As financial planners, our primary focus concerning each client’s investments initially revolves around accumulation. When it comes time to generate income from investments, as in retirement, the primary strategy is systematic withdrawals. We reduce portfolio volatility by reallocating a portion from stocks to bonds, or another investment class, to add stability. Then we can turn on the spigot, providing monthly income while keeping a keen eye on spenddown rates.
During the accumulation years, clients may have a greater tolerance for risk as they are working and generating income. However, when the ability to earn an income ceases and clients need to generate income from investments, the conversation takes a turn - and the terms in the conversation should also change. During the accumulation phase, we discuss a client’s tolerance for risk. During the decumulation phase, a better term is the client’s capacity for risk. Not how comfortable they are with fluctuations in their portfolio, but how much can they afford to lose in real dollars, even temporarily, before it impacts future withdrawals.
One method to establish risk capacity is to understand required vs. discretionary expenses. The benefit is that if there is a market downturn to the point it impacts monthly cash flow, the client may have a better upfront understanding of what expenses can be reduced or eliminated until the market has had time to recover. In addition to helping clients financially, it may help emotionally.
Another way to assist clients is to discuss sources of income in retirement; fixed vs. variable. Fixed sources include Social Security and defined benefit pensions. Both provide a monthly check with no control over an underlying portfolio. Variable sources of income include 401ks and IRAs, where clients manage an underlying portfolio in addition to deriving a monthly income. A tradeoff for this additional responsibility with variable sources of income is the potential to leave an inheritance to heirs. This option is typically not available with fixed sources. But what if you took some of the monies from your variable sources and voluntarily converted them to a fixed source similar to a pension-like income stream? What are the benefits? What are the costs?
Consider $100,000 of an existing IRA, structured as a 10-year period certain annuity. The monthly income is just under $1,000 per month, fully taxable, and continues for the stated 10-year period. On the surface, one benefit is the spenddown rate is reduced on the remaining IRA balance from approximately 3.3% to 2.7%. Looking below the surface, could the higher percentage of fixed income, which is subject to less volatility, affect the client’s psyche and potentially overall health and related retirement costs?
On the cost side of the equation, the projected difference in net worth at mortality (27 years in our scenario) is approximately $32,000 less for the heirs. Based on the numbers alone, this would appear to not make sense. Subjectively, could this shift affect the client’s psyche and potentially overall health and related retirement costs? If so, is it worth a little more than $1,100 per year? A similar example is a client who encounters extra monthly cash flow. The numbers alone suggest the client should invest in a portfolio earning 6%, as opposed to applying it to a Home Equity Line with a variable rate of 3%. But why does the client, close to retirement, often do the latter? Sleep factor. If clients can sleep better knowing the house is paid for, they are willing to forgo the potential additional interest earned.
These projections are estimates for illustrative purposes and not guaranteed. Although we may not be fans of annuities, if clients cannot stand the market volatility with the amount of assets allocated there, we may need to adjust to accommodate their risk capacity or, at least, sleep factor.
A question we often ask our clients is, “What is more important: income security, or building wealth that can be left to your heirs?”
There are always tradeoffs around these difficult choices. It may be worth a conversation.
Pete Ruma, CFP®, CLU, ChFC, was one of the founding members of Gould Ruma Financial Advisors in 2008 and now serves more than 200 clients who have entrusted him with their financial planning and asset management needs. Pete has more than 30 years of experience in the financial planning industry and he has worked with many of his clients for nearly as long. He sees the reward of the long-term planning relationships he forges with his clients as the “a-ha” moment, when their focus shifts from a single piece to how the pieces of their overall financial puzzle come together. His primary goal is to help his clients simplify their lives by focusing not on financial outputs but financial outcomes.
All investing involves risk including loss of principal. No strategy assures success or protects against loss.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.