Retirement income planning can be a slippery slope

By Christopher P. Hill, RFC

Wealth and Income Group LLC and

Why is creating a retirement income strategy exactly like climbing down a slippery slope?

I firmly believe that as financial advisors, one of the most important and challenging jobs we are called upon to do is establish a retirement income distribution strategy for our clients. One of the key goals of a financial or retirement plan is producing income for retirees that can ensure both enjoyment and financial independence in retirement. So with this in mind, we cannot take this sophisticated strategy lightly, mainly because of two key facts:
    1. There are a large number of factors that must be taken into consideration and analyzed.

    2. The margin of error is extremely small.
Reaching the highly elusive retirement years is clearly a major milestone in our lives. And since retirement is often referred to as the "the golden years," our income is clearly the cornerstone -- the gold in these "golden years" -- for all retirees.

Therefore, it is clearly our job as financial advisors to make sure to look at a retirement income strategy from all angles. We must make sure we are able to ask and answer such key questions as:
  • How much income do you need?

  • How much income do you have from other sources, such as pensions, Social Security, etc.?

  • What percentage of your portfolios should you withdraw?

  • Where should you take income from first (IRAs vs. non-IRAs)?

  • What are the best options for you to maximize your tax efficiencies?

  • What are your optimal spousal options?

  • How much travel do you plan on doing?

  • Are you charitably inclined?

  • What is the best way to invest your money?

  • How much inflation adjustment should we build in going forward?

  • Is the income you need before or after taxes?

  • What tax bracket will you be in?

  • Will your income be taxed at ordinary income rates or capital gain rates?
And the list goes on and on.

I've found that in doing retirement income planning, just about every retiree I meet with has these four common goals in mind:
  • Avoiding large investment losses, volatility, and sleepless nights

  • Paying as little taxes as legally possible

  • Having the ability to spend and enjoy those "golden years" without ever having the fear of running out of money

  • Making sure we have sound transfer strategies in place for our spouses and our heirs
If you've ever done any mountain climbing, particularly difficult feats like Mount Everest, you know approximately 90 percent of all major accidents and fatalities happen on the way down the mountain. When you look at putting together retirement income strategies for clients, you will find that there is a great analogy that can help your clients understand how dangerous it can be if they choose to go it alone.

The key message of the following analogy is that there are two totally different strategies to consider when we look at income distribution plan for our clients. The first strategy involves looking forward and trying to predict the level of retirement income that will be needed in the future, or while climbing up the mountain. The second strategy, which is far more complex and dangerous -- and I believe largely misunderstood -- is helping to design a strategy for withdrawing income during retirement, or while climbing down the mountain.

To help prove my point, when I conduct retirement workshops, many of the attendees are unable to answer these two questions correctly (Note: These examples and performance figures are purely hypothetical, and do not refer to any specific investments or portfolio asset allocation mix):
    1. Assuming a period of 20 years, when you are accumulating money for retirement (climbing up the mountain), which of these two scenarios would have a greater impact on your portfolio:

    • A 10 percent return every year except a portfolio decline of 50 percent in the first year?

    • A 10 percent return every year except a portfolio decline of 50 percent in the last year?
    2. If your portfolio declines by 50 percent in year one and then appreciates 50 percent in year two, is your portfolio back to even?
In question one above, the correct answer is actually neither one. As strange as it seems, when you are accumulating wealth and not withdrawing any income (climbing up the mountain), it does not matter whether losses occur in the early or late stages. To help explain, let's review the numbers. First, let's keep in mind that in both scenarios, you are achieving a 10 percent return in each of the 20 years except one year (which saw a steep decline of 50 percent). However, when you run the numbers, you will see that you end up with the exact same amount of money in both scenarios, whether you suffered the 50 percent loss in the first year or in the last year. You may be wondering "How can that be true?" Well, simply because while you were growing your money, you were not yet withdrawing any income, or coming down the mountain. So the key message here is that it is much less critical to focus on portfolio losses while we are accumulating wealth towards retirement, or climbing up the mountain.

However, now let's assume you are still receiving a 10 percent return in every year, but you are now retired and beginning to withdrawal 6 percent of your portfolio as income, or climbing down the mountain. Using the same 20-year period, if your portfolio appreciates 10 percent per year for 19 consecutive years, and then suffer a 50 percent loss in the last year, your portfolio will still have more than 30 percent of its original principal.

What this tells you is that, due to the fact that you suffered this large loss in the later stages of your retirement distribution years, you still have lots of quality retirement options. However, if you suffer the loss of 50 percent in the first year, here's where it gets tricky and dangerous, because you actually end up running out of money in approximately 13 years! Wow. Think about that.

So, as you can see, although this uses an extreme 50 percent loss in year one, it clearly illustrate the harsh reality that running out of money is much more of a possibility when you suffer large losses in the early stages of retirement and you are withdrawing income, or climbing down the mountain. (Note: This example does not factor in important considerations such as inflation and taxes, which can significantly increase your ability to run out of income much sooner.)

Now let's look at question number two. If your portfolio declines by 50 percent in year one and then appreciates 50 percent in year two, is your portfolio back to even? The answer is no.

To use another example: If you have a portfolio of $100,000 and you suffer a 50 percent loss in year one, you will obviously be left with only $50,000. However, if during year two, this $50,000 portfolio increases by 50 percent, your portfolio value will only be $75,000. The reality is that in order for your portfolio to get "back to even" ($100,000), you would need to experience a whopping 100 percent gain in year two. Again, this extreme example helps illustrate the point that it becomes much more critical to focus on avoiding the large losses that can be suffered in the early years of a retirement income strategy, or climbing down the mountain.

The reality is that most people mainly rely upon financial advisors for the wealth management part of their retirement plan. This is understandable, since managing our clients' wealth is clearly a large part of what we do. But I believe it is much more important -- and yet often overlooked -- to remember that our ultimate objective is to create a retirement income strategy that is not solely focused on achieving the best possible rate of return, but rather on making sure we do not make that unforgivable mistake of running out of money.

So, when financial advisors are asked to construct a sound retirement income strategy, you could easily suggest that this all-important strategy can be compared to hiring a mountain climbing guide to help someone climb down a mountain. The main similarities are that both jobs clearly require a tremendous amount of hard work and expertise, and both jobs have the ultimate objective of making sure their clients avoid a large fall that could cause irreparable losses!

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