Author: lvc-admin

Those who retire with investment assets, as opposed to living solely on Social Security and/or pension benefits, face two choices: 1) invest for income, thereby maintaining the portfolio’s principal; or 2) invest for total return, which involves dipping into the capital base as required. As the former strategy has drawbacks even under the best of circumstances, researchers typically study the latter.

This column follows suit. Recently, I built a model that evaluates income-withdrawal outcomes for retirees. Input: 1) expected portfolio returns, 2) expected portfolio standard deviations, 3) expected inflation levels, 4) the required time horizon, 5) a withdrawal rule, and 6) the desired probability of success, and the model calculates the highest acceptable withdrawal rate.

For this column, I created an initial case, which is not particularly helpful in isolation, because its assumptions will be incorrect (if I knew how investments would perform over the next three decades, Morningstar’s CEO would report to me). However, it is useful for analyzing changes. If altering a number doesn’t much affect the outcome, then that factor isn’t terribly important. If, on the other hand, the estimate greatly increases (or declines), then the item merits attention.

The assumptions are: 1) 7% annual return (returns are arithmetic nominal, and the investor is assumed to hold very low-cost index funds); 2) 8% annual standard deviation; 3) 3% annual inflation; 4) a 30-year time horizon; 5) withdrawals automatically adjusted for the growth of inflation, such that they remain constant in real terms; and 6) a 90% probability of success for the model’s simulations. That is, the scheduled amount can be withdrawn for the full 30 years in at least 900 of the 1,000 trials. Each year’s portfolio return is generated randomly, using the specified inputs and assuming a normal distribution.

The Performance Test

This calculation produces an initial withdrawal rate of 4.0%. Thus, for a $500,000 portfolio, the retiree could withdraw $20,000 at the beginning of Year 1. The next year, she could spend $20,600–the original amount plus a 3% upwards adjustment, to account for inflation. Again, what matters is not that the forecast is 4.0%, but instead what happens to that number as we tinker with the assumptions.

First, let’s see how the withdrawal rate improves with portfolio performance. The ability to affect investment results does not necessarily lie within retirees’ hands, but it’s instructive to understand their magnitude, because they almost certainly will occur, albeit involuntarily. After all, the financial markets will not duplicate anybody’s precise expectations.

If the portfolio achieves both goals by posting modestly higher gains, along with dampened volatility, our hypothetical investor can withdraw a constant 4.5% in real terms, meaning $22,500 out of the gate, as opposed to the previous rate of 4.0%, or $20,000. That’s a significant uptick in spending power. Regrettably, regardless of the investor’s savvy, the markets could behave otherwise, thereby lowering her withdrawal rate. Performance is a potent tool, but it cuts both ways, and is difficult to predict.

Working Longer

Investors are likely to have more control over when they retire than over their investment results. Therefore, a more-reliable path for elevating one’s retirement withdrawal amount is to work longer. Doing so confers two advantages. First, the investor has that much longer to grow her portfolio. Second, the expected retirement horizon becomes that much shorter, which increases the likelihood that the portfolio will be able to fund its obligation.

The outcome roughly matches that from the previous exercise. Applying one of the factors boosts the acceptable withdrawal rate from 4.0% to 4.5%. Adding the second factor provides further gain. Working longer is not permitted by every employer, and involves considerably more effort than conjuring better investment performance, but it nevertheless offers a meaningful benefit.

The Practical Solution

But … there is a third path, one that has quietly been adopted by most retirees: Concede some ground to inflation. States Morningstar’s David Blanchett, who has extensively studied the topic, “Retirees don’t tend to increase spending/consumption throughout retirement by the full amount of inflation. It declines between 1% and 2% per year in real terms throughout retirement.”

In other words, although researchers invariably build models that assume that retirees will maintain constant inflation-adjusted withdrawal rates, retirees are not so doctrinaire. Presumably, most realize that if they don’t increase their spending at the full rate of inflation, they will effectively reduce their income. Big deal. The decline occurs gradually, and usually the forgone income is not missed, because as time passes, the retirees usually has less need for income anyway.

And the effect is substantial

Permitting inflation to grow at 1 percentage point per year faster than consumption raises the model’s estimated withdrawal rate from 4% to 4.6%. Doubling the deficit hikes the model’s estimate to a robust 5.1%. Of course, adopting that approach doesn’t provide something for nothing. Although the erosion in purchasing power is at first imperceptible, after several years it becomes noticeable. Then again, the increase in the initial withdrawal rate is also perceptible. Forgo something later, receive more today.

Retirement-income projections typically incorporate a string of conservative assumptions. Never cut spending in response to market results. Seek a very high probability of success. Always raise spending by the full amount of inflation. Such prescriptions are fine for those who can afford them. Most retirees, though, will require more bang for their bucks, by stretching the researchers’ rules. Instinctively, it seems, retirees have recognized their need–and have made the sound decision to address it by refusing to keep entirely apace with inflation.

General Advice Warning

Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.

Assuming a 30-year horizon, there have been three retiree groups during the past 90 years–those who started their retirements in 1930, 1960, and 1990, respectively. Each fared better than its predecessor. Those who retired in 1960 were able to outspend those from 1930. One generation later, retirees from 1990 placed comfortably ahead of 1960’s cohort. The evidence for this assertion appears below. I constructed a model that calculated the highest acceptable withdrawal rate that each generation’s retirees could have achieved from their portfolios, with a 90%-plus success rate, assuming 1) they invested half their assets in stocks and half in bonds; 2) their annual withdrawals grew by the rate of inflation (unless the previous year’s portfolio return was negative, in which case they temporarily reduced their spending), and 3) they sought 30 years’ worth of income.

(These results differ from those in Bill Bengen’s landmark 1994 paper, which reported that retirees could have always managed a 4% withdrawal rate. The difference occurs because Bengen evaluated actual market history, whereas my study adopts the newer approach of creating simulations based on said history, which greatly increases the test’s sample size. No worries. What matters for this discussion is not the size of the estimate, but rather how it changes over time.

Another take on the topic arrived much more recently, from Morningstar’s Amy Arnott. Her analysis takes a different approach, while using a different model, but it is nevertheless complementary.)

A Surprising Result

That the class of 1930 fared worst comes as no shock. After all, its members retired five months into the Great Depression. However, while one might think that the group’s main problem was lower equity returns, such was not the case. Quite the contrary. Real equity returns for 1930’s retirees were the best among the three generations.

At first, this seems scarcely credible. After all, the S&P 500 dropped 25% in 1930, 43% the following year, and another 35% in 1937. Then it suffered consecutive annual losses from 1939 through 1941. How could the index’s 30-year gains have been stronger while enduring the Great Depression than during its most recent stretch, which included the longest stock bull market in U.S. history, from 2009 through early 2020, and the second-longest, which occurred during the 1990s?

The answer is twofold. First, although equity performances during the ’30s were indeed dismal, they were outstanding from 1942 through the late 1950s (and indeed, well into the 1960s). Second, those Great Depression results weren’t quite as bad as they looked, as their real returns were buoyed by deflation.

Good News #1: A Gentler Ride

What harmed the Great Depression’s retirees was not the level of stock returns, but instead the damage caused by those returns’ volatility. An average annualized real profit of 8.7% is excellent. However, if those gains arrive very unevenly, then their rewards may be nullified by bad timing, when retirees are forced to remove assets from a severely diminished portfolio. Such actions increase the chance that the portfolio will become depleted before meeting its investment goals. That possibility certainly threatened 1930’s retirees. Once the United States entered World War II, though, the stock market became much less turbulent. The following graph depicts the annualized standard deviations for U.S. equities during each of the three 30-year periods. Starting in about 1940, stock returns abruptly became much calmer. With only brief disruptions, they have remained so ever since.

Besides benefiting from lower stock volatility, the class of 1960 received somewhat higher real bond returns, thanks to the bond bull market of the 1980s. Those two factors combined to boost the group’s acceptable withdrawal rate from 3.6% to 4.0%. Otherwise, the portfolios did not outperform those of their parents. Their stocks gained less, their bonds were more volatile, and inflation rose, the latter of which increased their required withdrawal amounts.

Good News #2: Better Bonds

The class of 1990 looked unlikely to outdo its forebears. Although inflation had subsided, it still hovered in a range of 3% to 4%, which was well above what the Great Depression’s retirees had experienced. Nor did the benefits of higher stock market returns and/or lower volatility appear probable. Equities had already performed very well since 1940; asking more from them seemed unrealistic. Such analysis was mostly correct. Although real equity returns did improve somewhat during the next 30 years, and stock and bond volatilities slightly decreased, such effects were modest. The extraordinary success enjoyed by 1990’s retirees owed to a different reason: By the end of the period, inflation had virtually disappeared, which led bonds to post unprecedentedly high real returns.

Good News #3?

The conditions that held from 1990 through 2019 may not have represented the best of all possible worlds for retirement investors, but they surely shared the same solar system. Stock returns remained healthy, both because the economic booms were long and the busts short, and because lower inflation made equities that much more attractive. Meanwhile, bonds also performed well. During those 30 years, the 50/50 portfolio returned almost 9% per year, while annual inflation averaged less than 2%. Talk about the Golden Years! Given that almost all forecasts from 1990 overstated the problems facing that era’s retirees, I hesitate to predict failure for the class of 2020. Almost certainly, today’s newly minted retirees will not receive such high bond returns. (For that happy event to occur, fixed-income yields would need to rise substantially, even as inflation remained relatively calm.) But it’s possible that equity returns could nudge even higher, with volatility receding even further.

That, however, is not the way to bet. The investment markets have twice been generous to incoming retirees, first by sharply reducing stock market volatility, and then by fattening the returns of their fixed-income holdings. The third time is unlikely to be a charm.

General Advice Warning

Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.

Choice #1: Buy Treasuries

Traditionally, retirees sought the safety of Treasury securities. Although unsophisticated, this was a reasonably sound strategy. Treasuries paid handsomely–well above what stocks delivered–while being guaranteed by the U.S. government. Retirees who held Treasuries until their bonds and notes matured faced no principal risk and thus possessed few worries.  With that approach, the real value of a retiree’s capital eroded. Fortunately, inflation’s effect was less damaging than advertised because, for most retirees, the longer their retirement, the less they spent. True, sometimes this decline occurred by necessity, as reduced purchasing power crimped their spending habits, but for the most part it happened naturally due to health concerns. 

Regrettably, time has ravaged the Treasury strategy. Had couples through time placed $800,000 into 10-year Treasury notes, those who retired in January 1970, 1980, 1990, and 2000 would have generated hefty monthly incomes of $5,240, $7,333, $5,327, and $4,527, respectively. In contrast, today’s couple would earn a mere $1,113. The price for investment safety has become exorbitantly high.

Choice #2: Boost Income

Unlike in the past, retirees cannot simultaneously: 1) generate substantial income, 2) without touching their capital base, 3) while receiving a government guarantee. However, they may still achieve those first two goals, should they jettison the third. That is, retirees can buy investments that generate sufficient yield so that they need not supplement their income by dipping into their investment capital.

For example, our couple could buy a portfolio consisting of the following exchange-traded funds, which would collectively yield 4.17%. The monthly income on the $800,000 investment would be $2,780–far below what 10-year Treasuries paid during bond investors’ glory days but more than double Treasuries’ current level.

The danger with this approach is that although the portfolio ostensibly is diversified, holding both stocks and bonds, almost all the holdings are economically sensitive. Of course, my investment suggestions could readily be altered, but the conclusion would remain intact. Particularly now, with inflation fears abated, so that long investment-grade bonds no longer pay very much, there’s no real way to achieve high yields without courting recession risk. For that reason, “spend income and maintain capital” strategies are quietly hazardous. Unless the retiree is willing to slash the portfolio’s income by seeking proper diversification, such approaches tend to get clocked by economic slowdowns. Sometimes the losses are merely temporary, but on other occasions they are permanent, caused by corporate bankruptcies. That’s a tough way to live.

Choice #3: Spend Capital

A more prudent path is to accept lower portfolio income, then supplement those receipts by gradually removing investment capital. Psychologically, this tactic can be difficult. As financial advisor and author Michael Kitces explains, those who spend their working years increasing their assets tend to dislike doing the opposite. Growing one’s wealth is enjoyable; shrinking it, not so much.

Investing 50% in a broad U.S. stock market index and 50% in high-grade bonds makes for a 1.5% overall yield, which means that, to match the payout from the income portfolio, our couple would need to spend 2.67% of their capital during their first year of retirement. As U.S. stocks over the past century have posted annual price gains of slightly more than twice that amount, growth from the 50% of portfolio held in stocks would more than compensate for the lost principal. On average, our couple will fare just fine.

In practice, though, the financial markets fluctuate. Consequently, the “spend capital” tactic must be flexibly implemented. Those who adopt this approach will need to reduce their withdrawals after equity prices have fallen significantly, thereby avoiding the vicious cycle of raiding a declining asset base. With luck, lost ground will be recouped later. But unlike with the strategy of owning Treasuries, there are no guarantees.

Choice #4: Annuitize

Another possibility for those willing to part with their capital is to annuitize by buying a contract that promises future payments. While such investments come with a cost–just because they lack official expense ratios doesn’t mean that the insurer provides its services for free–they boast the benefit of pooled resources. A group of people can insure themselves more efficiently than can an individual.

There are several ways to use annuities. One is to buy an immediate lifetime annuity. Currently, a 65-year-old couple can earn about 4.8% annually on a joint lifetime annuity, to be paid until both parties have died. If our couple were to place $650,000 into that joint annuity and the remainder into equities, they would match the income portfolio’s yield, while retaining $150,000 that could be used for portfolio growth.

Conversely, the couple could buy a deferred annuity. The purchase occurs today, but the benefit is paid in the future. For example, the couple could devote $300,000 of the portfolio toward a joint deferred annuity that would pay $3,000 per month, starting at age 80. That would cut their current portfolio to $500,000 from $800,000, but that half million would only need to last for 15 years because, after that date, the deferred annuity would fully meet their needs.

Annuitizing is even harder psychologically than dipping into capital because the retiree forgoes a bigger chunk of money when annuitizing, which will never return. Also, the decision to annuitize can be complex, given how many options exist. For these reasons, the tactic isn’t very popular. However, it is worth considering. There is an advantage to locking down income, thereby freeing the remaining assets so that they can be invested for capital appreciation.

Wrapping Up

By design, this column surveys the topic of retirement income from the stratosphere. It will surprise nobody who works in the field. However, from my experience, workers who haven’t yet thought about how to convert their investment assets into income during retirement often struggle to find articles that lay the groundwork. This one makes that attempt.

General Advice Warning

Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.

Admittedly, the 401(k) network is incomplete; being unavailable to one third of private-sector workers, but 401(k) access could readily become universal by modifying the regulations.

The beauty of the retirement-accumulation approach is its simplicity. When 401(k) plans feature automated enrollment, employees succeed by doing nothing. Both their projected Social Security payments and the value of their 401(k) accounts quietly increase, with the latter typically invested in a highly diversified target-date fund that requires little investor attention. The machine runs itself.

Not so when retirement arrives. The Social Security benefit is straightforward, aside from the choice of when to begin, but converting lump sums into income is devilishly complex. Use the assets to buy an immediate annuity, thereby avoiding investment decisions? Spend some of the monies on a deferred annuity, for longevity protection, while keeping the rest invested? Skip annuities altogether?

With the investments themselves, preserve capital while spending its income? Adopt a total-return approach that involves regularly drawing down capital? If so, how much capital, what should be the asset allocation, and how flexible should be the withdrawal rates, should the markets perform poorly? Place the assets in a single portfolio, or separate them into several buckets, each of which is designed to meet a different investor need?

The Happy Few

Financial advisors answer those questions. They are paid to tailor solutions that reflect each retiree’s preference. For example, while some investors cherish the security provided by annuities, others shun them, because buying annuities means losing control of those assets. Experienced advisors recognize the differences among their clients, making their recommendations accordingly.

Regrettably, such advisors cannot serve the masses. Their services require time and expertise and thus are too costly for smaller accounts. Michael Kitcesrelays the story of a financial planner who explained his occupation to a Philippine citizen. The response: “Wow, you folks have so much money that you can hire somebody to tell you what to do with it.” Exactly. Traditional financial advice suits the relatively wealthy, but it fails everyday retirees.

Potential Solutions

In response to this need, the marketplace has developed two innovations: 1) digital advice, and 2) new retirement-income products. A third possibility is to extend the 401(k) framework so that it covers employees from job to grave.

1) Digital Advice

This approach has made the largest inroads. Delivering retirement-income counsel electronically (or by telephone) is an inevitable outcome of the technology revolution. No longer must financial experts hold individual meetings, dispensing their knowledge one client at a time. Instead, they can build systems to clone their insights, thereby serving more investors at a lower cost.

Various parties have made the attempt, including traditional advisory firms, discount brokers, and venture-capital upstarts. Adoption has been moderate. An October 2020 list of digital-advice providers (which admittedly, omits the efforts of the traditional advisory firms) estimates the industry size at $320 billion–about 0.3% of the value of U.S. stocks and bonds. Of that figure, more than half comes from Vanguard’s program, which was seeded by existing Vanguard assets. While it’s too early to conclude that digital advice will not become the mass solution, there are concerns. The major hurdle is that it requires investor activity. Even at its most streamlined, digital advice demands participation from its customers. As the 401(k) industry has shown, many workers dislike confronting their retirement realities. They will go to great lengths to avoid such experiences.

2) New Retirement-Income Products

I had high hopes for these. In 2007, Fidelity introduced a mutual fund series called Income Replacement. The following year, Vanguard and Schwab launched Managed Payout and Monthly Income funds. The names differed, but the goals were identical: Provide single-fund solutions that delivered income for retirees who possessed investments with the aim of supplementing their Social Security and/or pension benefits but who lacked sufficient assets to hire financial advisors.

The sponsoring fund companies were the right organizations, being industry leaders. Unfortunately, the time was very much wrong. As anybody who has studied retirement withdrawal rates can attest, the worst outcomes occur when stocks crash at the beginning of the withdrawal period. That is what happened, in a big way through the 2008 financial crisis, and the funds never recovered. Eventually, Fidelity and Vanguard merged their offerings. The Schwab funds remain alive but just barely, commanding a piddling $250 million.

I still like the idea. Such funds permit retirees to pool their resources, while also permitting them to redeem their shares on command. Unlike with annuities, the purchase decision is not final; the investor continues to own those assets. And unlike with digital advice, the process is exceedingly simple. Buy the fund, spend the income distributions, and forget about the rest.

However, if such funds ever do find favor, it will not be anytime soon. That three behemoths couldn’t sell the concept has understandably frightened others from launching such funds. It will take a while for the memory of that marketing failure to fade.

3) Extending 401(k)s

The most logical scheme is to expand the scope of 401(k) plans. Rather than assume that retirees will shift their workplace assets into individual retirement accounts, enhance the 401(k) structure so that it becomes the best solution for most retirees. Of course, those with greater wealth may decide to leave the system to receive customized advice, but rank-and-file employees will stay put.

This could be accomplished by defaulting retirees into investments that are more standardized and better defined than today’s “retirement income” funds, which vary widely and are not well understood by their shareholders. For example, one could default new retirees into structured products that protect against significant capital losses, while paying a competitive interest rate (such a combination is possible, if the investor foregoes stock market gains).

Over time, as the retiree better understands her financial situation, she could select other options, such as annuitizing a portion of the assets or buying a conservative allocation fund that would increase market risk but also improve the chances for capital appreciation. But that could come later. On the retirement date, the process would be automated unless the investor chose otherwise.

Summary

With retirement accumulation, businesses were given an inch of daylight through Section 401(k) of the IRS Tax Code. They seized the opportunity. The same can and should occur with retirement income. The need exists. What remains is for market ingenuity to align with investor demand. Regrettably, that has not yet occurred with mainstream retirement-income services     

General Advice Warning

Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.

If they take out too much, they risk running out of assets later in life, especially if they’re fortunate enough to enjoy a long lifespan. If they take out too little, they might miss out on some of the fruits of a lifetime of savings, such as travel, dining out, giving money to charity or family members, or spending more on leisure activities. Pinning down a number that’s neither too high nor too low is notoriously difficult, and the stakes are high.

Even retirement experts often disagree on the right number for retirement withdrawals. The 4% rule—which assumes that retirees set an initial withdrawal rate equivalent to 4% of the starting portfolio value and adjust the previous year’s withdrawal amount each year for inflation—has been widely adopted by financial advisors and individual investors. But there has also been debate about whether withdrawals should ratchet down (to account for lower market returns) or up (to account for lower inflation), as well as the need for more flexible systems that don’t assume a fixed withdrawal rate.

In this article, I’ll dig into the key assumptions behind the different estimates and what they mean for retirees. Assuming that future market returns are lower than in the past, an initial withdrawal rate closer to 3.5% looks like a reasonable starting point.

The Origins of the 4% Rule

Financial planner Bill Bengen’s landmark study was notable because it stress tested withdrawal rates based on return patterns over actual historical periods instead of relying on average returns over time.1 He examined each 30-year period with starting dates from 1926 through 1976, adjusting withdrawals for each year’s actual inflation rate. Based on this data set, he concluded that for a portfolio combining 50% stocks and 50% bonds, a 4% withdrawal rate never fully depleted the portfolio’s value, even during some of the worst periods, such as 1928 through 1957 and the 1973–74 bear market.

However, some observers argued that because it’s based on testing worst-case scenarios, the 4% rule could be considered overly conservative. Financial planner Michael Kitces looked at historical returns going back to 1871 and concluded that while a 4% withdrawal rate worked for a 60/40 portfolio in every scenario, actual sustainable withdrawal rates varied significantly (from 4% to 10%, with a median of about 6.5%) over different 30-year periods.2 As a result, retirees relying on the 4% rule would have often ended up with large remaining portfolio balances at the end of retirement.

Similarly, Cornerstone Wealth Advisors’ Jonathan Guyton argued that a 65% equity weighting combined with a more dynamic withdrawal strategy could produce safe withdrawal rates as high as 5.8% to 6.2%.

General Advice Warning

Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.

However, most investors may not have access to dedicated, or intentional, sustainable investment products owing to their general absence from 401(k) plans. In our research, we find that investors may still have a route to expressing their environmental, social, and governance preferences by taking advantage of their voting power regarding shareholder resolutions. Proxy voting, an often-unrecognized channel through which ESG concerns can be expressed, can be seen as the sleeping giant of ESG-oriented investing.

Building on previous Morningstar research into the sustainable investing options available in defined-contribution plans, we examine whether proxy voting on ESG issues is something that plan participants care about, and to what extent the most popular mutual funds offered via 401(k) plans support ESG resolutions in their proxy voting. We also discuss how proxy voting could extend plan participants’ influence on ESG investing.

 Key Takeaways

× Sixty-one percent of individuals surveyed felt that ESG issues should be addressed in their funds’ proxy voting, and a little more than 50% would consider a fund’s proxy voting record in making fund choices.

× Funds with the most 401(k) assets regularly vote against key ESG resolutions and tend to follow the voting strategy set at the asset manager level.

× A few asset managers dominate the 401(k) fund space, which limits the degree to which plan participants can choose funds to align with their voting preferences.

× Regulatory and market initiatives could raise the profile of fund ESG proxy voting, which may introduce greater choice for ESG preference alignment in fund selection at the individual and plan level.

General Advice Warning

Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.