2,070 a year and you have established enough guaranteed income to cover 100% of your monthly needs. Then, you are not dependent on the market to cover your basic expenses each month.

2. The second way to think of a SPIA is as a Bond replacement for your portfolio. Instead of buying Treasury Bonds and worrying if you will outlive them, you can buy a SPIA, and the insurance company will buy very safe bonds. The insurance company then assumes your Longevity risk.

Back to our example above, let’s say your $1 million portfolio is invested in a 60/40 allocation (60% stocks, 40% bonds). Just consider the SPIA as part of your fixed income sleeve. If you had a target of $400,000 in bonds, rather than letting them sit in 10-year Treasuries earning 0.7% today, go ahead and put $188,235 in the SPIA and keep $211,765 in bonds. Your $600,000 in stocks remains the same. Now, on your SPIA, you are getting a withdrawal rate of 5.1% to 6.4%. And although you are eating your principal with a SPIA, you have no longevity risk, it’s a guaranteed check. You have reduced the withdrawal requirement from your equities and can better weather the ups and downs of the stock market.

Is a SPIA Right For You?

A SPIA isn’t going to be for everyone. But if you want lifetime guaranteed retirement income a SPIA is a solid, conservative choice. Used in conjunction with the other pieces of your income plan (Social Security and Investment portfolio), a SPIA can help you sleep well at night. Especially for investors who are in great health and with a family history of longevity, it may be worth putting some money into a SPIA and turning on that monthly check. It can help offset the stock market risks that could derail your plans.

I know many parents think putting money into a SPIA will reduce money for their kids to inherit. That might be true. Of course, if you live a long time and run out of money, you won’t be leaving any money to your kids either. Our goal with any retirement income solution is to make sure you don’t outlive your money, which hopefully also means you are able to leave some money to your heirs.

What if the insurance company goes under? Isn’t that a risk? It is. Thankfully, most states protect SPIA policy holders up to $250,000. If you are planning to put more than $250,000 into a SPIA, I would seriously consider dividing your funds between several companies to stay under the limits. Read more: The Texas Guaranty Association. (Note that this information is provided solely for educational purposes and is not an inducement to a sale.)

In the next three articles in this five-part series, we will look at different withdrawal strategies for your investment portfolio. These approaches include the 4% rule, a Guardrails approach, and 5-year Buckets. All of these will help you manage the risks of funding retirement from stocks. But before we get to those, I wanted you to realize that you don’t have to put all your money into stocks to create retirement income. These withdrawal approaches are likely to work, and we know they worked in history. But if you want to buy your own pension and have a guaranteed retirement income, a SPIA could be the right tool for the job.

Creating Retirement Income

Creating Retirement Income

Today, we are starting a five-part series to look at creating retirement income. There are various different approaches you can take when it is time to retire and shift from accumulation to taking withdrawals from your 401(k), IRA, or other investment accounts. It is important to know the Pros and Cons of different approaches and to understand, especially, how they are designed to weather market volatility.

In upcoming posts, we will evaluate SPIAs, the 4% rule, a Guardrails Approach, and 5-Year Buckets. Before you retire, I want to discuss these with you and set up an income plan that is going to make the most sense for you. Today, let’s start with defining the challenges of creating retirement income.

Sequence of Returns Risk

During accumulation, market volatility is not such a bad thing. If you are contributing regularly to a 401(k) and the market has a temporary Bear Market, it is okay. All that matters is your long-term average return. If you invest over 30-40 years, you have historically averaged a return of 8-10 percent in the market. Through Dollar Cost Averaging, you know that you are buying shares of your funds at a more attractive price during a drop.

Unfortunately, market volatility is a big problem when you are retired and taking money out of a portfolio. You calculated your needs and planned to take a fixed amount of money out of your portfolio. If the market averages 8% returns, can you withdraw 8%? That should work, right?

Let’s look at an example. You have a $1 million portfolio, you want to take $80,000 a year in withdrawals. Imagine you retired in 2000, having reached your goal of having $1 million! Here’s what your first three years of retirement might have looked like, with $80,000 annual withdrawals:

  • Start at $1,000,000, 9% market loss = $830,000 ending value
  • Year 2: start at $830,000, 12% market loss = $650,400 ending value
  • Year 3: start at $650,400, 22% market loss = $427,312 ending value

This would blow up your portfolio and now, your $80,000 withdrawal would be almost 20% of your remaining funds. This is Sequence of Returns Risk: the order of returns matters when you are taking income. If you had retired 10 years before these three bad years, you might have been okay, because your portfolio would have grown for a number of years.

Because a retiree does not know the short-term performance of the stock market, we have to take much smaller withdrawals than the historical averages. It’s not just the long-term average which matters. Losses early in your retirement can wreck your income plan.

Longevity Risk

The next big risk for retirement income is longevity. We don’t know how long to plan for. Some people will have a short retirement of less than 10 years. Others will retire at 60 and live for another 40 years. If we take out too much, too early, we risk running out of funds at the worst possible time. There is tremendous poverty in Americans over the age of 80. They didn’t have enough assets and ran out of money. Then they end up having to spend down all their assets to qualify for Medicaid. It’s not a pretty picture.

And for you macho men who intend to die with your boots on – Great. You may wipe out all your money with your final expenses and leave your spouse impoverished. She will probably outlive you by 5-10 years. That’s why 80% of the residents in nursing homes are women. You need to plan better – not for you, but for her.

Read more: 7 Ways for Women to Not Outlive Their Money

We plan for a retirement of 30 years for couples. There’s a good chance that one or both of you will live for 25-30 years if you are retiring by age 65. There are different approaches to dealing with longevity risk, and we will be talking about this more in the upcoming articles.

Inflation Risk

Longevity brings up a related problem, Inflation Risk. At 3% inflation, your cost of living will double in 24 years. If you need $50,000 a year now, you might need $100,000 later, to maintain the same standard of living.

A good retirement income plan will address inflation, as this is a reality. Luckily, we have not had much inflation in recent decades, so retirees have not been feeling much pressure. In fact, most of my clients who start a monthly withdrawal plan, have not increased their payments even after 5 or 10 years. They get used to their budget and make it work. Retirement spending often follows a “smile” pattern. It starts high at the beginning of retirement, as you finally have time for the travel and hobbies you’ve always wanted. Spending typically slows in your later seventies and into your eighties, but increases towards the end of retirement with increased health care and assistance costs.

When we talk about a 4% Real Rate, that means that you would start at 4% but then increase it every year for inflation. A first year withdrawal of $40,000 would step up to $41,200 in year two, with 3% inflation. After 30 years (at 3% inflation), your withdrawal rate would be over $94,000. So, when we talk about a 4% withdrawal rate, realize that it is not as conservative as it sounds. Even at a low 3% inflation rate, that works out to $1,903,016 in withdrawals over 30 years. It’s a lot more than if you just were thinking $40,000 times 30 years ($1.2 million).

Periods with high inflation require starting with a lower withdrawal rate. Periods with low inflation enable retirees to take a higher initial withdrawal amount. Since we don’t know future inflation, most safe withdrawal approaches are built based on the worst historical case.

Invest for Total Return

There is one thing which all of our retirement income approaches agree upon: Invest for Total Return, not Income. This is counter-intuitive for many retirees. They want to find high yielding bonds, stocks, and funds. Then, they can generate withdrawal income and avoid selling shares.

It sounds like it would be a rational approach. If you want a 5% withdrawal rate, just buy stocks, bonds, and funds that have a 5% or higher dividend yield. Unfortunately, this often doesn’t work as planned or hoped!

Over the years, I’ve invested in everything high yield: dividend stocks, preferred stocks, high yield bonds, Real Estate Investment Trusts (REITs), Master Limited Partnerships (MLPs), Closed End Funds, etc. They can have a small place in a portfolio, but they are no magic bullet.

Problems with Income Investing

  • Value Trap. Some stocks have high yields because they have no growth. Then if they cut their dividends, shares plummet. Buy the highest dividend payouts and your overall return is often less than the yield and the share price goes no where. (Ask me about the AT&T shares I’ve held since 2009 and are down 14%.)
  • Default risk. Many high yield investments are from highly levered companies with substantial risk of bankruptcy. Having 5% upside and 100% downside on a high yield bond or preferred stock is a lousy scenario. When you do have the occasional loss, it will be greater than many years of your income.
  • Poor diversification. High yield investments are not equally present in all sectors of the economy. Often, an income portfolio ends up looking like a bunch of the worst banks, energy companies, and odd-ball entities. These are often very low quality investments.

Instead of getting the steady paycheck you wanted, an income portfolio often does poorly. When your income portfolio is down in a year when the S&P is up 10-20%, believe me, you will be ready to throw in the towel on this approach. Save yourself this agony and invest for total return. Total return means you want capital gains (price appreciation) and income.

For investors in retirement accounts, there is no tax difference between taking a distribution from dividends versus selling your shares. So, stop thinking that you need to only take income from your portfolio. What you want is to have a diversified portfolio and a good long-term rate of return. Then, just make sure you are able to weather market volatility along the way.

Read more: Avoiding The High Yield Trap

Ahead in the Series

Each of the retirement income approaches we will discuss have their own Pros and Cons. We will address each through looking at how they address the risks facing retirees: Sequence of Returns Risk, Longevity Risk, and Inflation Risk. And I’ll have recommendations for which may make the most sense for you. In the next four posts, I’ll be explaining SPIAs, the 4% Rule, a Guardrail Approach, and 5-Year Buckets.

Even if you aren’t near retirement, I think it’s vitally important to understand creating retirement income. Retirement income establishes your finish line and therefore your savings goals. If you are planning on a 4% withdrawal rate, you need $1 million for every $40,000 a year in retirement spending. Looking at your monthly budget, you can calculate how much you will need in your nest egg. Then we can have a concrete plan for how much to invest and how we will get there. Thanks for reading!

Retirement Withdrawals Without Penalty

Retirement Withdrawals Without Penalty

If you have multiple retirement accounts, when can you start withdrawals without penalty? This is very important if you want to retire before age 59 ½ and be able to access your money. The rules vary by the type of account, so advance preparation can make it easier to plan your withdrawals.

In our retirement income planning, we carefully choose the order of withdrawals. This can make a big difference in your tax bills. It’s also helpful to have multiple types of accounts so you can select from capital gains, tax-deferred accounts, and tax-free accounts. Let’s start with the early retirement penalties, by account type.

Five Retirement Plans with Different Rules

  1. 401(k) and 403(b): 10% penalty on distributions prior to age 59 ½.
  2. A 457 Plan can be accessed after you retire without penalty, regardless of your age. This is the easiest plan for accessing your money.
  3. Traditional IRA: 10% penalty for distributions prior to age 59 ½. This also applies to a SEP-IRA.
  4. SIMPLE IRA: 10% penalty prior to age 59 ½. Additionally, any distributions within the first two year of participation are subject to a 25% Penalty. Ouch. Don’t do that.
  5. Roth IRA. 10% penalty on earnings before age 59 ½, AND the five-year rule. You must have had a Roth open for five years before taking penalty-free withdrawals. So, if you open your first Roth at age 57, you’d have to wait until age 62 to get the tax-free benefit. However, you can access your principal at any time without tax or penalty. It is only when you start drawing down your earnings that the tax and penalty might apply. To withdraw tax-free and penalty-free, you must be over 59 ½ and have had a Roth for at least five years.

Read more: The Secret Way to Contribute $35,000 to a Roth IRA

Exceptions to the Penalty

  1. For 401(k) and 403(b) Plans: if you are at least age 55 and have separated from service, the penalty is waived. This means that if you retire between 55 and 59 ½, you can access your account without penalty. You would lose this exception if you roll your money into an IRA.
  2. 72(t) / Substantially Equal Periodic Payments (SEPP). If you are before age 55 and want to access your 401(k), 403(b), or Traditional IRA, you can take Substantially Equal Periodic Payments and waive the penalty. This means that you commit to taking the same amount from your account, annually, for at least five years or until age 59 ½, whichever is longer. Even if you later don’t want or need the distribution, you must continue to withdraw the same amount.  
  3. You may be able to avoid the 10% Penalty on an IRA or 401(k)/403(b) distribution if you qualify for these exceptions:
    • Total and Permanent Disability
    • An IRS Levy
    • Unreimbursed Medical Expenses in excess of 10% of AGI
    • Qualified Military Reservists called to Active Duty
  4. There are some exceptions which are available to IRAs (including SEP and SIMPLE), but not allowed from a 401(k) or 403(b). For these exceptions, you may want to roll your 401(k) into an IRA to qualify.
    • Qualified higher educational expenses
    • Qualified first-time homebuyers, up to $10,000
    • Health insurance premiums paid while unemployed

Full List from IRS: Exceptions to Tax on Early Distributions

Using Exceptions and Planning Your Income

I’m happy to let people know about these exceptions for retirement withdrawals without penalty before age 59 1/2. However, you should be very careful about tapping into your retirement accounts in your 30’s, 40’s or 50’s. This money needs to last a lifetime. I sometimes hear of people who take from their 401(k) accounts to buy a car or build a pool. And they have no idea that taking $50,000 now is stealing $400,000 from their future. Here’s the math: At 8%, your money will double every 9 years. That’s the Rule of 72. $50k will become $100k in 9 years, then $200k in 18 years, and $400k in 27 years. (Yes, this is a hypothetical rate of return, not a guarantee.)

The order of withdrawals does matter when planning your retirement income. While we can work to avoid the 10% penalty before age 59 ½, distributions from “Traditional” retirement accounts are still taxable as ordinary income. It’s often better to access your taxable accounts first. When eligible for long-term capital gains rate, that will be lower than IRA distributions which are taxed as ordinary income. And you have a cost basis on a taxable position, so only a portion of your sale ends up as a taxable gain.

Many retirees avoid touching their retirement accounts until they have to take Required Minimum Distributions. RMDs used to be at age 70 ½, but now are age 72. If there are years when you are in a low tax bracket (sabbatical, retired, year off, etc.), it may make sense to do a partial Roth Conversion. Start shifting money from a tax-deferred account into a tax-free account and save yourself on future taxes.

Once you reach age 72, you could be subject to a lot of taxes from RMDs. That’s the problem with being too good at waiting to start distributions from your retirement accounts. You’re creating a bigger tax bill for yourself later. While you are accumulating assets, it pays to plan ahead and know when and how you will be able to actually access your accounts. Have a question about retirement withdrawals without penalty? Let me know how I can help.

457 403b Plan

Choosing a 457 or a 403(b) Plan

Does your employer offer both a 403(b) and a 457 Plan? What should you do and what is a 457 anyways? A 457(b) Plan is an employer sponsored retirement plan for state or local government employees. It is a pre-tax, salary deferral plan, with an annual contribution limit of $19,500. Sounds just like a 401(k) or 403(b), right? Yes, but with one very interesting difference.

If you have more than one 401(k) or 403(b), your combined contribution to all 401(k) and 403(b) accounts cannot exceed $19,500 a year. 457 Plans are not included in this rule. That means that if you work for a government employer who offers both a 403(b) and a 457, you can contribute the maximum to both!

IRS Publication 4484: Choose a Retirement Plan for Employees of a Tax-Exempt Government Entity

457 Versus 403(b)

Besides the amazing tax-savings of doubling your contributions, there are a couple of other unique features of 457 plans.

The 457 has the same catch-up feature as a 403(b). Participants age 50 and higher can contribute an extra $6,500 a year. Additionally, if you are within three years of normal retirement age, you may be able to contribute up to two times the usual limit. Instead of $19,500, you could contribute up to $39,000 to a 457. Eligibility for this catch-up is limited by your previous contributions, so check with your HR to calculate your actual amount.

Most employers do not contribute to a 457 Plan. If they do, their contribution is counted towards your $19,500 limit. That’s a difference from a 403(b), where an employer contribution is on top of your individual limit.

There is no 10% penalty on distributions before age 59 ½. At whatever age you retire, you can access your 457 Plan without penalty. This is a big advantage compared to a 403(b) or IRA for people who want to retire early. And it’s a good reason to not rollover a 457 into an IRA. Once it’s in the IRA you would have to wait until after 59 ½ to avoid the penalty.

Let’s Evaluate Your Options

If your employer offers a 457 in addition to a 403(b), look into the 457. Want to contribute the maximum to both plans? That would be $39,000 for 2020, or $52,000 if you are age 50 or above. And potentially even higher if you are within three years of normal retirement age. Of course, you will also want to compare both plans being offered to you. Consider if any match is available, as well as the investment options and expenses of each plan.

You’d love to do both, but not sure you can contribute more than $19,500? Start here: 5 Steps to Boost Your Savings

Whatever type of retirement plan you have, let’s make sure you are taking full advantage of the benefits available to you. Not sure where to begin? I’m here to help, just send me a note.

2020 RMDs

2020 RMDs Fixed

At the end of March, the CARES Act waived 2020 RMDs (Required Minimum Distributions) from retirement accounts. This will help people who do not need to take distributions. They can leave their IRAs alone and not be forced to take a taxable withdrawal while the market is down.

Unfortunately, this change created a couple of problems. People could have started their 2020 RMDs as early as January 1, but the waiver didn’t occur until late March. Some people set up monthly distributions from their IRA, but can only put back one, due to the rules regarding 60-Day Rollovers. Later, the IRS said that if you took a withdrawal between February 1 and May 15, you could put it back before July 31. But that left out people who took RMDs in January.

This week, the IRS corrected both of those situations with IRS Notice 2020-51. The ruling will provide relief for anyone who wants to put back their RMDs taken after January 1. You have until August 31 to roll them back into your IRA. Also, if you took multiple withdrawals, you can put them all back. That’s because this one-time rollover is not going to be considered a 60-Day Rollover. (You con only do ONE 60-day rollover in a 365 day period.)

Also, Inherited IRAs (Stretch or Beneficiary IRAs) were never allowed to do 60-day rollovers. Under this week’s ruling, if you had taken your RMD from an Inherited IRA, you can put now return the money to the account through August 31. Unprecedented!

As a reminder, the age for RMDs increased to 72, from 70 1/2, last year. It’s good that the IRS has provided relief from the quagmire Congress created with CARES Act changes in March. So, if you don’t want to take an RMD, you don’t have to. And now you can reverse your RMDs if you had already started.

Planning Opportunities

Currently, tax rates are low, but the Federal rates are supposed to sunset after 2025. So, if you have a choice between paying some taxes now at 12% or 22% that might be better than paying 15%, 25%, or more down the road. Also, if you anticipate needing to take more than your RMD next year, you might be better off spreading that amount over 2020 and 2021, if it will keep you in a lower marginal tax bracket.

Another opportunity afforded by the 2020 RMD waiver is to do a Roth Conversion. If you had planned to pay the taxes on a $50,000 RMD, you could do a $50,000 Roth Conversion instead. Once in the Roth, your $50,000 is growing tax-free with no future RMDs. You paid some taxes at today’s lower rates, and reduced your future RMDs by doing a conversion in 2020.

A Roth Conversion does not count towards your RMD amount. So for people over 72, most never want to do a conversion because they are already paying a lot in taxes on their RMD. It’s best to do conversions after you retire – and are in a low bracket – but before you start RMDs. For people who missed that window, 2020 is the year to do a Roth Conversion.

Retirement Income Expertise

Creating tax-efficient retirement income is our mission and passion. If you want professional advice on establishing your retirement income plan, we can help. Here’s how:

  • We stay informed. Rules regarding your IRAs and 401(k) accounts have actually seen significant changes in the past couple of years.
  • Tools, not guesses. We analyze the likelihood of success of your retirement income plan through MoneyGuidePro. You will create a baseline scenario, which we will monitor and adjust based on market changes.
  • Asset location. Improving tax-efficiency through placing investments which generate ordinary income into tax-deferred accounts, and keeping long-term capital gains and qualified dividends in taxable accounts. Research and select more tax-efficient investment vehicles.
  • Sequence of Withdrawals. Determine the optimal order of withdrawals by account type and asset. Evaluate when you begin Pension payments and Social Security.

I suspect that there are not a lot of my readers who need to put back RMDs from January and are impacted by Notice 2020-51. But, I do have clients in this exact situation, and this type of detailed work is how I can add value to your financial life. Whether you are already retired, soon to be retired, or it’s just a dream at this point, we can create a plan to take you through the steps you need to feel comfortable about retirement.

Unplanned Retirement

Unplanned Retirement

With job losses this year reaching 40 million, many Americans are being forced into an unplanned retirement. Maybe they wanted to work until age 65 or later and find themselves out of work at age 60 or 62. Job losses due to Coronavirus layoffs may be the most common reason today. However, many people also enter early retirement due to their health or to care for a spouse or parent.

Each year, the Employee Benefits Research Institute publishes a Retirement Confidence Survey Report. Here are some findings from their 2020 report published in April:

  • 48% of current retirees retired earlier than they had planned. Only 6% retired later than they originally planned.
  • Less than one-half of workers have tried to calculate how much money they will need to live comfortably in retirement.
  • Of workers who reported their employment status would be negatively effected by the Coronavirus, only 39% felt confident that they will have enough money to last their entire life.

Half of all retirees retired at a younger age then they had planned. That statistic has remained very consistent over the years. In the 1991 report, it was 51%. This is a reality that more people should be preparing for. If you want to retire at 65, 70, or “never”, will you be prepared if you end up retiring at 64, 60, or 55? Certainly, if you enjoy your work, keep on working! But sometimes, the choice is not ours and people find themselves in an early, unplanned retirement.

If you have lost your job or just want to be better prepared should that happen, you need to plan your retirement income carefully.

Unplanned Retirement Steps

  1. You should begin with a thorough and accurate calculation of your spending needs. Not what you want to spend but what you actually spend. Determine your health insurance costs until age 65 and for Medicare after age 65, including Part B premiums, and Medicare Advantage or Medigap coverage, and Part D prescription drug coverage. Read more: Using the ACA to Retire Early.
  2. Reduce your expenses. This will require setting priorities and determining where you can do better. Still, there may be some low hanging fruit where you can save money with little or no change in your lifestyle. Read more: Cut Expenses, Retire Sooner
  3. Calculate your sources of retirement income. Read more: When Can I Retire?
  4. Be careful of starting Social Security at age 62. This is very difficult for people to not access “free money”, everyone wants to do it. Be sure to consider longevity risk and the possible benefits of spending investments first and delaying Social Security for a higher payout later. Read more: Social Security, It Pays to Wait
  5. Consider going back to work, even part-time, to avoid starting retirement withdrawals. The more you delay your retirement, the more likely you will not run out of money later. Here’s the math on why: Stop Retiring Early, People!

Be Prepared for the Unexpected

I think the best way to survive an unplanned retirement is to achieve financial independence at an early age. If you could retire at 50, plan to work until 65, and end up retiring at 60, it’s no problem. This requires saving aggressively and investing prudently from an early age. And that’s why retirement planning isn’t just for people who are 64. Retirement planning should also be for people who are 54, or 44, or even 34. Plan well, and an early retirement could be a good thing. It’s your chance to begin a new adventure!

If – surprise! – you do happen to be facing an unplanned retirement, let’s talk. We can help you evaluate your options for retirement income and establish a process and budget. Our retirement planning software can help you make better informed decisions, including when to start benefits, how much you can withdraw, and if you have enough money to last your lifetime.

It certainly is a shock to people when they end up retiring earlier than they had originally planned. However, it is very common and about half of all retirees are in the same situation. Unfortunately, not everyone who has an unplanned retirement will be having the comfortable years they had hoped. Basing your retirement on the assumption that you will work until age 70 or later may not be realistic. It could even set you up for failure if you end up needing to retire early. Whatever your age, retirement planning is too important to not seek professional help.

Retirement Income at Zero Percent

Retirement Income at Zero Percent

With interest rates crushed around the world, how do you create retirement income at zero percent? Fifteen years ago, conservative investors could buy a portfolio of A-rated municipal bonds with 5 percent yields. Invest a million dollars and they used to get $50,000 a year in tax-free income.

Not so today! Treasury bonds set the risk-free rate which influences all other interest rates. Currently, the rate on a 10-year Treasury is at 0.618 percent. One million dollars in 10-year Treasuries will generate only $6,180 in interest a year. You can’t live off that.

You can do a little better with municipal bonds today, maybe 2-3 percent. Unfortunately, the credit quality of municipal bonds is much worse today than it was 15 years ago. A lot of bonds are tied to revenue from toll roads, arenas, or other facilities and are seeing their revenue fall to zero this quarter due to the Coronavirus. How are they going to repay their lenders?

Debt levels have risen in many states and municipalities. Pension obligations are a huge problem. The budget issues in Detroit, Puerto Rico, Illinois, and elsewhere are well known. Shockingly, Senator McConnell last week suggested that states maybe should be allowed to go bankrupt. That would break the promise to Municipal Bond holders to repay their debts. This is an appalling option because it would cause all states to have to pay much higher interest rates to offset the possibility of default. And unlike Treasury bonds which are owned by institutions and foreign governments, Municipal Bonds are primarily owned by American families.

With Treasuries yielding so little and Municipal Bonds’ elevated risks, how do you plan for retirement income today? We can help you create a customized retirement income plan. Here are three parts of our philosophy.

1. Don’t Invest For Income

We invest for Total Return. In Modern Portfolio Theory, we want a broadly diversified portfolio which has an efficient risk-return profile, the least amount of risk for the best level of return. We focus on taking withdrawals from a diversified portfolio, even if it means selling shares.

Why not seek out high dividend yields and then you don’t have to touch your principal? Wouldn’t this be safer? No, research suggests that a heavy focus on high yields can create additional risks and reduce long-term returns. Think of it this way: Company A pays a 5% yield and the stock grows at zero percent; Company B pays no yield but grows at 8%. Clearly you’d be better off with the higher growth rate.

When you try to create a portfolio of high yield stocks, you end up with a less diversified portfolio. The portfolio may be heavily concentrated in just a few sectors. Those sectors are often low growth (think telecom or utilities), or in distressed areas such as oil stocks today. The distressed names have both a higher possibility of dividend cuts, as well as significant business challenges and high debt.

The poster child for not paying dividends is Warren Buffett and his company, Berkshire Hathaway. He’s never paid a dividend to shareholders in over fifty years. Instead, he invests cash flow into new acquisitions of well-run businesses or he buys stocks of other companies. Over the years, the share price of BRK.A has soared to $273,975 a share today. If investors need money, they can sell their shares. This is more tax-efficient, because dividend income is double taxed. The corporation has to pay income taxes on the earnings and then the investor has to pay taxes again on the dividend. When a company grows, the investor only pays long-term capital gains when they decide to sell. And the company can write off the money it reinvests into its businesses.

2. Create a Cash Buffer

Where a total return approach can get you into trouble is when you have to sell stocks in a down market. If you need $2,000 a month and the price of your mutual fund is $10/share, you sell 200 shares. But in a Bear Market when it’s down 20%, you’d have to sell 250 shares (at $8/share) to produce the same $2,000 distribution. When you sell more shares, you have fewer shares left to participate in any subsequent recovery.

This is most problematic in the early years of retirement, a fact which is called the Sequence of Returns Risk. If you have a Bear Market in the first couple of years of retirement, it is more likely to be devastating than if you have the same Bear Market in your 20th year of retirement.

To help avoid the need to sell into a temporary drop, I suggest keeping 6-12 months in cash or short-term bonds so you do not have to sell shares. Additionally, I prefer to set dividends to pay out in cash. If we are receiving 2% stock dividends and 2% bond interest, and need 4% a year, we would have to sell just two percent of holdings. This just gives us more flexibility to not sell.

Also, I like to buy individual bonds and ladder the maturities to meet cash flow needs. If your RMD is $10,000 a year, owning bonds that mature at $10,000 for each of the next five years means that we will not have to touch stocks for at least five years. This approach of selling bonds first is known as a Rising Equity Glidepath and appears to be a promising addition to the 4% Rule.

3. Guaranteed Income

The best retirement income is guaranteed income, a payment for life. This could be Social Security, a government or company Pension, or an Annuity. The more you have guaranteed income, the less you will need in withdrawals from your investment portfolio. We have to be fairly conservative in withdrawal rates from a portfolio, because we don’t know future returns or longevity. With guaranteed income, you don’t have to fear either.

We know that Guaranteed Income improves Retirement Satisfaction, yet most investors prefer to retain control of their assets. But if having control of your assets and the ability to leave an inheritance means lower lifetime income and higher risk of failure, is it really worth it?

I think that investors make a mistake by thinking of this as a binary decision of 100% for or against guaranteed income. The more sophisticated approach is to examine the intersection of all your retirement income options, including when to start Social Security, comparing lump sum versus pension options, and even annuitizing a portion of your nest egg.

Consider, for example, if you need an additional $1,000 a month above your Social Security. For a 66-year old male, we could purchase a Single Premium Immediate Annuity for $176,678 that would pay you $1,000 a month for life. If you instead wanted to set up an investment portfolio and take 4% withdrawals to equal $1,000 a month, you would need to start with $300,000. So what if instead of investing the $300,000, you took $176,678 and put that into the annuity? Now you have guaranteed yourself the $1,000 a month in income you need, and you still have $123,322 that you could invest for growth. And maybe you can even invest that money aggressively, because you have the guaranteed annuity income.

Conclusion

It’s a challenge to create retirement income at zero percent interest rates. Unless you have an incredibly vast amount of money, you aren’t going to get enough income from AAA bonds or CDs today to replace your income. We want to focus on a total return approach and not think that high dividend stocks or high yield bonds are an easy fix. High Yield introduces additional risks and could make long-term returns worse than a diversified portfolio.

Instead, we want to create a cash buffer to avoid selling in months like March 2020. We own bonds with maturities over five years to cover our distribution or RMD needs. Beyond portfolio management, a holistic approach to retirement income evaluates all your potential sources of income. Guaranteed income through Social Security, Pensions, or Annuities, can both reduce market risk and reduce your stress and fear of running out of money. The key is that these decisions should be made rationally with an open mind, based on a well-educated understanding and actual testing and analysis of outcomes.

These are challenging times. If you are recently retired, or have plans to retire in the next five years, you need a retirement income plan. We had quite a drop in March, but recovered substantially in April. The economy is not out of the woods from Coronavirus. I think global interest rates are likely to remain low for years. If you are not well positioned for retirement income, make changes soon, using the strength in today’s market to reposition.