Last month, I moderated a panel at the Morningstar Investment Conference, called “Investing for Income in a Low-Income Environment.” The participants were Michael Finke, professor at The American College of Financial Services; Jonathan Guyton, a financial advisor and prolific author; and Hong Cheng, who runs income strategies for Morningstar Investment Management. My expectation was reflected in the session’s title: If it weren’t for bad news about the amount of income that portfolios can generate, there wouldn’t be any news at all.
I was mistaken. The speakers were decidedly upbeat. Admittedly, they weren’t enthusiastic about investing directly for income, by receiving interest and dividends, while leaving their capital untouched. With both Treasuries and stock indexes yielding less than 2%, there’s little blood in that turnip. But they were optimistic about the prospects of retirees who planned to spend down their portfolios, dipping into principal to supplement their interest/dividend checks.
(Technically, withdrawals that include return of capital aren’t “income.” In practice, though, investment professionals tend to use the term informally, extending it to cover retiree drawdowns.)
Bigger Pie, Bigger Slices
A major reason for their good cheer was the increase in stock and bond prices. Initially, that argument seems counterintuitive. Had equity prices fallen during recent years rather than risen, the expected total returns for stocks would be higher. Similarly, Treasury yields are depressed because of the bond bull market. Such factors suggest that upcoming retirees will struggle to match their predecessors’ portfolio-withdrawal rates. The Golden Investment Age has passed.
Well, not really. As Michael Finke pointed out, retirees spend dollars, not percentages. And, if they have owned investments, particularly equities, 2021’s retirees possess far more dollars than they once anticipated. It matters not if their sustainable withdrawal rates are below those of the previous generation, because their nest eggs are so much larger.
(In spirit, Finke’s logic echoed Jack Bogle’s negotiating strategy with Vanguard’s subadvisors. When an investment manager complained to Bogle that Vanguard’s proposed fee was too low, Bogle responded yes, the percentage was less than what the organization customarily received, but because of the size of Vanguard’s funds, the dollar amount would be greater. That argument usually prevailed.)
Consider, for example, the streamlined–but nonetheless instructive–example of two workers who plan to retire in 10 years. Each holds a single investment, consisting of $400,000 in Vanguard Balanced Index (VBINX). Each makes no further retirement contributions. The first investor’s starting date is Jan. 1, 2001. When she retires on Dec. 31, 2010, her portfolio is valued at $600,000. The second investor begins one decade later, on Jan. 1, 2010. When she calls it quits this past December, her portfolio is worth $1.05 million.
The first retiree withdraws 5% each year from her portfolio, adjusting each year’s amount by the change in inflation. That withdrawal rate is 1 percentage point above the conventional rule of thumb, which is 4%, but our retiree feels bold, reasoning (correctly) that the stock market will rebound from its beating. A 5% withdrawal rate on $600,000 gives her $30,000 per year. In contrast, the second investor is careful, withdrawing at a tame 3% rate. That generates $31,500.
In other words, today’s retirees can eat their cake, while preserving it, too. That is, if they have owned investments that have profited from the stock and bond bull markets, they can extract relatively large sums from their portfolios, even if applying a conservative withdrawal rate.
That quiet advantage for retirees owes to current conditions. In contrast, the remaining two benefits are eternal. One is that while financial-planning software cannot anticipate market returns, investors can react to what they experience. As a practicing financial advisor, Jonathan Guyton works with upcoming retirees to establish their spending expectations. He reports that most of his clients underestimate the amount that they can withdraw from their portfolios, because they seek to create plans that, in advance, can survive every conceivable scenario.
Recognizing how and when a plan might fail is a useful exercise, but it should not dominate the spending decision. Should the financial markets perform poorly shortly after the retirement date, which is when the portfolio is most vulnerable (because the earlier during retirement, the greater number of years that the assets must support), the investor can and should adjust her behavior. Reduce the amount of portfolio withdrawals until the storm clears.
Conversely, if the markets behave unusually well, as they have during recent years, retirees can give themselves raises. Just as spending may be trimmed following bad news, it can be increased after favorable events. To be sure, tinkering with withdrawal rates on the fly creates uncertainties. Over time, a retiree’s actual spending pattern may diverge sharply from the original plan. On average, though, being flexible increases the retiree’s effective withdrawal rate–in some cases, by as much as a full percentage point per year.
Adjusting for Inflation
The other boon, from the perspective of retirement planning, is that most retirees spend less as they age. In contrast, not only do Social Security payments provide cost-of-living adjustments, but so do most projections of investment withdrawals, including the famed 4% rule. They assume that spending will increase along with inflation. In practice, therefore, spending projections can be overstated and the retiree’s initial withdrawal rate too cautious.
Letting inflation ride can have a meaningful effect on a retiree’s withdrawal rate. When I tested a retirement-spending model that calculates sustainable withdrawal rates during retirement, it raised its estimate by 0.4 percentage points per year if I had the investor forego her inflation adjustments during the second half of retirement. (The improvement would be greater yet if I had used an annual inflation estimate higher than 2.2%.)
Were our retiree to adopt such an approach–which retirees tend to do in practice anyway–her Social Security payments would continue to adjust for inflation. Thus, the portfolio withdrawal amount would still increase, albeit by only a modest amount. Those worried that they might live for an abnormally long time, and in good health, could protect against that concern by buying a deferred annuity when their retirements begin.
The upshot: Although retirement-spending models that use conservative inputs for future stock and bond returns–which is prudent given the level of current market valuations–calculate disappointingly low withdrawal rates, the practical implications for today’s retirees are nowhere near so dire. If they have accumulated investment nest eggs, those amounts are larger than could have reasonably been expected. What’s more, by being flexible and considering the possibility of foregoing inflation adjustments, retirees can further improve their results.
John Rekenthaler (email@example.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar’s investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.
John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.