Managing Your Money During Retirement Maria Crawford Scott

Managing Your Money During Retirement Maria Crawford Scott Former Editor, AAII Journal 1 1

The Retirement Savings Dilemma: Competing Goals 2 n Ensuring your savings last throughout your lifetime n Withdrawing as much as possible each year 2

Discussion Topics n Your Withdrawal Rate: How to determine the amount of money you can safely withdraw each year. The key to your portfolio’s long-term survival. n Asset Allocation: What is a prudent approach? n Maintaining Your Portfolio: Steps you can take to ensure you remain on course, especially during challenging times. 3 3

One Popular Withdrawal Approach: The Downside n Each year, withdraw only the income generated from your portfolio. Downside: Encourages heavy allocation to high-income but low-growth investments such as bonds. 4 4

Another Possible Withdrawal Approach: The Downside n Each year, withdraw only the real rate of return from your portfolio. Downside: Does not produce a stable annual source of income. 5 5

The “Withdrawal Rate” Approach n Create your own immediate annuity based on your total investment assets. n First, determine a “first-year withdrawal rate” (a percentage of your portfolio). Use your life expectancy as the time period and the estimated real return (return AFTER inflation) for your portfolio over your life expectancy as the assumed return rate. n Second, translate the first-year withdrawal rate into a dollar amount, which is your first-year “income”—the actual dollar amount that you can withdraw from the portfolio the first year. n The next year, you are allowed to withdraw your prior-year dollar amount, but increased by the rate of inflation. 6 6

An Example 7 n $1 million portfolio n 4% first-year withdrawal rate n 3% inflation n First-year withdrawal amount: $40, 000 (4% of $1 million) n Second-yr. withdrawal amount: $41, 200 [$40, 000 + (3% x $40, 000)] 7

Withdrawal Rate Approach Clarified 8 n The withdrawal “rate” is a percentage that applies only to your first-year withdrawal. n The withdrawal amount is a “gross” figure that, along with any other sources of income, is used to pay annual living expenses, including taxes. n The withdrawal amount does not take into consideration taxes that may be due based on the source of the withdrawal. n The withdrawal rate has nothing to do with “required” withdrawals from retirement accounts. 8

The Withdrawal Rate Approach Advantage 9 n The point of this approach is to separate your asset allocation decision from your immediate withdrawal needs so that they do not drive your allocation decision. n Encourages you to invest for the long term, since the withdrawal rate does NOT depend on any income component. 9

Adapting the Withdrawal Rate Approach to the Real World n Annuity tables assume unvarying return rates each year, but in the real world, your return rates will vary significantly year-to-year. n For portfolios in which there are NO additions and NO withdrawals, the return sequence has NO IMPACT on the ending value. n For portfolios in which there ARE withdrawals each year, return sequences matter: For two portfolios with the SAME long-term average return, the one with higher returns at the beginning will have a higher end value than the one with higher returns toward the end. 10 10

Adapting the Withdrawal Rate Approach to the Real World (con’t) n Base your withdrawal rate on studies of portfolio “success” (or “survival”) rates. n The “success” rate is the percentage of times a portfolio is able to sustain the given payout over the entire time period without running out of assets prematurely. 11 11

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Portfolio Success Rates: Updated 13 13

Shortfall Risk (Runout Percentage) at Various Withdrawal Rates Source: “Guidelines for Withdrawal Rates and Portfolio Safety During Retirement, ” by John J. Spitzer, Jeffrey C. Streiter and Sandeep Singh, Journal of Financial Planning, October 2007. 14 14

The Key to Portfolio Survival n Use a realistic withdrawal rate: not more than 4% of the initial portfolio value. In subsequent years the annual dollar amount can be increased by your assumed inflation rate. n Maintain a prudent asset allocation. 15 15

What Is a “Prudent” Asset Allocation? n Based on your personal investment profile: your return needs (income vs. growth), your tolerance for risk and your time horizon. n No single asset class will match all of your requirements. n Diversifying your portfolio among the major market segments allows you to meet various needs while reducing various risks. 16 16

Major Market Segments n Stocks: Higher growth potential, lower and unsteady income, ability to outpace inflation, liquid markets but high risk of selling at a loss n Bonds: Low growth potential, steadier income, unable to outpace inflation, liquid markets but high risk of selling at a loss n Cash: No growth, unable to outpace inflation, use to reduce liquidity risk of total portfolio 17 17

Stocks, Bonds and Cash: 1926 Through 2012 Total Annual Average (%) Large Co. Stocks 9. 8 Long-Term Gov’t Bonds 5. 7 T-Bills 3. 5 Inflation 3. 0 After Inflation (%) 6. 7 2. 6 0. 5 na Average Growth (%) 5. 6 0. 4 0. 0 na Source: “Stocks, Bonds, Bills and Inflation— 2013 Yearbook, ” Ibbotson Associates, Chicago. 18 18

Highest and Lowest Returns (1926 through 2012) Highest Lowest Annual Returns (%) Large Co. Stocks Long-Term Gov’t Bonds Balanced (50/50 Stocks/Bonds) T-Bills Inflation 53. 9 (1933) 40. 3 (1982) 34. 7 (1995) 14. 7 (1981) 18. 1 (1946) -43. 3 (1931) -14. 9 (2009) -24. 7 (1931) 0. 0 (1938) -10. 3 (1932) 5 -Year Rolling Returns (%) Large Co. Stocks Long-Term Gov’t Bonds Balanced (50/50 Stocks/Bonds) T-Bills Inflation 28. 6 (1995 -99) 21. 6 (1982 -86) 20. 9 (1982 -86) 11. 1 (1979 -83) 10. 0 (1977 -81) -12. 4 (1928 -32) -2. 1 (1965 -69) -2. 8 (1928 -32) 0. 1 (1938 -42) -5. 4 (1928 -32) Source: “Stocks, Bonds, Bills and Inflation— 2013 Yearbook, ” Ibbotson Associates, Chicago. 19 19

Highest and Lowest Returns (1926 through 2012) (cont’d) Highest Lowest 10 -Year Rolling Returns (%) Large Co. Stocks Long-Term Gov’t Bonds Balanced (50/50 Stocks/Bonds) T-Bills Inflation 20. 0 (1949 -58) 15. 5 (1982 -91) 17. 0 (1982 -91) 9. 2 (1978 -87) 8. 7 (1973 -82) -1. 4 (1999 -08) -0. 1 (1950 -59) 2. 0 (1965 -74) 0. 1 (1933 -42) -2. 6 (1926 -35) 20 -Year Rolling Returns (%) Large Co. Stocks Long-Term Gov’t Bonds Balanced (50/50 Stocks/Bonds) T-Bills Inflation 17. 9 (1980 -99) 12. 1 (1982 -01) 14. 7 (1979 -98) 7. 7 (1972 -91) 6. 4 (1966 -85) 3. 1 (1929 -48) 0. 7 (1950 -69) 4. 6 (1929 -48) 0. 4 (1931 -50) 0. 1 (1926 -45) Source: “Stocks, Bonds, Bills and Inflation— 2013 Yearbook, ” Ibbotson Associates, Chicago. 20 20

One Starting Point: Cash for Liquidity n Provides liquidity, particularly during extreme market conditions when you do not want to sell any stock holdings. n Helps protect stock holdings during bad times—provides a cushion so you are less likely to panic and sell at a market low, the worst possible time. n Recommendations: 3 to 5 years’ living expenses. n A 4% withdrawal rate, combined with cash totaling 5 years, implies at least a 20% cash component. 21 21

Stocks for Portfolio Survival Over Long-Term Withdrawal Periods n The longer your payout period, the greater the stock exposure required to ensure a portfolio’s survival. For 30 year time horizons you need roughly a 50% stock commitment to ensure portfolio survival if you use a 4% initial withdrawal rate. n Stock portfolios must be diversified. n One suggested rule of thumb: 120 – your age = stock % 22 22

Bonds for Stability and Yield n Your bond allocation depends on your risk tolerance (stock allocation)—whatever percentage remains after allocating to cash and stocks. n Keep maturities short- to medium-term (5 to 7 years) to reduce downside risk. 23 23

Asset Allocation Among the Market Segments n The least volatile segment should be used as the core (at least 50% of that asset class). n More volatile segments can be added to varying degrees, but at least 10% is needed to have a meaningful diversification effect. n Make sure you understand the risks of the noncore segments. 24 24

One Approach to Allocating Among Market Segments Stock Market Segment Large Co. Core: 80% to 50% Small Co. Non-Core: 10% to 40% International Non-Core: 10% to 40% Bond Market Segment High-Quality Core: 80% to 50% High-Yield Non-Core 10% to 40% International Non-Core: 10% to 40% The percentages range from conservative to aggressive and are based on the concept of effective diversification within the asset classes, with variations based on your investor profile. However, final allocation decisions should be based on a thorough understanding of the investment categories. Never invest in a segment if you don’t understand it or are uncomfortable with the risks. 25 25

Maintaining Your Portfolio Management Rules n Inflation Rules n Withdrawal Rules n Capital Preservation Rules n Midcourse Adjustments n 26 26

Portfolio Management Rules Portfolio management rules add only minimal benefits to the withdrawal rate: 1) 27 In a year when performance causes an asset class to become overweighted, sell excess and invest in cash. 27

Portfolio Management Rules (cont’d) 2) Withdrawals each year are funded in the following order: Stock overweightings; fixedincome overweightings; cash; withdrawals from fixed income; withdrawals from stock segments based on prior year’s performance. 3) No withdrawals from any stock segment following a year in which it had negative returns if cash or fixed-income assets can fund the required withdrawal. 28 28

Inflation Rules add slight benefits to the withdrawal rate: 1) Maximum annual inflation increase is 6%. 2) There is no “make-up” for a capped year. 29 29

Withdrawal Rules: Modest Benefits Withdrawal Rules add modest benefits to the withdrawal rate: 1) No increase in withdrawal amount for inflation if prior year’s investment return is negative. 2) No “make-up” for a missed year. 30 30

Capital Preservation Rules do benefit the withdrawal rate: 1) If current year’s withdrawal rate rises more than 20% above the initial withdrawal rate, then the current year’s withdrawal is reduced by 10%. 2) Decreased withdrawal rate becomes basis for determining next year’s withdrawal amount. 3) Rule expires 15 years before maximum planning age. 31 31

Capital Preservation Rules (Cont’d) n Drawback: Lost purchasing power each time rule is triggered. n “Prosperity rule” (increases the withdrawal rate when current withdrawal rate is 20% below the initial withdrawal rate) can be applied; drops the benefits to the withdrawal rate by about 0. 5%. 32 32

Capital Preservation Rule Example Initial Portfolio Value: $1 million; First-Year Spending Rate: 5. 5%; Trigger Rate: 6. 1% Year 1 2 3 4 5 6 7 8 9 10 11 33 Annual Actual Spending Annual Amount Return ($) (%) 55, 000 8. 3 56, 650 -3. 1 56, 650 14. 0 58, 350 7. 6 60, 100 -2. 3 60, 100 4. 0 61, 903 9. 2 63, 760 11. 5 65, 673 -5. 4 65, 673 -11. 3 65, 673 20. 6 Savings at Year-End ($) 1, 022, 963 936, 840 1, 003, 417 1, 016, 420 934, 802 909, 691 925, 360 960, 684 847, 128 693, 541 757, 209 50% Stock/50% Bond Portfolio New Current Spending Savings Spending Rate Amount Year-End Rate (%) ($) ($) (%) 5. 5% 6. 0% 5. 8% 5. 9% 6. 4% 54, 090 915, 941 5. 8% 6. 8% 55, 713 938, 939 6. 1% 50, 141 945, 020 5. 5% 6. 9% 51, 646 996, 113 5. 5% 6. 8% 53, 195 892, 471 5. 3% 7. 8% 53, 195 744, 858 6. 0% 9. 5% 53, 195 834, 145 7. 1% 33

Decision Rules and the Withdrawal Rate 90% Success Rate Max Amt Initial of W/D Rate Increase (%) No Decision Rules Portfolio w/50% Stock na Portfolio w/80% Stock na Portfolio Management Rules Portfolio w/50% Stock 0 Portfolio w/80% Stock 7 Inflation Rules Portfolio w/50% Stock 12 Portfolio w/80% Stock 13 34 Withdrawal Rules Portfolio w/50% Stock 95% Success Rate Max Amt Initial of W/D Rate Increase (%) 3. 6 na 3. 3 3. 6 na 3. 0 3. 6 0 3. 3 3. 6 0 3. 2 4. 1 14 3. 7 4. 0 11 3. 4 4. 3 19 3. 9 34

Decision Rules and the Withdrawal Rate (Cont’d) 90% Success Rate Max Amt Initial of W/D Rate Increase (%) All Three Rules Portfolio w/50% Stock 30 Portfolio w/80% Stock 43 Add Cap Preserve Rule* Portfolio w/50% Stock 45 Portfolio w/80% Stock 106 95% Success Rate Max Amt Initial of W/D Rate Increase (%) 4. 7 31 4. 3 4. 8 33 4. 3 5. 1 42 4. 8 6. 3 75 6. 2 Assumes a 40 -year horizon. *Inflation Rule was dropped for this scenario. 35 Source: “Decision Rules and Maximum Initial Withdrawal Rates, ” by Jonathan T. Guyton and William J. Klinger, Journal of Financial Planning, March 2006. 35

Portfolio Maintenance: The Midcourse Adjustment Strategy Every 5 years, re-evaluate and re-adjust withdrawal amounts based on size of portfolio and shorter time horizon. The results of the study indicated this strategy was: n Less likely to run out of money early in retirement. n More likely to provide larger total withdrawals over the retirement span. n Not designed to provide a large estate. n Likely to produce more variability in withdrawal amounts, with the possibility of some being much lower than average. 36 36

Midcourse Adjustment Study Strategy comparison: Withdrawal amounts for 5% shortfall risk and a 50/50 stock/bond allocation Fixed Withdrawal Strategy* Mid-Course Correction Strategy** Maximum Sustainable Withdrawal Rate (%) 3. 8 17. 17 Average Withdrawal Rate (%) 3. 8 8. 4 Shortfall (% out of 10, 000 sequences) 4. 5 4. 8 Earliest Runout Year 14 29 206 23 Balance Remaining ($; start amount: $100) * Fixed Strategy: Fixed withdrawal and fixed allocation (50/50 stocks/bonds). ** Mid-Course Correction: Revised withdrawal rate every 5 years and fixed allocation (50/50 stocks/bonds). Source: “Retirement Withdrawals: An Analysis of the Benefits of Periodic ‘Midcourse’ Adjustments, ” by John J. Spitzer, Financial Services Review 17 (2008). 37 37

Maximum Withdrawal Rates and Corresponding Stock Allocations Longevity (Years) 5 10 15 20 25 30 35 5% Shortfall Risk Stock Max Alloc. * W/D (%) 20 18. 6 20 9. 5 25 6. 6 35 5. 3 35 4. 4 30 3. 9 40 3. 5 10% Shortfall Risk Stock Max Alloc. * W/D (%) 25 19. 3 35 10. 1 35 7. 1 40 5. 7 55 4. 9 50 4. 4 45 4. 0 *Remainder is in bonds Source: “Retirement Withdrawals: An Analysis of the Benefits of Periodic ‘Midcourse’ Adjustments, ” by John J. Spitzer, Financial Services Review 17 (2008). 38 38

Strategy Comparison: Withdrawal Amounts for 5% Shortfall Risk Max Sustain W/D Rate (%) Avg Withdrawal Rate (%) Shortfall (% of 10, 000) Earliest Runout Year Balance ($; Start: $100) Fixed Strategy* 3. 8 4. 5 14 206 Mid-Course Correction Strategy** 17. 2 8. 4 4. 8 29 23 Mid-Course/ Variable Allocation Strategy*** 11. 3 6. 7 5. 2 29 12 * Fixed Strategy: Fixed withdrawal and fixed allocation (50/50 stocks/bonds). ** Mid-Course Correction: Revised withdrawal rate every 5 years and fixed allocation (50/50 stocks/bonds). *** Mid-Course/Variable: Revised withdrawal rate and variable allocation (decreasing stocks). Source: “Retirement Withdrawals: An Analysis of the Benefits of Periodic ‘Midcourse’ Adjustments, ” by John J. Spitzer, Financial Services Review 17 (2008). 39 39

Live Long and Live Well: A Portfolio Survival Guide n NUMBER 1: Use a ‘withdrawal rate’ approach to separate your asset allocation decision from your immediate withdrawal needs, and to encourage you to invest for the long term. n NUMBER 2: Use a realistic withdrawal rate—not more than 4% of the initial portfolio value. In subsequent years, the annual dollar amount can be increased by your assumed inflation rate. n NUMBER 3: Asset allocation helps you reduce the risk, over the long term, of unknown (in advance) adverse conditions. Make sure your portfolios are well-diversified among the major market segments, and do NOT make any major bets on any one market segment or any single style of investing. 40 40

Live Long and Live Well: A Portfolio Survival Guide n NUMBER 4: Use your cash allocation as a life preserver for extreme market conditions—maintain a cash exposure of 3 to 5 years’ living expenses for liquidity. And if you have a longer-term horizon, maintain at least a 50% exposure to stocks to provide growth and to protect the long-term purchasing power of your future withdrawals. n NUMBER 5: Use rules regarding annual withdrawal amount increases and decreases to help maintain your portfolio—and ensure that you stay on course. 41 41

AAII Journal Resources ARTICLES (all are available at the AAII website: www. aaii. com) n “A Key to a Lasting Retirement Portfolio, ” by John Sweeney, April 2013. n “Finding the Right Withdrawal Rate: One Key to Portfolio Sustainability, ” by Maria Crawford Scott, July 2012. n “Portfolio Rebalancing: Diversification, Risk Control and Withdrawals, ” by Charles Rotblut, March 2012. n “Getting Through Difficult Markets, ” by Julie Jason, November 2011. n “Retirement Spending on Planet Vulcan: Longevity Risk and Withdrawal Rates, ” by Moshe Milevsky and Huaxiong Huang, September 2011 n “Repairing the Damage to Assure the Flow, ” by Christine Fahlund, February 2009 n “Will Your Savings Last? What the Withdrawal Rate Studies Show, ” by William Reichenstein, July 2008 n “Optimizing Your Retirement Income: What Works Best and Why, ” by Christine Fahlund, August 2008 n “Invest or Delay? Strategies for Taking Social Security Benefits, ” by Christine Fahlund, February 2007 n “Withdrawal Strategies to Make Your Nest Egg Last Longer, ” by William Reichenstein, November 2006 n “Tax-Efficient Investing: Picking the Right Pocket for Your Assets, ” by William Reichenstein, November 2005 n “Withdrawal Rules: Squeezing More From Your Retirement Portfolio, ” by Jonathan Guyton, August 2005 n “Allocation During Retirement: Adding Annuities to the Mix, ” by William Reichenstein, November 2003 n “Bear Market Strategies: Watch the Spending, Hold the Stocks, ” by T. Rowe Price Associates, May 2003 n “Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable, ” by Philip L. Cooley, Carl M. Hubbard, and Daniel T. Walz, February 1998 42 42