Close Close
Sign In
Newsletters
Popular Financial Topics Discover relevant content from across the suite of ALM legal publications From the Industry More content from ThinkAdvisor and select sponsors Investment Advisor Issue Gallery Read digital editions of Investment Advisor Magazine Tax Facts Get clear, current, and reliable answers to pressing tax questions
Luminaries Awards
Podcast Center Video Center Webcasts Resource Center Events
About ThinkAdvisor Contact Us Advertise With Us Asset & Logo Licensing Sitemap Terms of Service Privacy Policy Copyright © 2024 ALM Global, LLC. All Rights Reserved.
ThinkAdvisor
David Blanchett and Michael Finke

Retirement Planning > Spending in Retirement > Income Planning

Which Strategy Wins the Retirement Spending 'Smackdown'?

By John Manganaro

X
Your article was successfully shared with the contacts you provided.

What You Need to Know

  • Different approaches stand out for different reasons, experts agree, but flexibility is key.
  • Some methods are easier to understand, but they are often more rigid and hard to follow in practice.
  • Researchers David Blanchett and Michael Finke prefer responsiveness and more guarantees.

Retirement income planning has moved far beyond the traditional 4% withdrawal rule. There is now a growing stable of potential income strategies that financial advisors and their clients can turn to when it comes to managing spending and legacy goals during life after work.

Some strategies emphasize predictability and a high degree of safety against running short in old age. Others embrace a risk-taking attitude that maximizes lifestyle early in retirement, while clients are presumably most able to enjoy their wealth. Still other strategies seek a middle ground that accepts flexibility as the means of maximizing utility.

Selecting the “right” approach will depend on a variety of factors, ranging from the client’s disposition to the market conditions upon their retirement. While such planning isn’t easy, it does represent one of the best opportunities for financial advisors to deliver value for clients.

This dynamic was the focus of a recent episode of the Shares podcast from the American College of Financial services, hosted by Michael Finke, the income researcher and American College professor, with special guest David Blanchett, a portfolio manager and PGIM DC Solutions’ head of retirement research.

The duo discuss what they called their “favorite topic” — comparing what’s good and bad about various retirement income planning strategies. It’s a “retirement income strategy smackdown,” as the episode notes suggest. Spoiler alert: While different strategy contenders stand out for different reasons, the duo concludes that flexibility is the key in the real world.

Why the 4% Rule Falls Flat

As Blanchett and Finke explained, the 4% rule is ubiquitous for a few good reasons, starting with it being (relatively) easy for both advisors and clients to understand. Plus, it’s so commonly discussed that it offers an almost an ingrained air of authority.

The main issue with such a simple rule, Blanchett said, is that it fails to match up with the complex reality that is retirement.

“Even when people say this is their strategy, nobody actually follows it down to the letter,” Blanchett said. “No one, like, calls up their advisor each year and says, well, since the CPI was at 3.8% last year, I’m going to spend exactly 3.8% more this year. They just don’t behave that way.”

While people can think they are following a safe spending strategy, they are often either under- or over-spending. The rigidity of this framework makes one of these negative outcomes almost inevitable.

In addition, the 4% rule looks only at the individual’s private savings accounts and fails to recognize that many Americans receive a guaranteed lifetime pension benefit, such as Social Security.

This means that a retiree’s portfolio is generating income in addition to these guaranteed sources, Finke and Blanchett said, thereby providing a safety net that might allow for a different portfolio withdrawal rate.

In past research, Blanchett has found that using more realistic outcome metrics like goal completion, and incorporating things like retirement spending flexibility, results in higher optimal spending levels.

“Based on this research, I think 5% is a more realistic fixed starting point for the average retiree assuming a 30-year retirement period, but the actual target depends on a host of factors,” he said.

The Virtues of a Guardrails Approach

The guardrails approach to retirement income attempts to deliver adequate (but not overly high) raises for retirees during upward-trending markets while adjusting downward after market losses. Guardrails can be built in a variety of ways, but the key is making regular adjustments based on evolving success projections.

One example is with a client wanting a retirement success probability of 90%, based on traditional Monte Carlo calculations. If the portfolio experiences strong growth in the first year after retirement and the recalculated success probability reaches 99%, the client could increase spending to a level that would again leave a 90% probability of success.

If the client experienced tough markets early in retirement — or ended up spending more than anticipated — and the recalculated probability of success fell to 70%, spending could be decreased back to a level affording a 90% probability of success.

The appeal of this approach is clear, Blanchett and Finke said. It can help clients continually revisit their plan and feel confident that, despite big market moves or unexpected spending surges, they can move forward with confidence.

The catch? A relatively high level of potential variability in the anticipated annual income stream that a client will be able to enjoy. Such variability can be hard for clients to stomach if they have not been adequately coached on how dynamic spending strategies work.

The ‘Unconstrained’ RMD Strategy

Blanchett and Finke also discussed is the “RMD approach,” which in a sense is the most straightforward strategy a client can employ. The idea is that a client can essentially mimic the framework that underpins the calculation of required minimum distributions from tax-deferred accounts.

They can either wait for RMDs to legally kick in at age 73, or they can start “taking their RMDs” earlier than that.

“In its simplest form, the RMD method is to set withdrawals by taking the portfolio value divided by life expectancy,” Finke explained.

The advantage of this method is that it is “inherently safe,” as it is designed to ensure that a retiree will never deplete the portfolio, because the withdrawal amount is always a percentage of the remaining balance. In contrast to the other methods, the percentages withdrawn are based on the current portfolio value, not the original balance.

The primary drawback of this approach stems from the RMD system incorporating just two variables for retirement spending plans: remaining life expectancy and remaining portfolio value. Thus, while changes in life expectancy are gradual, that the remaining portfolio value can change significantly adds major volatility to cash flows.

Often, clients find their optimal spending level will be relatively low early in retirement before peaking dramatically in the early or mid-80s. It then falls very quickly toward the end of life, potentially leaving someone highly exposed to longevity risk.

“For most people, this isn’t really a projected spending pattern that is going to align with their ideal retirement lifestyle,” Finke said.

Using Annuities as a License to Spend

Finally, Blanchett and Finke delved into the results of a recent paper on which they collaborated. The research found that clients who purchase guaranteed income annuities effectively buy themselves a “license to spend” and to potentially take greater risk in the remaining equity portion of their portfolio if desired.

Financial professionals often view guaranteed annuities as a sacrifice of potential portfolio growth for income stability in retirement, Finke and Blanchett said, but that point of view misses a much more important planning concept.

By shifting a portion of non-annuitized wealth into annuitized wealth, Finke and Blanchett found, the typical retiree could feel comfortable spending twice as much each year per dollar of accumulated savings. Clients also gain substantial flexibility when it comes to how much risk to take in other parts of their portfolio, all without making bankruptcy more likely.

One downside?: partly annuitized client could theoretically lose out on some portion of potential wealth growth that could come along with a major bull market.

But that is beside the point when a goal is to navigate retirement with predictability and stability, according to Blanchett and Finke — especially with where interest rates stand.

The paper suggests that annuity payouts would need to be reduced by about 50% to eliminate the difference in added spending potential between non-annuitized and annuitized assets. Such a reduction would imply a spending rate of about 3.7% from assets — which is itself not far from the most basic 4% rule.

So, Which Strategy Wins?

Any rationally constructed income planning framework will have its virtues, Blanchett and Finke said. However, they feel that the best outcomes are going to be associated with responsiveness to changing conditions, regular advisor-client communication about the status of the plan, and a willingness to embrace some degree of flexibility in the actual income figure.

As such, both are particularly interested in continuing to circulate the results of their annuity-focused research project, and they also are regularly discussing the virtues of the guardrails framework with their advisory peers.

Pictured: David Blanchett and Michael Finke

John Manganaro

NOT FOR REPRINT

© 2024 ALM Global, LLC, All Rights Reserved. Request academic re-use from www.copyright.com. All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.