By Michael Hathaway, CFP®, CFA®, AIF®
A lot of people used to think that 4% was a safe withdrawal rate. If you only withdrew 4% of your retirement savings a year, it would be enough to last at least 30 years. This meant that if you needed $120,000 a year to live comfortably in retirement, you could save up $3 million and be set for life.
But unfortunately, figuring out how to fund your retirement isn’t this cut-and-dried. It’s not a straight line formula. Your personality, goals, financial situation, and risk levels are unique, so your retirement income plan needs to fit you and your life. Here’s how we approach this vital aspect of retirement planning.
Accumulation vs. Decumulation
Investing strategies during the working years have been discussed exhaustively in financial media and publications. Generally, we invest for the greatest total return consistent with our risk capacity and risk tolerance. Many in the world of the financial press and practitioners have labeled this time the “accumulation” period, for which a risk-based approach is appropriate. However, as we approach and begin retirement, our objectives change. We must now replace our lost paychecks and generate “income” (really cash flow) to fund our expenses in retirement. There are several different categories of retirement expenses that need to be funded:
- Essential spending: Keeps us sheltered, clothed, and fed
- Lifestyle spending: Discretionary spending, based on our unique interests and activities
- Shock spending: Liquidity needed for unexpected needs, often large and/or extended spending, such as health events, home repairs, and others
In addition to the above categories of spending, additional concerns that retirees face with respect to using their finite resources are:
- Longevity: How long will we live, and how long will our resources need to last?
- Legacy: How much, if any, do we want to give to our next-generation heirs and/or to causes that are important to us, either while alive or after through our estate?
I have read through many articles in the financial world on this topic and seen many more. They all describe strategies and approaches to providing funding for our spending in retirement. They have titles like “Why the 4% Rule is Dead,” “Dynamic Withdrawal Strategies in Retirement,” or “Bucket Strategies for Retirement.” They all try to help “solve” the retirement expense funding problem. But they all start from the basic premise of a “fully invested” retirement portfolio. And while they present various approaches to investing (e.g., income investing), they really just offer different methods for accessing or receiving cash flows from fully invested portfolios.
I want to “widen the lens” and look at truly different approaches to funding spending in retirement, including a new method that can help determine which approach might work best and be most congruent for each of us. In this article, I will generalize and treat all approaches that fund retirement spending using fully invested portfolios as “total return” approaches.
Can I Afford to Retire Yet?
Before addressing the main thread of this article, I first want to address another set of retirement articles that revolve around the question of retirement readiness. Specifically, some articles ask whether there is a “magic number” (i.e., an amount of assets that an investor needs to be ready to retire). First, I will say that I think the answer is no—a single number is too simplistic to address the above spending needs and concerns. Second, if you have a sizable enough nest egg that you can easily address all of the above needs and concerns, then you have enough. But most of the people asking for a magic number aren’t in that position.
My best answer is, yes, there is a minimum amount of assets that you need before you should even consider voluntary retirement. Unfortunately, it involves complex calculations and analysis, which I am planning to describe in a future article. For now, suffice it to say that I think a pre-retiree should have a “funded ratio” (which includes assets as well as retirement income sources, such as Social Security, pensions, and annuities) of greater than 100% for at least all their essential spending needs and a significant portion of their lifestyle spending needs (those that can be reduced if available funding requires it). Finally, an additional buffer of separate rainy-day or emergency funds should be available for shock spending needs.
A New Approach
Separate from the discussion of when you can retire is the discussion around strategies and methods for using retirement assets to fund retirement spending, or what is known as investing for the “decumulation” period. In his newest book, Retirement Planning Guidebook, (1) researcher Wade Pfau describes the Retirement Income Style Awareness (RISATM) Profile, (2) that he and his research partner, Alex Murguia, developed to describe an individual investor’s preferences for funding their essential spending needs in retirement.
Here’s my overview of the different profiles identified in the RISATM approach, and what they might mean for investors as they approach retirement. The RISATM Profile effectively replaces the Risk Tolerance Questionnaire (RTQ), which is traditionally used by financial advisors to design investment portfolios during the accumulation phase. Instead, the RISATM Profile is a robust analysis that identifies an individual investor’s retirement income style, or preferences, based on responses to a series of questions. The RISATM Profile is therefore a more appropriate tool for guiding investors as they enter the “decumulation” phase.
Preferences in the RISATM Profile are measured across two dimensions:
- Probability-based vs. safety-first
- Optionality orientation vs. commitment orientation
Combining these two dimensions yields four different primary styles based on individual preferences:
- An individual who prefers probability-based approaches and has an optionality orientation will likely prefer a total return approach to fund essential spending in retirement, along with any guaranteed income sources available such as Social Security, a pension, or an annuity already in place. In the total return approach, some portion of the volatile portfolio is sold each period to fund essential spending needs in the short term, regardless of recent performance. The total return approach is the default for many investment advisors and is the subject of many published articles. In general, this approach has the greatest upside (and downside) potential. The total return approach is the default for many investment advisors and is the subject of many published articles. In general, this approach has the greatest upside (and downside) potential.
- An individual who prefers safety-first approaches and has a commitment orientation will likely prefer an income floor approach to fund essential spending in retirement, along with any guaranteed income sources available such as Social Security, a pension, or an annuity already in place. An income floor is built using guaranteed income solutions, such as annuitizing a portion of their assets (fixed or fixed index, immediate or deferred) to “lock in” the funding for their essential spending. A benefit of annuitization is that the income that is “locked in” is generally guaranteed for the remainder of the retiree’s lifetime. Together, the total return approach and the income floor approach are the most popular. Each is found in approximately 35% of the RISATM questionnaires administered to date.
- An individual who prefers probability-based approaches and has a commitment orientation will prefer a Risk-Wrap approach to fund essential spending in retirement, along with any guaranteed income sources available such as Social Security, a pension, or an annuity already in place. The Risk-Wrap approach is built using annuities with variable investment accounts, such as variable annuities or registered index-linked annuities (RILAs), so that the retiree can benefit from probability-based (or market-based) returns while retaining the right to generate lifetime income with a guaranteed lifetime income rider or through annuitization.
- An individual who prefers safety-first approaches and has an optionality orientation will prefer a time segmentation approach to fund essential spending in retirement, along with any guaranteed income sources available such as Social Security, a pension, or an annuity already in place. The time segmentation approach is traditionally built using “buckets” of investments, each designed for a different time segment: shorter (nearer) time periods would involve the least risk (or price volatility) and the greatest liquidity; middle time periods would involve moderate levels of risk and liquidity (and maybe some inflation protection); and the longer time periods would carry the greatest levels of risk and have the lowest liquidity. This longer-term “bucket” could also be implemented using a total return portfolio, designed to outpace inflation over time. Together, the Risk-Wrap approach and the time segmentation approach have been equally popular. Each is found in approximately 15% of the RISATM questionnaires administered to date.
Once an investor has identified her retirement income style, specific implementation strategies can be discussed and put into place, either alone or with an advisor. Many financial advisors have their own biases and preferences (sometimes based on incentives), and/or restrictions and limitations (from their firms and/or by licensure). Individuals and couples should ensure that their unique retirement income styles and preferences are included in any investment plan developed in partnership with a financial advisor. Fiduciary fee-only advisors who have the right tools and who take the time to help clients understand their personal retirement income styles are better prepared to assist clients in designing appropriate retirement income strategies to provide the funding for their various spending needs in retirement.
At Epsilon Financial Group, we use the RISATM Profiles to provide planning, analysis, coaching, and portfolio investment services that help our clients generate retirement income consistent with their unique preferences. We believe the RISATM Profile is a powerful new tool for helping uncover the approach that works best for each client.
If you would like to see how it works and how it can help you create a customized retirement income plan, reach out to us at Mike@wealthmatters.com or (707) 428-5500 to take the RISATM Profile questionnaire for yourself and discuss the results with us at no cost and with no obligation.
Michael Hathaway is a fiduciary financial advisor at Epsilon Financial Group, Inc., an independent, fee-only wealth management firm. Mike has worked in the finance industry for more than 20 years and brings a wealth of knowledge and experience in sophisticated financial planning to help his clients make sound financial decisions. He is known for caring deeply for his clients’ well-being, being compassionate, and thinking creatively to help clients attain their financial goals. He prioritizes building long-term relationships and takes the time to listen, understand, and explain so that his clients feel confident in their financial plan. Mike is a CERTIFIED FINANCIAL PLANNERTM, Chartered Financial Analyst® (CFA®), and Accredited Investment Fiduciary® (AIF®) professional; he has a bachelor’s degree in cybernetics from UCLA and an MBA in finance and accounting from the University of Virginia. When he’s not working at Epsilon, you can find Mike enjoying anything related to exercise and fitness. He especially loves activities in the great outdoors, such as mountain biking, camping, hiking, and snowshoeing. In the fall of 2016, Mike successfully climbed to the top of Mount Whitney in a single day, the highest peak in the continental United States. To learn more about Mike, connect with him on LinkedIn.
(1) Pfau, W. D. (2021). Retirement planning guidebook: Navigating the important decisions for retirement success. Retirement Researcher.