Turning Your Portfolio into a Paycheck

As our Clients approach retirement and prepare to begin making distributions from their portfolio to meet their spending needs, we often hear questions like these:

• How much can I safely spend from my portfolio in retirement?
• How will I know if I’m heading for trouble?
• What will I need to do to get back on track?

TheLiveBigWay^® Safe-Spending System, backed by the results of some of the best available research, answers the aforementioned questions by targeting a spending rate and implementing decision rules to ensure Clients remain on a sustainable path.

In this space, we discuss our approach to managing sustainable distributions in retirement and the evidence-based decision rules that act as guardrails to keep spending levels consistent in retirement.

Sustainable Distributions

We work with each Client to create a spending plan that fits their lifestyle, and we manage the spending plan in the following ways to maximize growth, minimize costs, and build in as much resiliency as possible:

• When possible, we set spending targets below the identified Safe-Spending Policies target so that if a reduction must be made, the actual distribution may not need to be reduced. Building in additional layers of resiliency in this way creates peace of mind while increasing the portfolio’s capacity to weather the inevitable storms in markets.
• In general, we keep about two-thirds of the portfolio balance invested in stocks to harness growth and maintain purchasing power throughout retirement. We use a combination of high-quality bonds and money market funds as a “stable reserve”; assuming a 5% spending target, our bond portfolios carry up to six years’ worth spending that acts as a “bridge” when stocks are down.
• We keep a year’s worth of spending in cash, which is also topped up throughout the year via dividends and capital gains distributions to reduce the taxable gains realized by selling investments.
• Once a spending target has been established, we set up electronic transfers from the portfolio to the desired account on a cadence that feels comfortable to ensure consistent and reliable distributions.

Decision Rules as Guardrails

TheLiveBigWay^® Safe-Spending System framework is designed to address a Client’s spending concerns in explicit terms via a set of decision rules. These decision rules act as guardrails, keeping Clients’ spending levels consistent year after year even as markets fluctuate. The three decision rules – the Inflation Rule, the Capital Preservation Rule, and the Prosperity Rule – and explanations of how they work are listed below.

The Inflation Rule

This decision rule is triggered the most frequently and allows a Client to increase their withdrawal target by the amount of inflation over the past 12 months as long as the portfolio value is greater than or equal to the balance when the Client began spending.

The Capital Preservation Rule

The Capital Preservation Rule is used to adjust the withdrawal amount when a portfolio balance decreases by enough that the target becomes 6% (or more) of the portfolio’s new balance. When this happens, the Client’s spending target is reduced by 10% to reduce the strain on the portfolio and give it a better opportunity to recover.

As an example, let’s assume that a Client has a portfolio of $1,000,000 and is applying a 5% withdrawal rate against that balance, meaning they have an annual spending target of $50,000. The withdrawal rate is assigned a 20% threshold, meaning that if the portfolio shrinks to the point that the withdrawal target becomes 6% of the portfolio’s new balance, the spending target will be decreased to $45,000.

The Prosperity Rule

The Prosperity Rule works in the opposite way. If the portfolio’s value increases by enough that the target becomes 4% (or less) of the portfolio’s new balance, the withdrawal target is increased by 10%.

SPACE

SPACE

Evidence-Based Application

The researchers who developed these decision rules analyzed every 40-year retirement period from 1928 to 2004 (meaning the period from 1928 to 1968, and from 1929 to 1969, and so on) and ran 14,000 scenarios for each period to stress-test the application of the rules. They found that, depending on the aggressiveness of their portfolio, Clients increased their spending via the Inflation Rule between 33 and 35 times in retirement, and received an average of five to eight Prosperity Rule raises. In contrast, they only had to take two to four Capital Preservation Rule reductions. This makes sense intuitively, as we expect markets to rise in the long run, and pave the way for larger portfolio values that can support greater distributions as time goes on.

The research also aligns with our anecdotal experience. We began applying this framework before the Great Recession. While a few of our Clients who retired before or during 2008 and 2009 had to make Capital Preservation Rule adjustments, none had to do so more than once. Most of our Clients didn’t even have to apply the rule as their portfolios recovered quickly enough from the worst part of the downturn to continue to support their distributions at the same level. Even as they continued to spend at their normal rate, virtually all of our Clients’ portfolios returned to their pre-recession highs within three or four years.

If you’d like to discuss how our Safe-Spending Policies work in greater detail, please contact a member of Yeske Buie’s Financial Planning Team at AFP@YeBu.com.