What is the best approach to draw down on our retirement nest egg?
I will retire in the Spring of 2018 (by then I will have turned 65). My wife is a teacher and will retire in June of 2018. When we chose 2018 as our retirement date, we paid off our house. At the same time we replaced one of our older cars with a new one and paid cash. We have no debt. We will begin drawing down on our investments shortly after my wife retires. Also we both plan to wait until we are 66 to draw on Social Security. Our current nest egg is divided 50/50 in retirement accounts and regular brokerage accounts. About 60% are in equities and mutual funds. The rest is in bonds and cash. I've read about the 4% rule, adjusting annually up depending on inflation, expenses and market performance. As of today, based on our retirement budget, we can generate enough cash only using our dividends to live on. In our case this approach would have us taking interest and dividends from all accounts, including IRA, 457 B and 403 B before we are 70 years old. Seems that this approach would make it easier to deal with market volatility, yet it does not seem to be favored by the experts.
You are spot on in your analysis. Understand that if everyone did what you are planning - live off of dividends, there would be no need for "investment experts" and about 50% of the investment industry. Most products and strategies are designed to make the fund companies and brokerage firms rich, not you.
In over 30 years of investing experience, researching the market, writing a book and receiving awards for my research, I will not accept a client unless they understand and are willing to live off of our dividend strategy throughout retirement. Here are some considerations:
- Dividend stocks still need to be managed. The highest yielders can be "dividend traps" - great yields but negative overall returns. The Dividend aristocrats are stocks that have increased their dividends for 25 consecutive years, or more. This is a good place to start.
- Yields are low now as prices are high, don't force the issue and buy bad stocks. You have a long time, be patient.
- Don't worry about benchmarking to the market. This is the biggest reason IMO that more people don't use a dividend strategy. One "bad" year compared to the S&P 500 and they bail out.
- But stocks that paid their dividends and increased them through both the Tech wreck and the financial crisis. Despite current turmoil, look at PG as an example. Their stock dropped 30% in market value during the financial crisis, but they increased their dividend payout each year. While your fellow retirees were getting crushed in their buy and hold asset allocation strategies, a P&G investor got a rise every year! And of course the stocks price did go on to recover.
If the above amount of manement is within your expertise you can do fine. If not find an advisor that focusses on a dividend strategy. Feel free to send me an email, of course I'd love to work with you directly, but I can also give you some great resources online to help you out if you prefer to do it on your own.
And one last suggestion - consider waiting until age 70 for social security, it is significantly higher if you wait.
Hello. Thanks for a great question.
Part 1 – Commentary on the “4% Rule”
The “4% Rule” originated in a 1994 paper published in Journal of Financial Planning by William Bengen entitled, Determining Withdrawal Rates Using Historical Data. One of Bengen’s research objectives was to determine the maximum inflation-adjusted withdrawal rate a retiree could take from a portfolio that would survive virtually any economic conditions over a 30 year retirement horizon. From his analysis of rolling historical return data, he concluded that the maximum safe withdrawal rate or “SAFEMAX” was approximately 4% for a portfolio with a 50/50 to 75/25 allocation.
Bengen’s seminal contribution to the financial planning world was his raising awareness of the threat posed by “sequence of returns” risk (the danger of portfolio depletion caused by the misfortune of retiring just before a number of major down market years). Unfortunately, however, Bengen is still best known for coining the “4% Rule.” I say unfortunately, because subsequent research has shown that his analysis and assumptions were horribly flawed. Despite this, many financial planners and individual investors not only continue to tout the 4% Rule but apply it to scenarios that are very different from the two asset, 50/50, 30 year time horizon that Bengen modeled.
One of the limitations in Bengen’s analysis was that the historical returns he used for bonds were far, far higher than rates investors can realistically earn today. He also only used a two-asset portfolio model, he failed to account for the effect of investment fees and expenses, and he wrongly assumed that automatic rebalancing in retirement is an efficient spending strategy. Further, we now also understand that basing retirement income off of a spending rate that is designed to survive an extremely low probability down market event is inefficient and likely to cause the retiree to live a sub-optimal lifestyle in retirement while leaving high remaining balances for heirs.
For more on this subject, see the following articles:
- William Bengen’s SAFEMAX (Wade Pfau, Retirement Researcher’s Blog)
- The 4 Percent Rule Is Not Safe in a Low-Yield World (Journal of Financial Planning)
- Determinants of Retirement Portfolio Sustainability and Their Relative Impacts. (Journal of Financial Planning)
As the co-author of the third paper on this list, one of my comments in the conclusion was that contemporary research finds that there is no X% rule for any given time horizon because there are so many different variables that can impact sustainability. Even if there was a an X% rule, basing your retirement withdrawals off this rate would be highly inefficient.
Part 2 – Your Retirement Planning Strategy
With respect to your situation, my initial inclination is that your 50/50 allocation is too bond and cash-heavy for a low interest rate world. Back in the old days when cash paid 5% and bonds pay 6-8%, the interest rates were a major contributor to portfolio returns. In a low yield world, high allocations to bonds are a drag on returns and may actually accelerate depletion.
Additionally, I caution against rebalancing in retirement (i.e., maintaining a constant allocation). Instead, although it may seem counter-intuitive, as a means to ameliorate sequence of returns risk, retirees may wish to adapt some form of bonds-first spending strategy or, at the very least an approach that does not entail liquidating stocks during down markets. In support of this guidance, see the following articles:
You also mentioned that your portfolio is already generating enough income to meet your needs in retirement and that a portion of this income is being generated by dividends. If you own rising dividend stocks, and your portfolio income rises enough each year to keep pace with the cost of living, you may not ever need worry about portfolio depletion!
With respect to withdrawing from all of your taxable and tax sheltered retirement accounts upon retirement at age 66, you should also be aware that account type spending order and account type selection are hot topics in retirement sustainability research in 2017. Simply put, the less money you have to pay to the IRS over time, the longer your assets may last. As a general rule, if you are able to withdraw funds from your qualified plan accounts (IRA, 457(b), and 403(b)) at an effective tax rate of 15-20%, it may be very wise to do so when you retire. However, if your distributions from these accounts are taxed at a high marginal rate, such distributions may be inefficient and your interests early in retirement may be better served by spending down your after-tax savings first. Similarly, companies that pay qualified dividends may be an excellent choice in taxable accounts while mutual funds and taxable bonds may be better suited for your retirement accounts.
For more on this, see the following articles –
My apologies for the lengthy response, but I hope it provides some new and useful information.
In closing, if you would like to test your retirement portfolio’s down-market preparedness, feel free to try Nest Egg Guru’s Retirement Spending App. (It is free for you to use, and no one will call or email you).
Congratulations. You have planned meticulously and are doing everything right. The issue is how to withdraw.
Think of your invested net worth as an overcoat with different pockets. You can take money out of any pocket you want. Take money out of one pocket and you can spend it all; take money out of the other pocket and you have to set 25% of it on fire. So -- this is really important -- don't touch the IRA/retirement accounts at all. You will eventually be required to when you turn 70-1/2 of course, but leave them untouched until then. They will grow as your regular brokerage accounts are drawn down -- the overcoat will list to starboard a little -- and that's perfectly fine. Reinvest the dividends in the IRAs so the yield compounds. As they grow, it's OK to take more from the regular accounts than they generate in cash income. This strategy will minimize your taxes in the years before you turn 70-1/2.
I approve of a 60-40 asset allocation for a young retiree, by the way. Most of your savings won't be touched for 10-plus years, so you are in fact a long term investor. But please invest your cash. I might suggest that you look at preferred stocks -- they behave more or less like long term corporate bonds, and pay about 6%. If you want more information, get in touch with me.
Based on the description of your broader portfolio allocation, and your ability to satisfy your income objectives with your current dividend income, it sounds like your asset to desired income ratio is robust enough to provide you with several options. If I am correct in this assumption (and it is just an assumption based on the limited information provided), then it also sounds like the appropriate income strategy for you is going to largely be a matter of managing for tax efficiency.
When the present and future value of assets is in excess of that required to satisfy present and future income objectives – plus contingencies – assets have a tendency to balloon. This is a good problem to have, obviously, but, in my experience, it can begin to create excess cash flow and, therefore, tax issues once Required Minimum Distributions kick in after age 70 ½.
When planning for long-term income distributions from pre-tax retirement accounts, it is important to consider what the value of those assets might look like in the future (far into the future) and think about how much income you will eventually be forced to take. What starts as a 4% withdrawal strategy, might turn into a forced 8% withdrawal strategy, wreaking unintended tax consequences.
You will also want to consider what happens to your assets when you are gone. That is, if it looks like a fair amount of assets will remain, you will also want to consider how those assets might be taxed as they are passed to the next generation, or elsewhere.
I only mention these things because you are still young enough to build some beneficial tax efficiency into your distribution plan, and I frequently see retirees get blindsided by the effects of required minimum distributions because they went unconsidered when distributions began. It is not uncommon to find that tax inefficiency among distributions cost far more in excess taxes over time than could have been earned with near-perfect investment execution.
I apologize that I can’t provide specific distribution advice, but the ability to do so would require substantially more information. Because there is so much at stake, however, I do recommend finding a financial planner that you feel comfortable with to at least walk you through the potential outcomes of different distribution strategies according to your unique circumstances.
Congratulations on planning so well for your retirement. Questions regarding which accounts to draw from and when, in retirement (or otherwise) are complex, and depend on a number of factors specific to your situation. However, there are certain rules of thumb that you can consider.
Generally, when you are spending your assets in retirement, from a tax perspective, you should start with taxable assets, then move to tax-deferred assets (Traditional IRA, 401k/45b/403b, etc.), then move to tax-exempt assets (Roth IRA, Roth 401k, etc.). The idea is that you continue to realize growth/income in the accounts that are tax-advantaged, drawing first on the accounts that are fully taxable.
Obviously, you won't want to deplete your taxable assets completely before moving on to your tax-preferenced accounts, as you may wish to maintain a liquid reserve in your bank savings or checking account for an emergency. You may also be forced to draw on your tax-deferred accounts before you need to, due to required minimum distributions.
These rules of thumb are focussed mainly on tax-efficiency. However, the RMDs also play a role in terms of legacy planning - if you can live off of your taxable and tax-deferred assets alone, you will never be forced to take RMDs on Roth assets, and these can be left entirely to your heirs. Whereas, you might be forced to draw on your tax-deferred assets, because of RMDs, even if you don't need the money.
One school of thought that contradicts what I have described is that drawdowns from tax-deferred accounts are taxed as ordinary income, however, gains in a taxable account are capital gains, and could be taxed at a lower rate if they are long-term gains.
To summarize, I would try to leave any after-tax (tax-exempt/Roth) assets alone, for as long as you can. I would also try to make sure the draws from your taxable assets are long-term gains (>365 days) rather than short-term.