Part III: Puttin’ It In; Takin’ It Out – Methods
You know the phrase ‘theory is one thing but the reality quite another.’ Well, in personal financial planning for decumulation (distribution) reality and inevitable change, regardless of theoretical back testing of a proposed method or methods, decimate both theory & reality. Furthermore, before presenting the different methods/approaches to distribution/de-cumulation, here are further qualified stipulations:
- There is no SET IT FORGET IT ANSWER let alone THE ANSWER (book of said title or otherwise). THERE IS NO ‘SECRET’ LET ALONE ‘SECRET SAUCE.’ There are only tradeoffs (and ‘objecting ‘Yes, Butts,’ are only for fine tuchasses)
- Things not worth doing are not worth doing well
- Preservation of Income takes priority over Preservation of Wealth. Yes, Preservation of Income takes priority even at the expense of Preservation of Wealth – as you don’t sacrifice what you need for what you don’t need
- The unquestioned premise that annuities (issued by insurers) are rock solid ‘safe’ is a dubious problematic assumption (remember Mutual Benefit Life rated AAA+, New England Life, Confederation Life, and Executive Life collapses and or camouflaged mergers?) to queried not blindly accepted. Safe better answered by ‘relative to what?’
- Given the underlying fear/concern of ‘outliving one’s money,’ your longevity estimate is an overarching factor – go to www.livingto100.com or other similar calculators to get a better probability of your life span rather just ‘grandpa and grandma’ lived to 90.
- There is a great deal of self dealing twaddle, confirmation bias (especially by so called phds – back testing back scratching) not only in advocating method but also in misnomer naming of their advocated method in terms of false choices and unquestioned titling premise.
- There are most likely at least 3 phrases during retirement (go go, slow go, no go) which require different funding amount assumptions
- In the end remember: Context is Everything (revisit Part II again)
Again, as Professor Thomas Sowell so eloquently stated: ‘there are tradeoffs not solutions.’
Essentially there are but three methods (with variations) for decumulation / distribution (other than the consequence of doing nothing or ‘eliminating it’ away) for ‘takin’ it out.’
- Matching (no note, Gene Rayburn & The Match Game©)
- Systematic Withdrawal (‘SW’ usually with rules and or probability assumptions)
- A combo of #1 & #2
“The acquisition of investments whose payouts will coincide with an individual’s or firm’s liabilities. Under a matching strategy, each investment is chosen based on the investor’s risk profile and cash flow requirements.”
Investopedia Definition Matching Strategy
There are two basic ‘matching’ approaches to distribution
· The Gottas (Required Often Fixed Expenses) & The Discretionary
The Bucket Match Method
1. Bucket#1 – 2-5 years of anticipated expenses in cash (cds, money markets etc) and near cash (i.e like bonds that matured in a year or two)
2. Bucket#2 – 5-10 years of anticipated expenses in laddered bonds at mature within the time frame sequentially and income annuities – for income)
3. Bucket#3 – 10 years plus period – stocks, mutual funds for growth
In general, the buckets are ‘rebalanced annually’ from the distributions (capital gains, dividends, interest etc.) to replenish the bucket to the desired level of years.
The Gotta Required & Discretionary Match Approach
One American College of Chartered Life Underwriters ‘Professor’ deems this ‘The Safety First’ (with emphasis – surprise on annuities for what would be the essential portion (i.e. the required income)) with the other portion termed ‘discretionary.’ Naming the essential portion as safe is dubious (without caveats) given the above mentioned history (even with limited state annuity guarantee funds) of the highest rated insurers going into the tank and annuities and or surrender values delayed and or reduced – not that ‘where one chair sits is where they stand.’
The required element is invested in annuities for the floor of income required while the remainder – the discretionary – is devoted to stocks, mutual funds etc. Furthermore, it is suggested to take no more than 2.5%-2.8% out of the discretionary + yearly inflation adjustment of no more than 3% based to recent history extrapolated.
A couple additional words of caution: first, given interest rate risk, annuities should be purchased spread the purchase over several years – to minimize the impact of fluctuation of your annuity income. In the current environment of low interest rates, should interest rates spike up and you bought all your annuities at once, your payout could be significantly less than had you dollar cost averaged in. Secondly, looking at credit ratings quite frankly isn’t enough as the rater still gets paid by the rated (the insurer). Ask the agent for the risky asset to surplus ratio as well as risk based capital and liquidity ratios of the insurer. Third, don’t buy all your annuities from just one insurer. Remember it is the life and health insurers that brought us long term care and quickly exited the market or curtailed benefits offered in new policies due to their genius actuaries using lapse supported policies for pricing (though their big bang geniuses will argue it was all the fault of low interest rates on bonds). As one insurance wonk said to this writer, actuaries are cpa’s without a personality – some of their actuarial are responsible for further understating the undervaluation of your state’s person liability forgetting the concept of sequence of risk of returns (another story) which will wind up in either new taxes, displacement of social programs by issuing new bonds lowering credit ratings and increasing interest costs for the state’s general funds.
Annuities - safety? Safe is a question of relative to what: Inflation risk? Issuer Risk? Safety First my tushie ! A characterization of Safety First is a mischaracterization at best misleading at worst. A better characterization given a low risky asset ratio, excellent risk based capital as well as outstanding liquidity of the issuing insurer would be to say – those annuities have a lower probability of volatility (in the sense of failure and nominal principle value than many other instruments.)
One can only wonder if for the ‘discretionary’ element in this approach equity indexed variable annuities with their high acquisition costs (front end and or back surrender charges) are suggested.
Systematic Withdrawal Method (and variations)
Though not exhaustive, below are 5 popular variations of systematic withdrawal method (Note: the rhythm method is not an investment systematic withdrawal method ):
- 4% rule & 4.5% rule
- The Glidepath
- Triple Leverage
- RMD (Required Minimum Distribution by The IRS)
4% Rule & 4.5% Rule
Essentially, given a 60% in stocks and 40% in bonds one could take out 4% a year plus up to 3% increase for inflation rebalancing annually. The increase to a 4.5% distribution was due to a reallocation: 42.5% in large stocks, 17.5% in small stocks and 40% in bonds rebalancing annually. This approach was the gold standard of distribution rules for years until the recent artificial low interest rate environment. Some would now argue this withdrawal rate should be 2.8% plus the yearly maximum 3% increase for inflation.
The PE10 approach is an adaptation of Prof. ‘Irrational Exuberance’ Shiller’s PE10 asset allocation concept to improve long term returns and lower the risk of large portfolio drawdowns.
The rules for the percentage withdrawal under this method where the Standard & Poors overall Price to Earnings Ratio (P/E) are :
- The P/E is over 20x then 4.5% withdrawal rate
- The P/E is 12-20x then 5.0%-5.5% withdrawal rate
- The P/E is below 12 then a 5.5% withdrawal rate
To minimize sequence of return risk (revisit part II), at the beginning of retirement distribution have an allocation of 30% stocks and 70% treasury bills and or short term bonds increasing the stock allocation 2% every year until stocks/mutual funds reach 60% of the allocation. Thereafter hold at that allocation. such that the withdrawal rate can be 4% to 4.3% with inflation (3% max). In effect, historically, this method through backtesting gives up much of the upside (capital preservation) to lower downside risk to the income preservation (which aligns with ‘don’t sacrifice with what you need for what you don’t need’ or your need probability takes precedence over your luck sperm club progeny’s inheritance if push comes to shove.
Triple Leverage – Floor Leverage Rule
One man’s (raised) floor is another’s ceiling
In back testing by Jason Scott of Financial Engines (as counter intuitive as this may seem) indicates by putting 85% in TIPS (Treasures that are inflation protected) and or annuities and 15% into triple leveraged exchange traded funds (meaning if the market goes up 1 this triple leverage ETF will go up 3 but if the market goes down 1, the triple leverage ETF goes down three) that if ‘you want a substantial upside but want to be confident that spending won’t run out, then this is a strategy that makes a lot of sense.”
One should note, that per Standard & Poors rating service – there are several corporations with AAA+ ratings while under the Obama Administration (which is suing S&P but not the other rating agencies), US government debt was downgraded from the highest rating. (Note coincidentally, the other rating agencies have maintained giving the US government their highest rating and these rating agencies, coincidentally, are not being sued by the Obama Administration). The aforementioned notes S&P (nor the other rating agencies paid by whom they are rated) have a dubious rating track record from the rating of Mutual Benefit Life etc previously noted, to Whoops bonds, and of course the housing meltdown giving high ratings to crapola. One can only wonder akin to the enemy of my enemy is my friend if the rater of my rater is my credible rater. (Note the world rate is in rater.)
One other note, ETFs do not always parallel their intended purpose dollar for dollar as ETF’s (irrespective of the underlying holdings) are subject to the supply and demand of buyers and sells. Thus, ETF’s can and may be align as planned and actually be out of synch with their intended purpose at times – thus, one cannot anticipate 100% synchronized correlation of the triple leverage ETF in unusual markets.
Scott’s Liquid Fool’s Gold?
RMD (Required Minimum Distribution Method) by IRS
A required minimum distribution is the amount the federal government requires you to withdraw each year – usually after you reach age 70½ – from retirement accounts, including traditional IRAs, simplified employee pension (SEP) IRAs and SIMPLE IRAs, as well as many employer-sponsored retirement plans.
Utilizing the tables from the IRS Required Minimum Distribution Publication 590 Uniform Lifetime Tables (there is a calculator at https://personal.vanguard.com/us/insights/retirement/estimate-your-rmd-tool, one can also start taking distributions prior to age 70 ½. Dividing one’s total retirement accounts value (less any Roth retirement plans as well as the amount of after tax contributions to plans) by the number corresponding to one’s age or the combined age for calculation of both spouses, the IRS essentially is projecting your and or yours and your spouse’s longevity in effect requiring an annuitized amount and payout of your account (of course without so called insurance company“guarantees.” It appears that their calculation is conservative relative to longevity lowering otherwise the amount required to be distributed per increasing longevity.
However, in any event, at least at 70 ½, the required minimum distribution amount per this RMD, should be calculated whatever method you choose (systemic withdrawal and or matching method) and distributed least you incur a substantial penalty.
This eclectic approach is like going to a Chinese Restaurant – one from column A (matching) and one from column B (systematic withdrawal) and hoping you are neither hungry a half an hour later or outlive your resources.
One application is to have a fixed portion that is to last 40 years (which most likely assumes annuities and long lived parents and grandparents) for your required expenses drawing down the other side (the discretionary side) as needed or until it is exhausted.
As you know, there are known knowns; there are things that we know that we know. We also know thee are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns, the one we don’t know we don’t know
Former Sec’t of Defense Donald Rumsfeld
Friends there are no guarantees, no set it forget it answer – no secret sauce (except at McDonalds – which is really mayo and ketchup). And even with probabilistic approaches, there is the concern not of risk but increasing uncertainties ‘Black Swans’ and unknown unknowns.
As for myself, after now 40 years involved with personal finances (starting with being my 3nd grade PFFS (a then Philadelphia bank) weekly banker in Ms. Gottfied’s class thru 20 years of fee only financial planning practice, and 30 plus years of writing in the field including this blog – I can only give this one assurance: like women, and my Judaism, the more I know it seems the less I know so I’ve got to go with probabilities tempered by common sense, and Judaic thought. So with the aforementioned in mind, part IV will examine – not what I am suggesting for you – but what I’m doing for myself and my Crown JEWels (my standard poodles Simcha & Her Royal Highness Goodie).
Yaakov ben Elisha (Jim son of Ellis)