One of the most common questions financial planners hear from clients, especially those nearing retirement, is, “How can I be sure I have enough to live on for the rest of my life?”
Conservative advisors usually tell clients they can take out 3% to 5% of the income from their investments. This will keep the principal amount intact and help to insure that they have a lifelong source of income.
Jonathon Guyton, CFP®, of Cornerstone Wealth Advisors, Inc., in Minneapolis, uses a different approach. His method offers a way to take out more in income without jeopardizing one’s portfolio. He has used it successfully with his own clients for several years and has written about it in major financial planning journals. This is no “have your cake and eat it, too” scheme; Jon is an experienced planner who is widely respected in the profession. He was gracious enough to join us on August 30 for a teleconference.
The standard research upon which most income projections are based assumes that clients will withdraw a fixed percentage of their total portfolio every year, plus adjust that amount annually to compensate for inflation. Under this method, a base rate of 4% will provide a secure income for at least 30 years.
With a portfolio of one million dollars, 4% would mean an initial income of $40,000. If inflation is at 3%, for the second year this would be increased by 3% of $40,000, for a total of $41,200. In this way, the withdrawal amount increases slightly every year. The “fixed” 4%, however, actually fluctuates. During times when returns are high, the withdrawal amount will fall below 4% of the total portfolio value. When returns are low, the withdrawal may exceed 4%.
Jon uses this fluctuation as the basis for his more flexible approach. He commonly starts clients out at a withdrawal rate of 5.5%, which is then adjusted annually for inflation. The catch is that clients need to be willing to adjust the amount withdrawn in years when their portfolio returns are low.
This method works as long as clients and planners follow the following guidelines:
1. In any year with a negative portfolio return, you freeze the withdrawal amount for the following year instead of increasing it for inflation.
2. Any time your withdrawal rate increases to 20% more than your initial rate, you give yourself a 10% pay cut for the following year. (If you start with 5.5% of one million dollars and increase it by 3% every year, after five years your annual withdrawal is nearly $62,000. If the market goes through a down period, so your portfolio at year five is still only worth one million, you are actually withdrawing 6.2%. The pay cut is to get you back to the target amount of 5.5%.)
3. Any time your withdrawal rate decreases by more than 20% from the initial rate, you give yourself a one-time bonus of 10%, then go back to maintaining the regular adjustments for inflation.
Jon emphasizes that another key to this approach is a diversified portfolio, with approximately 65% in stocks. Conventional wisdom says retirees should keep less in stocks and more in bonds, but making such a move too early in retirement will not provide enough income to maintain the 5.5% withdrawal rate.
It is also important for clients to manage their cash flow so they have a reserve. In Jon’s experience, this isn’t usually a problem. The method reflects the way people naturally tend to behave. If you have more, you can and probably do spend more. If you have less, you spend less. Overall, he finds that this approach significantly reduces clients’ fears of outliving their assets.