Where Do I Get My Money When I Retire?
The Importance of a Withdrawal Strategy
Incomplete plans can be disastrous. A man named Carl McCunn learned this painful lesson amid the chilling landscape of Alaska. The wildlife photographer arranged for a bush pilot to fly him to an isolated region hundreds of miles north of Fairbanks. He carried enough provisions for his five-month excursion. As the end date approached, he made a startling conclusion. “I think I should have used more foresight about arranging my departure,” he wrote[i] in his journal. He was never able to follow through on his return flight plans. In the end, McCunn died. Planning is the one thing that could have saved him.
The complexity and details of building retirement savings often distract us from the ultimate end game: making withdraws. Failing to compose a complete plan can be costly. Once this problem presents itself, it's often too late to fix. In this article, we'll look at why conventional approaches to withdrawing retirement funds are inadequate and what considerations you need to make.
Why ‘Conventional Wisdom’ Lacks Wisdom
To appeal to a client's desire for simplicity many advisors overlay a basic ‘one size fits all' approach to withdraw planning. The result of this method is that money, and a lot of it is left on the table. At the end of the day, the IRS has more of your hard-earned dollars. Commonly, advisors direct clients to first withdraw from taxable accounts followed by tax-deferred, then finally, exempt sources. Why? Some experts posit that abstaining from Social Security holdings at the beginning of retirement ensures that the retiree is in a lower tax bracket upon withdrawing from tax-deferred accounts.
Solutions are as varied as the retirees themselves. That is, what works for one may not work for the other. There is no rule of thumb to withdraw planning. Moreover, the art and science of tax savvy withdraw planning is so intricate that experts in the field have turned to computer programs to customize solutions. “It can be like a Rubik’s cube,”[ii] remarks the co-founder of Social Security Solutions. “I solve the green side—and suddenly it creates problems with the yellow side.” The need for these digital solutions underscores the layers of obscurity plaguing most retirement plans. The output of such programs consists of a series of careful chess moves. Rarely is there a commonality among the outputs. This variance upends the popular notion that a simple 4% per year withdraw of one’s nest egg will suffice.
Ignore The ‘Rules’
The universal 4% rule is a fail-safe solution so long as you ignore the words ‘fail' and ‘safe.' The problem with such a rule is that it ignores inevitable market downturns. Even a portfolio of diversified asset classes is at risk of a secular market drop. This risk is real for three reasons.
First, as performance among equities becomes more correlated diversifiable risk erodes. Correlations among stocks have nearly doubled since 1980[iii]. Thus, the level of risk mitigation stemming from diversification is dropping. There are likely several causes including a more global economy and advances in trading among economies.
Second, a retirement plan relies on continued growth throughout the span of your non-working years. Markets can become volatile during this particularly sensitive period for a retiree. As a result, the impact is considerable given that there is little or no time to recover.
Third, inflation can make significant moves over the course of your retirement years. However, more problematic is the less discussed increasing personal consumption expenditures (PCE). This number is considered by many to be more accurate than the CPI in measuring rising costs for consumers. From 1959 to 2009 the PCE “grew by an average annual rate of 3.4%” according to the Bureau of Economic Analysis[iv]. What category is most directly responsible for this rise? “A large increase in the share of PCE accounted for by services, particularly by health care,” according to the same report. This growth puts unseen pressure on the longevity of retirement savings during a time when one can expect health care needs to increase.
You'll Retire, Risk Won't
The game of managing risk is simpler in one's prime earning years. Why? You have a wide margin of error. Market downturns are recoverable over the long-term. This margin narrows as you near retirement. As discussed earlier, it becomes difficult to recover when the timeline shortens.
Simultaneously, when withdrawals occur the asset allocation balance changes. This dynamic illustrates why a retirement withdrawal strategy goes beyond choosing which account to draw from first. Retirees must also consider how asset allocations will change. If the optimal account to draw from first consists primarily of your bond holdings, then you may become over weighted in equities. This loss must have been a painful lesson for retired equity holders during the recession when the DJIA lost 54% between early October of 2007 and March of 2009. Diligent rebalancing helps with this but you must actively do it.
Such an ugly equities picture means opting for more bonds, right? Wrong. As we noted in a previous post, 2013 was a trying year for some bondholders. The 10-Year Treasury rate increased significantly ending the year at 3.01%. This rise hammered Vanguard’s Extended Duration Treasury Bond ETF (EDV). By the end of the year, the fund lost 21.66 percent. Inflation risk can be more daunting than most expect. Today, we’re seeing plenty of signs or rising inflation which only serves to reiterate the risks. <see: The Definitive Guide to Using Bonds in your Portfolio>
There's no perfect balance for all retirees. The important takeaway is to acknowledge this layer of complexity. Your plan must account for the intersection of risk tolerance both emotionally and concerning your solvency.
The Choice You Cannot Make
In a process fraught with choice it might be something of a relief to know that some decisions will be made for you. That is, at the age of 70 ½ you’ll face required minimum distributions (RMD) from tax-deferred retirement savings accounts. This inevitability must be included in your plan. RMDs must be calculated separately if you have numerous retirement accounts. Given the IRS penalty of 50%, you'll want to keep this parameter in mind when running the numbers.
While the required minimum is law, there are different ways to execute the provision. Some opt to use IRA funds to purchase an annuity. This strategy prevents the risk of outlasting your savings while also satisfying the RMD. However, due to the costs involved, this is rarely the best choice. Others go with an annual recalculation based on life expectancy. This choice means your RMD will be recalculated each year as you live out your retirement. Whichever way you go, remain cognizant of the fact that you’re operating in a rigid framework when it comes to RMDs.
A Dynamic Solution is Optimal
There is no way for me to give you an easy solution in the breadth of an article like this. However, if you are going to explore this alone, the biggest consideration is your tax brackets. This will guide how and when to withdraw your funds. The goal is to minimize taxes paid over the life of your plan. You can do this by picking and choosing from which accounts to draw your funds, converting and re-characterizing at opportune times, and being mindful of future key dates such as social security, pensions, and RMD’s, etc. An example would be to withdraw from your 401(k) until, let’s say, the 25% tax bracket. From their withdrawing the rest of your funds needed from your Roth IRA tax free. This is one of the simplest examples I can give which illustrates the point that using a “rule of thumb” is never the best strategy.
When planning for retirement make sure to account for a withdrawal plan. The difference between a smart strategy and a careless one can easily be hundreds of thousands of dollars. Consult a professional who can guide you through the challenges of Roth conversions, minimum distributions and tiered withdraws.
As the months wore on the stranded McCunn ran low on provisions. Colder weather crept in and soon there was nothing left. He began to starve. Exercise careful planning to ensure there will be plenty to sustain you through the golden years.
[i] Kaniut, Larry. Danger Stalks The Land: Alaskan Tales of Death and Survival. Macmillan, 1999.
[ii] Miller, Mark. Solving The Retirement Withdraw Equation. WealthManagement.com. June 14, 2016.
[iii] Increased Correlation: A Challenge to Diversification. BlackRock.