Cash flow in retirement can be confusing. There is the question of where to get the money. Should it come from your IRA? How about your nonqualified investments? What if you have pension income? How much should you factor in social security?
Maybe you’ve heard of the 4% rule, which states that you can take 4% of your investment portfolio each year and you “should” never run out of money. Some have said you can even take more than 4%, and still others could argue that you should take less.
At Foster Group, we get into the detail of what your spending goals and objectives are and then review that over a long period of time. We come at it from the angle of how much do you need or want, rather than how much you should or shouldn’t take. Also, we adjust for inflation and some assumed investment portfolio growth.
But what if that assumed growth is close on average, but the investment return comes at different times? Your portfolio might average 6% over a long period of time, but it doesn’t return those numbers year in and year out. There always have been negative return years, so what happens to a portfolio in the long run if you are withdrawing when it’s down 20%? These are the concerns retirees often face. We want to be able to give our client’s peace of mind and at the same time give them a realistic long-term picture.
One of the biggest concerns financial advisors pay attention to is called the sequence of return risk. It’s basically the idea of compounding interest, but it’s happening in the opposite direction. Imagine if you had a $1,000,000 investment portfolio and you took out $50,000 every year. If you could average 6% in the long run, one would think that you would never run out of money. But when you factor in the investment return pattern, you could be very wrong. What if the investment return was low the first 10 years? Maybe it averaged 6% over 30 years, but the first 10 years it was only at a 3% average? Keep in mind you were still withdrawing $50,000 each year. By year 11 when the investment return started coming around, you had a lot less money for the investment return to compound than you did in year one. This is the big idea behind sequence of return risk. It’s great that you might still average a 6% return in the long run. But if you have less money for the return to compound on, then you have the risk of running out of money.
Another variable in the sequence of return risk is inflation. What if you need $50,000 in year one for living expenses but due to inflation, you need $60,000 in year 4 or 5? This is real life. Not everything goes up with inflation, but most will agree that we are paying more for goods and services than we were 20 years ago. A “real rate of return” factors in inflation. When we look at a client’s individual situation, we always are looking at the inflation-adjusted spending withdrawals in correlation to the investment portfolio and assumed growth over time. Even more fascinating, we can run Monte Carlo simulations to illustrate the sequence of return risk of your portfolio to identify the probability of success: not running out of money, for instance. This has been an excellent guide for clients when making decisions, like when to retire, what pension option to take, when to turn on social security income, when to sell a business, etc.
So, what if you retire, start taking withdrawals and the next decade of investment return is “lost”? Well, it has happened before, so it certainly could happen again. As financial planners, we prepare for these types of scenarios to give you the highest probability of success. Note that I didn’t say we try to give you the highest investment return. We want to do that too, but not at the expense of running you out of money. We prepare by controlling the controllable and embracing the fact that the future is uncertain. The investment portfolio, itself, will be highly diversified. This gives us the flexibility to decide where to take portfolio withdrawals when and we don’t know which investment asset class will be the winner or loser this year or next. We build a buffer, called your “lifeboat”, which acts as insurance during negative investment markets so we aren’t forced to sell growth-oriented investments while they are down. We ensure that your investment allocation is appropriate, and we do this by understanding your actual cash flow needs now and in the future. We regularly check-in to see if the withdrawal rates are reasonable and can withstand various risks, such as sequence of return, inflation, and markets.
When you were working it was easy. Money came in and you spent some and saved some. In retirement, cash flow is completely different and might seem confusing at first. Just know that at Foster Group, our job is to understand the details and help navigate all these decisions so that you can get on with living a meaningful and generous life.
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