Recent academic research by Gordon Pye on the impact of emergency withdrawals on retirement planning may put into question the rule of thumb used by many advisers to determine a safe, sustainable withdrawal rate.
For many investors and their financial advisers, the accepted rule of thumb has been to withdraw no more than 4% of an investment portfolio in any given year to provide a sustainable income stream when in retirement.
Is this rule of thumb reasonable given the potential impact of personal emergencies? And how can a withdrawal strategy be created to account for them and the impact of external forces like a market correction or longer bear market?
Cloudy Crystal Ball
Analytical tools and software have come a long way but even contemporary tools can’t account for everything.
I spoke with an estate attorney the other day. We were talking about the many challenges for helping clients plan properly for contingencies in the face of so many internal and external variables.
What he said is worth keeping in mind when thinking about any sort of financial planning: If you tell me when you’re going to die, I can prepare a perfect estate plan for you?
The same sentiment can be adapted for retirement income planning. Sure, if you tell me how long you’ll live in retirement, how much it will cost each year and when you’re going to die, I can tell you how much you’ll need.
In reality, this is unlikely. More often than not, the crystal ball is cloudy. So you have two choices here: Wing it or Plan.
Winging it is pretty simple. Nothing complicated. Simply keep shuffling along. Sometimes you’ll scramble. Other times you’ll be “fat and happy” for lack of a better phrase.
Planning, on the other hand, is a lot like work. It requires assumptions and conversations. It may even require bringing in others to help create the framework.
While nobody wants another job to do given an already busy day, there is an upside to investing the time here: Peace of mind.
What the Doctor Says:
Here’s a summary of what Dr. Pye wrote recently in his article.
- In retirement, you may never have an emergency or you may have one or more.
- The timing and extent of these emergencies is unknown.
- While a retiree may be able to reduce the damage caused by a bear market maybe through market growth, other emergencies may require withdrawals that siphon money away from the investment pot that can never again be used to help repair the hole left by that withdrawal.
- The timing of these emergency withdrawals may cause a retiree to abandon a market strategy at an inopportune time.
The biggest unknown? Health care is the biggest likely emergency on your retirement budget. These can be related to your own health or even an adult son or daughter. Other emergencies may be caused by catastrophic weather (mudslide, wind or flood damage to your home), the extended loss of a job by a son or daughter or a divorce compelling you to help out.
In other research by Dr. John Harris supports the notion that what matters most to all investors – and retirees in particular – is the sequence of returns not simply the average rate of return on a portfolio.
Intuitively, we understand this. A bird in the hand is worth two in the bush. Cash now is better than cash later (which may be a deterrent against planning now for a future need). If you were to just retire and the market takes a nosedive as you are withdrawing funds, you would be in tough shape because you have a smaller base that is invested that has to do double (or triple) duty. The amount of appreciation needed to make up for the hole left by the withdrawals combined with market losses would be near impossible or require an investor to take imprudent risks to try to regain lost ground.
So what’s an investor to do?
- Save more – easier said than done but this is really key or otherwise choose a different lifestyle budget.
- Reduce initial withdrawal rates from 4% to 3%.
- Follow an “endowment spending” policy instead of a simple rule of thumb.
- Invest for income from multiple sources (dividend-paying stocks as well as bonds).
- Stay invested in the stock market but change up the players. Not even a championship ball club has the same line up from game to game. As markets change, you need to add more tactical plays into the mix of asset types
- Separate your investments into different buckets: short-term lifestyle budget, medium-term and longer-term. Each of these can have different risk characteristics.
- Keep a safety net of near-cash to cover lifestyle needs for 1 to 2 years.
- Monitor the buckets so that one doesn’t get too low or start to overflow. This will require moving funds from one to the other to maintain consistency with the targets.
- Don’t let your insurances lapse. Insurance is there to fill in the gap so you don’t have to shell money out-of-pocket. Here you want to regularly recheck your homeowner coverage for inflation protection riders, cost of replacement and liability. Check your coverage and deductible limits for wind, sump pump and other damage.