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By Morningstar.com | 03-11-2017 11:00 AM

How Much Income Can Your Portfolio Safely Provide?

Retirement Readiness Bootcamp Part 3: The 4% withdrawal rule can be a good starting point to assess your portfolio’s viability.

Jeremy Glaser: In our first two sessions, we described how to figure out what your spending in retirement is going to be--what you can count on from Social Security, pensions, other guaranteed sources. But now we're really getting to where the rubber hits the road--is your portfolio going to be able to provide that gap between first two items. And I am here again with Christine Benz, our director of personal finance, and also with Maria Bruno, she is senior retirement strategist at Vanguard.

Thank you for joining me again.

Maria Bruno: Thank you.

Christine Benz: Jeremy, great to be here.

Glaser: So, Christine, let's start a little bit. I know you brought some slides here to talk about, how to just determine, what this gap is, what is kind of the arithmetic of it.

Benz: Yeah. Jeremy, you alluded to the basic calculation, that's the starting point for calculating your spending rate. So, you are looking at your annual anticipated in-retirement spending, that's the starting point as we talked about in the first session. It's easier to do that. The closer you are to retirement, try to get a good number there, then from that number, you are subtracting any annual sources of other nonportfolio income that you will be able to rely on in retirement. So, that is Social Security, perhaps a pension, perhaps some type of annuity we talked about, some of the other things in the preceding session.

The amount that you are left over with is your annual spending rate. So, that's the starting point. You can then take that number and determine whether that is a sustainable spending rate, so that would be the next step in the process.

So, let's say we have in my next slide I have got 67-year-old Mark. We are assuming that he needs in my example; he has determined that he needs $70,000 in total spending per year in retirement. So, his Social Security is going to step up and provide almost half of that, $32,000. He also has a small pension leftover from the previous employer, so that pension is supplying $3,000 a year. That means that he will need to withdraw $35,000 a year from his portfolio to meet his cash flow needs. So his spending is $35,000 per year and then he needs to walk through whether it passes the sniff test of sustainability. If $35,000, that's his withdrawal in year one of retirement, he then needs to take it through some math. So, let's assume that Mark has a $1 million portfolio. He has enjoyed the nice stock market rally. If his portfolio is at that level, he is in good shape from a spending standpoint--$35,000 in his initial withdrawal of his $1 million portfolio is 3.5%, and we'll talk in the session about why that seems like a decent number for someone just embarking on retirement.

If Mark's portfolio is significantly smaller, so if he has $600,000, his initial spending rate is probably too high or very likely too high. So, $35,000 of that $600,000 portfolio would be closer to 6%. Most planners if they were to look at that number would say Mark, let's see if we can figure out some things to either try to reduce your in-retirement spending, or try to enlarge your portfolio before you get close to retirement.

Glaser: Maria, this 4% rule gets kicked around a lot, we talked about it a lot, but say, that I just misunderstood, can you explain to us exactly what that 4% rule, what it's saying?

Bruno: Yeah. I think we'll talk about that in more detail with our experts today as well, but the 4% rule really--well, the intent of it was to, as Christine had mentioned, you look at your portfolio balance, and if your target rate is 4%, you would spend 4% of that. One way to calculate that in terms of the 4% spending rule. As we have known for the past 20 years or so is that that number would increase every year for inflation, so the intent was to provide a predictable income stream for retirees.

The danger, though, with that, as Christine had mentioned around portfolio size, if you continue with that type of spend rate and you might encounter a bear market then what you thought was 4% could actually be even 6%, much greater. The concern would be if that were to happen early in retirement. It could put the portfolio longevity at a great risk. So really need to look at and calibrate what that spend rate is relative to the portfolio on an annual basis. There are different ways that you can do that and we'll talk about that.

Glaser: Yeah, we'll definitely spend some time there. But Christine, something we hear a lot is that people want to have a zero percent withdrawal rate, that they only want to attach dividend, they only want to touch growth, they never want to touch the principal. Is that realistic for most retirees?

Benz: It's not, and first of all, that's not a zero percent withdrawal rate, either. If you are withdrawing something, it doesn't matter whether it comes from income or your harvesting capital gains or whatever you are doing. If you are taking money out of your portfolio in any form, that counts as a withdrawal rate, so I would just put that out there. And I think that the problem is while there is a lot that is intuitively appealing about just living on the income from a portfolio, there is a lot over the past couple of decades, three or four decades, that has made that a really tricky thing.

So retirees who want to subsist exclusively on income distributions from their portfolio have had a tough choice because they too have been buffeted around by the declining rate environment, declining interest-rate environment. So their choice has been either stick with the safe stuff that has historically been the raw material for retirement portfolios, or if I want a higher yield than 1% or 2% that I can get with cash in high quality bonds, I need to venture out on the risk spectrum. We have been seeing a lot of retirees make that latter choice, the ones who are income-centric. We see a lot of gravitating to some of these higher incomes but in some cases, higher risk--or frankly every case--higher risk investment type.

So my thought would be to just a take a step back, not focus so much on current income, you certainly want income producers as a portion of your portfolio, but just take a step back and think how can I build a portfolio with the best total return characteristics going forward. And if you are to do that, if you are to listen to our colleagues in Morningstar Investment Management or your colleagues who do investment management at Vanguard, they would say building a portfolio strictly of high-income producers is not going to produce the best diversified portfolio with the best forward-looking prospect. So, I think it's important to not focus exclusively on current income,to just think about building a portfolio with the best total return characteristics and using that as a starting point.

Glaser: If I can make a plug for one of our afternoon sessions we do have Travis Miller who is one of our chief utility analysts, the dividend expert, who will talk about some of the few places you can find yield today. 

Maria, I know Vanguard has done a significant amount of research on a fixed-percent withdrawal rate but by putting a ceiling and floor around it, to make sure that you are not getting too crazy during bull and bear markets. Can you explain kind of what this process is and how it works?

Bruno: Sure. I'd be happy to. So, as I first had alluded to the 4% spending rules, we know it has been intended to provide a predicable income stream. The risk is it doesn't really acknowledge the portfolio volatility. The flip side would be to take a percentage of portfolio method and that's exactly that--you would look at your prior year end balance, you would take 4% of that every year. The downside to that is it can provide a volatile income stream, and that could be difficult for some retirees who need some type of predictable income stream to meet their expenses.

So, a hybrid approach that we recommend at Vanguard is really marrying the two. It would be setting what your initial rate would be, let say it's 4%. And what you would generally speaking do is look at your prior year end balance and look at what 4% of that would be. But then also look at your prior year spending and set a ceiling and floor. So, for instance, hypothetically, it's 5%, and 2%, what you would do is you would look at your prior year-end spend, estimate what it would be the 5% real increase or 2% decrease, and look to see where--so basically what it does is it sets a ceiling and a floor, it sets some barriers around that relative to the 4% and you would take within that whether the 4% of it were to fall outside of that, you would actually instead take the ceiling.

And what it does is, it allows for market participation, so in years when the markets are generous, it allows you to spend more, but it puts a ceiling on it, thus allowing a little bit more downside protection. So, it does require little bit of math through the years, but what it does is, it actually--we've done the research--it actually helps with the durability of the portfolio, but while giving some variability around this 4% rule or whatever rule you've set out as a retiree.

Benz: It's a great research paper. I've referred to it before, and I think it's a really helpful way to think about in retirement spending. Jonathan Guyton, the financial planner has done something kind of similar right with the guard rail idea. But the basic idea is that fixed-rate of expenses with some buffers on either side.

Bruno: Right, and there is different research. It kind of all supports the same notion of, you know, allowing some type of guard rails around the market volatility to help smooth the payment. Another way could be potentially a smoothed payout, looking at potentially maybe the prior three years of a balance, take 4% of that. Endowments and foundations for instance tend to use a spending policy such as that. So, a couple of different ways that you could approach it as a retiree.

Benz: And the Vanguard Managed Payout Fund kind of works in that way too.

Bruno: Exactly yes. Correct.

Glaser: And we have a question here that I think leads nicely into our next segment, which is that maybe this 4% rule isn't necessarily a rule. You know that it's something that's worked in the past, but maybe it won't work in the future. So, let's start with Michael Kitces, who is going to share with us the genesis of the 4% rule.

Michael Kitces: A lot of people have heard of the 4% rule, or sometimes called the safe withdrawal rate research, that determines how much money you can spend from an initial retirement portfolio. But I find very few actually know where that number came from in the first place, and understanding its source is really important when we look out at the landscape like today when interest rates are lower than historical norms, market valuation is higher than historical norms and ask the question, is 4% even an appropriate number today or should it be more like 3.5% or 3% or 2.5% or something lower.

Now, when we actually look at where the 4% rule came from, it came forth from a Journal of Financial Planning Study in the mid-1990s from actually former engineer-turned-financial planner named Bill Bengen. And what Bengen was actually looking at was the media of the day when market returns were very good through the '80s and early '90s and it was common to see industry publications saying things like, well, since markets have been returning 10% to 12% a year, we think a safe spending level might be 8%.

And Bengen came forward and said, wait a sec, I get that, in today's market, returns have been good and maybe 8% looks OK. But when you look historically, sometimes returns aren't so good. Sometimes you get really bad years or entire decades that are horrible. And so, what Bengen did was he said, let's go back through the past 100 years of history, and we're going to look for any particular 30-year time period--what was the best and worst time periods to be a retiree.

And so, he actually went through and meticulously re-created for every possible rolling 30-year time period in history, what safe withdrawal would have worked given that particular 30-year time period's inflation, stock returns, and bond returns--recognizing that sometimes you get good returns, sometimes you get bad returns, sometimes you get good returns at the beginning were bad at the end or bad at the beginning and good at the end. So, he ran through all the possible scenarios, and what he found was that an initial withdrawal rate that's sustainable can vary anywhere from as low as about 4% to as high as 11%.

And so, where the 4% rule came from was actually very simple. Bengen simply looked at all of the historical numbers that would have worked. And so, well, if you want a safe withdrawal rate number, you really want pick a number that's safe, pick the worst one that's ever happened, the worst one in history. And that was actually where the 4% rule came from--4% was the number that would have worked in scenarios like retiring on the eve of the Great Depression, in the middle of the Great Depression, or in the mid-1960s right before that nasty inflation spike and stagflation that struck in the 1970s. 4% would have been low enough to get you through all of those worst-case scenarios that we've ever seen in our market history. And that was really where the number came from.

The idea was simply, let's assume that today is the first day of the next worst scenario we've ever seen in history. If so, 4% should barely carry you to the end, just as it did in all the other worst-case historical scenarios. And in any other scenario, where markets are less than horrible--basically you'll have one of two outcomes: Either A, you'll get an opportunity to raise your spending as you go once it's clear that you're not in trouble; or B, you'll end up leaving a really nice inheritance behind for someone. Either way, we make sure that we're not at risk to run out of money even if a bad sequence of market returns occurs.

Glaser: Christine, one aspect of this rule or withdrawals, generally is that you get to give yourselves a raise for inflation every year. Can you walk through an example of what that would look like?

Benz: Yeah, I think, it's useful to look at an example, because I have experienced that people have some confusion over what these inflation adjustments look like. So, in my example we've got someone with an $800,000 portfolio, and they are employing the 4% guideline. So, their year one portfolio withdrawal would be $32,000. So, assuming that they experience some inflation over their short--admittedly short time horizon--assuming they experience 3% inflation, they will then nudge up that $32,000 to account for the inflation. So, their year two withdrawal would be $32,960, so that takes that initial $32,000 and just adjusts it by 3% upward.

Sometimes people say, so if I'm taking 4% initially and inflation is 3% does that mean I get to take 7% in year two? No, it works like the way that I have it in this example. So, in year two, I'm sorry in year three, assuming that the person has experienced 2% inflation then they would inflation-adjust that $32,960 that would go up to $33,619. So, you're inflation adjusting that dollar amount--you're not worrying about your initial starting percentage.

Glaser: So, you do get that little bit of a raise. You know, as we've I think alluded to a few times here there's some discussion about if 4% still is kind of safe in this worst-case scenario given that we're on--we've had an eight-year bull market, interest rates are not very attractive, bonds may not be that attractive today. David Blanchett has actually done some research on this topic, and here is his thought on if 4% is still a reasonable starting point.

David Blanchett: I think that a better prospective is what it means for--well you have to save your retirement. So, one divided by 4% is 25. What it really means is you need 25 times your income goal when you first retire. Now there are some really important caveats around this 4% rule, or 25 times rule. The first is it's based upon historical U.S. data. Today is a difficult time for investors. Morningstar, we do projections for market returns, and this is one of the worst times we think ever for investors. We see a very low bond yield historically and a relatively high stock market valuation.

So, right now we see this to be a trying time for retirees. And so that right there would suggest that you need more then that base estimate. So, if 25 times is the starting point, our current market landscape would suggest maybe 30 times your income goal or withdrawal rate of say 3% from your portfolio.

Now there's some really important parts, though, that you should consider when it comes to what is a right number for you. The first and I think most important that is often overlooked is what does failure or change mean to you. This 4% rule is based upon this idea of taking this constant dollar in inflation terms out for 30 years. An important question then is, is can you adjust this consumption over time? Do you have flexibility with respect to your withdrawal from your portfolio? If you do, you need less saved for retirement.

Second and this is along the same lines what are your existing guaranteed income sources. If you're getting pension and Social Security the portfolio is a small piece of your overall consumption, then you have more flexibility with your withdrawals. So I think a really important question for retirees is what kind of certainty do you need for this income stream, and the more certainty that what you have to have saved for retirement.

Glaser: Michael Kitces also gave his take on if the 4% rule, is still a good starting point.

Kitces: One of the points of debate in the marketplace today about safe withdrawal rates and the 4% rule is what the 4% rule can really hold in today's environment. It is based historically on some of the worst-case scenarios that we'd ever seen in U.S. market history. But the reality is we're still limited to about 100 years of market history data, and frankly the U.S. overall has actually done better than many other countries around the world which had at least slightly lower withdrawal rates or much lower if you had the great misfortune to say live in Japan, Germany, or Italy in the aftermath of World War II. And that's led to a lot of question about whether the 4% rule will hold in today's environment, particularly given what is truly a bit of an unprecedented scenario of market valuations being as high as they are today, while interest rates are still as low as they are today.

Now when we look at how safe withdrawal rates have fared even for the past 15 years, we do see that if you were using the 4% rule, starting in 2000, that market peak you're still ahead of the worst-case scenarios in history. If you use the 4% rule from the eve of 2008, you're actually still ahead of the worst-case scenarios in history. In other words, 4% rule is still proving robust through 2000 and 2008, which means if you want to bet that it's going to be broken going forward, you need a market crisis even worse than what 2000 and 2008 provided. Nonetheless we can't guarantee that something worse won't happen in the future. So, we do see some retirees curtailing the number even lower as a form of sort of last resort conservatism. And we see others coming to table and saying look I'm in the start at 4% but if it ever looks I'm veering too far off track I'm still going to be ready to cut my spending if it's absolutely necessary to do so.

Ultimately we still think 4% is about as reasonably robust of a number as we can get just given the uncertainty of history at the end of the day. Of course, if I really want to make sure I'm never going to run out on money just don't spend any of it, but in a world where we have to spend it at some point, we want to enjoy the money that we've created, recognize that you'll always have the option of making midcourse adjustments if the situation truly turns into something that's literally worse than the Great Depression, worse than the 2008 financial crisis, worse than the stagflation of the 1970s, and the midcourse adjustment can keep you on track. But short of that we still think that 4% is a reasonable baseline number to look at the marketplace today.

Glaser: Christine, I can't let you off the hook of this debate too. Do you think 4% is what retiree should be, or people assessing their retirement readiness should be using right now?

Benz: I liked Michael's last comments about that flexibility. So maybe starting with 4%--and let's face it, it's a very wealthy retiree who can make do on 3% of his or her portfolio or even less. So, the fact of life is that for many people if you can take the number up to 4% that helps a lot in terms of maintaining quality of life in retirement, you're not having to cut out going to movies, and going out to dinner that you are still able to do some of those things. I loved Michael's point though about this course correction--that if for whatever reason 2017 or 2018 is Armageddon in terms of the equity market, that you have to plan to be flexible to tighten your belt a little bit, and that will be particularly important for new retirees just starting out if they've made their projections based on today's enlarged balances. That they need to be particularly careful about pulling in their spending if they encounter that really lousy market right out of the box.

Glaser: Maria, should everyone be using the same rate though? What are some of the factors that could make it higher or lower?

Bruno: Again, we've used 4% and there are assumptions that have gone into 4%. First is time horizon, I would say. For retirees who are leaving the work force and spending from their portfolios at an earlier age, they'll want to err on a more conservative withdrawal, maybe closer to 3% for instance. The flip side--someone who is an advanced retirement should not be locked in to a 4% spending rate. They could spend up to potentially 8%, 9%, 10% for instance, so some flexibility there in terms of time horizon is a guide.

The other is asset allocation. A lot of the spending policies are predicated upon a balanced asset allocation--balanced being anywhere from 60% to 40% equities. So, for someone who is more conservatively allocated that would also warrant a more conservative spending policy. The flip side is with more aggressive portfolios, yes, longer term you could support a higher spending rate. The caveat that I will add there is that if you are more aggressively allocated and you have a shorter time horizon, the volatility around equities could cause a premature depletion. So, a little bit of caution there for individuals who have a short-term time horizon and more aggressively allocated. But those are the two big things in terms of time horizon and asset allocation.

Glaser: Definitely, we're going to come back to that idea of sequence of withdrawals and the risk there. But first off, we're going to hear from David Blanchett who talks about how leaving a legacy is going to impact your choice of withdrawal rates.

Blanchett: Bequests are an important consideration when thinking about what is the right safe withdrawal rate for me. And obviously, if you have goals beyond just funding lifetime income, it negatively affects the portfolio income. If your goal is to leave $100,000 to your children when you die, what that generally means from a withdrawal perspective is taking out less over time, because it's really hard to kind of know where you'll be when you die. And so, when you're thinking about, if you want to leave more for your kids, I would say you need to start at a lower number.

Glaser: And speaking of that sequence of withdrawal risk, David Blanchett has some thoughts about what that could mean for your withdrawal rate.

Blanchett: Sequence risk is a very important risk for retirees. It's simply the fact that when you experience the returns, it's very important for your retirement outcome. So, for example, if you have a negative 20% return, if you have that in the first year of retirement that has a dramatic impact on your retirement outcome. If that happens, say at the 20th year, the impact is much less. And I think that sequence risk is really valid today because we don't have high expectations for the market. I think that there is a good possibility of a shock at some point in the future. And so why its problematic especially is if you have a portfolio that possibly isn't matching your risk tolerance level, if you're very aggressive, the markets go down. And if you pull out, you will experience that negative return and not possibly get the rebound. And so, sequence risk is a reason. It's very important to understand how much risk can you afford to take in your portfolio based upon your overall, your funded status, as well as, what is the right risk level based upon your risk preference.

Glaser: Christine, you're a big proponent of this bucket strategy. Where we have these different pots of money for kind of near, medium, and long term. Can that help mitigate some of the sequence of return risk?

Benz: It can and that's really the basic principle in play, that you are building enough assets in your portfolio, parking them in safer securities to tide yourself through one of those equity market shocks. So, in some of the research that looks at the negative sequencing and how that can impact investors, it's assuming that the retiree is pulling some money out of equities, leaving less in place to recover when the markets eventually recover. The bucket strategy tries to insulate against that possibility. So, in my bucket portfolios, which I'll talk about in the next session, the basic idea is that you're holding one year to two years in true cash instruments, the next actually three through 10 years worth of living expenses are going--and these are living expenses not supplied by certain sources of income like Social Security--the next three to 10 years are going into generally a high-quality bond portfolio. 

So, when you think about it, we'd have to go through really terrible and sustained equity market downturn, to not have equities recover over that 10-year time horizon. In fact, when we look at equity market performance, we see that equities are really reliable if you have at least the 10-year time horizon. So, that's the basic idea. I think there's also sort of a practical thought process here as well that people don't feel very good when their portfolios are declining and they're spending from them and they're watching them dwindle. Knowing that you have enough parked in safe assets, gives you some peace of mind to put up with the fluctuations that will inevitably accompany your equity portfolio.

And I can't talk about the bucket approach without tipping a hat to Harold Evensky, the financial planner in Florida who really is the architect of this strategy as I think about it. And he has said that when he talks to his clients, that this really works. That during the financial crisis, he would phone them to kind of check up and say how are you feeling, the market is not performing well obviously. And they'd say, I know, but bucket number one is there and that's what I'm using for my spending. And he has said that it really works in practice, and I anecdotally have been talking to retirees about this, and they say that it works for them too. That knowing that they have enough safe assets helps them cope psychologically with equity market downturns.

Glaser: Maria, so far we've been talking about your retirement portfolio as this monolith, but in reality, you're probably coming to retirement with a tonnage of accounts, traditional IRAs, Roth IRAs, 401(k)s, taxable accounts. When you have all of these different accounts, how do you think about where to take that 4% from and what withdrawal sequence should look like?

Bruno: It's a good question. Usually we get the question of how much and then well, how do I do that. That's where the different account structures come into play. The first point would be, if you as a retiree are subject to required minimum distribution. So, if you're over age 70 1/2 for instance, and you have traditional deferred assets, then you will be required to take distributions from those on an annual basis. So, generally speaking that can be the first source, since those dollars have to come out and they're going to be taxed anyway.

Beyond to that, there's a conventional drawdown wisdom. Again, if the goal here is is really to try to maximize what your lifetime income could be--step aside from individuals that have bequests, motives or whatnot. The conventional drawdown, would be to spend from your taxable, your nonretirement assets first, allowing the taxed advantaged accounts to continue to grow. And the benefit to that is taxable accounts, when you take distributions from them, are taxed at capital gains rates, which currently are lower than ordinary income-tax rates.

So, they're generally taxed more favorably, it also allows the tax advantaged accounts to continue to grow. So, generally speaking that's a good rule of thumb. I say it's a good rule of thumb because then in situations, where you might have different goals that might warrant a different account drawdown, or there maybe annual tax planning opportunities that could be opportunistic in drawing down from the different accounts.

Glaser: There could be a case then for say tapping in your Roth earlier in retirement?

Bruno: There can be. Generally, I would say, especially for individuals who are newly retired, before they start being subjected to mandatory distributions or before they start taking Social Security benefits, they maybe in a relatively lower tax bracket than later in retirement. So, it actually maybe an opportunity to accelerate tax deferred distributions.

It seems counterintuitive because you are accelerating a tax liability, but you are doing that in order to pay at lower, relatively lower marginal rates. And it also reduces the potential RMDs down the road as well. So, that can be a practical guideline.

Glaser: Christine, this tax diversification seems like it could be valuable if you are in accumulation, if you are farther from retirement. How should you go about trying to build these diversified accounts?

Benz: It's a really valuable concept to bear in mind and, in a way, it's a really great form of deferred gratification to think about contributing to Roth accounts, traditional tax-deferred accounts, as well as perhaps some taxable accounts. Traditional tax-deferred accounts are the ultimate and immediate gratification because you get a tax break on your contribution.

So, a lot of people--and I think of myself really, before we had a Roth option in Morningstar's 401(k) plan--I was just plugging my money into that traditional tax-deferred 401(k) every year. But the idea of coming into retirement with all of my money that will be fully taxable upon withdrawal isn't really attractive. It makes sense to, as Maria discussed, come into retirement with the multiple account types. That way in a given year, I can kind of pick and choose where best to go for the cash I need based on other things that might be going on in my life at that time.

Glaser: But if you haven’t prioritized tax diversification and you're getting closer to retirement, is it too late? Is there anything you can do in maybe that decade before you retire?

Benz: I think Maria talked about--you've called it the sweet spot, right, for retirement planning that post-retirement, pre-required minimum distribution period as being a time to consider doing some conversions, perhaps or perhaps accelerating the drawdowns from them.

Bruno: Right. When you're working, you can make the active decision of where to direct your deferrals. So, whether it's traditional deferred or Roth account. So, you can channel the cash flows accordingly. Once you are retired, your options are much more limited and you either take the distributions and spend from the traditional deferred accounts or you can do Roth conversions and that creates the diversification.

There are no income limits on conversion. So, essentially anyone really can convert. You want to be mindful in terms of how much additional income you may be triggering as a result of the conversion. But, again, what we're seeing is that retirees can be in a relatively lower tax bracket before Social Security and required minimum distributions, and it can be a very strategic way to maximize the low tax brackets, while reducing potential RMDs down the road, because essentially those tax-deferred balances would be smaller.

Retirees leaving the workforce today are an RMD generation--they are leaving with large deferred balances. So, it's a very real situation. And there may be an unwelcome tax surprise at age 70 1/2 once they start taking distributions. We are seeing--I mean, Roth conversions overall at Vanguard are very, very low, but we are seeing a trend where individuals are doing conversions and it's increasing substantially up through age 70 prior to RMD. So, that makes us think that this potentially it's a zone period, where it makes sense to accelerate some of that income.

Benz: One point I would make, Jeremy, too, before we leave this topic. This is complicated …

Bruno: Yes.

Benz: So, this is an area where if you do not really understand the tax treatment of these various vehicles or it's just not your thing, definitely get some help. So, either with a tax-savvy financial advisor or a CPA who's versed in the ins and outs of this, you may be able to work with that person to help determine the best sequence of withdrawals and if you're still accumulating the best vehicles to use for your retirement savings. So, definitely, don't be afraid to ask for help.

Bruno: Yeah, I totally agree. And you said a tax-savvy planner, and I would agree with that, because there's really--there's an interplay there and it can have adverse consequences. So, you want to really be mindful of the trade-off decisions.

Glaser: How about those RMDs, though? If you are having an RMD that's maybe bigger than the 4%, if it's more than you really think that you need or withdraw, how do you handle that? You're not obligated to spend it, correct?

Benz: That's right. We get this question all the time, where we talk about withdrawal rates and people have in their minds how much they want to withdraw from their portfolios. And if they are of that RMD generation that Maria talked about, maybe most of their portfolio is in a tax-deferred account that's going to be taxed upon withdrawal and subject to RMDs.

In that case, it's important to remember that even though you have to pull that money out of the confines of the IRA or whatever tax-deferred vehicle it is, you don't have to spend it. So, you should, in fact, if it's going to take you over your optimal withdrawal rate, you need to reinvest it elsewhere, that would typically be a taxable portfolio if you're someone who is subject to RMDs and you're still working, for whatever reason, you can also funnel those RMDs into a Roth IRA, or maybe your spouse is working and you are not, that's another idea. But for most people it will be that the money comes out of the traditional tax-deferred account that is subject to RMDs. And then if you don't need it or don't want to spend it, put it in a taxable account that you have managed for tax efficiency.

Glaser: Speaking of or thinking about asset location of what types of bonds or stocks you're going to hold in each of these accounts, what's kind of the rule of thumb on where you should be holding your various asset types?

Benz: Generally speaking, anything that kicks off a high level of income and almost nothing kicks off of high level of income right now, but any income producers like taxable bonds, certainly high-yield bonds, any of those very high-income categories, you'd want to make sure that you're stashing within some sort of a tax-sheltered account.

If you have higher growth assets, because Maria talked about the sequence of withdrawals that you definitely want to use your Roth accounts for the high growth assets that you'll hold for the longest period of time. You can use, if you have taxable accounts, you can use tax-efficient assets. So, there I would focus on broad market index equity products, you might use municipal bonds there.

Bruno: Yeah, I think the guideline is the assets that have the potential for the greatest return, but the greatest tax inefficiencies, those are the assets that you want to prioritize into their retirement accounts.

Glaser: Let's look at underspending, Maria. This might seem like--or, excuse me, like if you're not going to spend enough on retirement, how do you, what would you say to an investor who just has not taken enough out of their retirement portfolios?

Bruno: Yeah. I mean, we talk a lot about longevity risk as we should and we focus on the primary risk of outliving your assets. That's the primary concern of most retirees, and it should be. But there is also--I often call longevity risk a two-sided coin, because there is also the risk of underspending. And there is an interplay there and we do see precautionary spending in the earlier years because later in life, as we've talked about in-depth today, there is concern around late stage healthcare cost or bequest motives. So, we still see--at Vanguard, we've done some survey work, we still see especially affluent investors still be net savers and that could be the precautionary motive.

But if you are working with the financial advisors, they can help work through that in terms of finding that right balance. But it is a bit of a trade-off because we can't control how long we're going to live. That's the biggest unknown here in terms of what actual longevity would be, and we're trying to manage that as best as possible as retirees. But I don't think the goal for many retirees would be to forego their retirement and leaving this large pool unintentionally.

Benz: I think that's such a good point. And I think it is also--I don't want to leave the topic of bequest without discussing it little further. The idea of trying to get a feel from your kids about whether this is something they even care about, because I think there is a disconnect. I have seen some research where you've got retirees who are determined to leave a big kitty behind for their kids, and perhaps if they were to talk to their kids maybe their kids would say, yes, do that. But their kids may very well say it's--and I know this was the attitude of me and my siblings--it is your money, spend your money during your lifetime.

So, if you are close to your kids try to gauge their sentiment before assuming that they want you to die with a lot of money leftover, especially if it means foregoing your own goals for your lifetime.

Bruno: Many retirees with the children or grandchildren want to give the money to them when they need it the most; so maybe that is a newly married couple, that may be purchasing a home or whatnot. So oftentimes just trying to assess can I do this, that may mean I would give the money to my child while, when they need it while alive but I want to make sure that that doesn't adversely impact my retirement. But many will try to do it with their children, more of a conversation-based or a goal-based. But it is a trade-off, yes.

Glaser: Let's tackle some user questions. The first is about taxes and the 4% rule. Are we looking at 4% over the entire portfolio or a post-tax number when you're trying to calculate what your distribution should be?

Bruno: Well, the withdrawal rate is a withdrawal rate so taxes are part of that. So when you think about 4% or whatever your target is, that does include whatever you are paying in taxes.

Glaser: This is something to always keep in mind.

Benz: Absolutely.

Bruno: Because taxes are an expense, much like any other expense.

Benz: Right.

Glaser: We have another question here about if you do want to leave an inheritance, say, you have half a million dollars in mind. Do you just subtract that from the value of the portfolio and then apply the rule, just to kind of assume that that half million dollars just doesn't exist, in terms of your planning. Or is there a better way to think about it? 

Benz: I like the idea of walling it off. If it is very much a goal to make sure that you leave that amount of money behind I like the idea of not factoring it into any spending rate planning. And the same goes for folks who are self-funding long-term care needs that if that is your plan, well, make sure that you are not factoring that into your spending either, that you need to effectively segregate that from your other assets. I would position it pretty aggressively because that probably would be the money that would be tapped late in life, but I think you do want to segregate it from your spending assets. I don't know if you approach it the same way?

Bruno: No, I agree. And I think we're seeing more and more retirees embrace retirement as a multigoal framework. In that, yes, they need to make sure they can spend throughout the retirement, but they might have legacy goals or want to self-insure for longevity risk. And those should be treated as separate buckets or separate pools of money. So, you need to be thoughtful in terms of which accounts should I be designating toward these goals, and then how do I asset allocate within that.

Benz: How about, I have a question for you. In terms of bequest, the Roth accounts would those be the best option if that's my goal?

Bruno: It can be. I will say that traditional deferred assets may not be the best unless you are designating a charity, because the charity doesn't have to pay income tax, they get the full benefit of the legacy or the gift. But if you are passing assets to a noncharity beneficiary, if it is a child, for instance, Roth assets can be advantageous because the beneficiaries won't have to pay income tax on their distributions when they take them.

The flip side would be taxable assets, if you are equity heavy, for instance, those assets can get a stepped up at basis. So what that means is when the beneficiary inherits those assets they get the fair market value of the basis resets at the death of the account owner. So, I would actually just say traditional deferred assets are probably the least beneficial to give to individuals.

Glaser: We have a question about retiring early again. That if you do want to retire early the 4% rule may not be a good starting point, just because your length of retirement would be so much longer. How would you think about how much you would need in order to retire early. Maria, do you ever deal with this question?

Bruno: We've done research at Vanguard. And we have done forward-looking projections based upon market forecast, and we have information on our website, for instance, with the research that we have done. There is also tools and calculators online, Vanguard has a nest egg calculator. There are other firms that have calculators as well that you can actually put in some figures, but you need to make sure in terms of how you're asset allocated. But usually what you will see is moving from 4% to maybe 3% if you are talking to somebody potentially in their mid-50s who is retiring. The thing though is you really need to make sure that you've got that flexibility window built in, in that because you are investing over a long period of time and the markets will be volatile. So you need to have some flexibility accounted for in that spending rate.

Benz: And the other thing I think we can't ignore healthcare in this situation, either especially with frankly some potential changes to healthcare delivery and paying for healthcare in the U.S., that the early retiree who is not yet eligible for Medicare has some uncertainty going forward in terms of paying for healthcare. So, certainly factor that into as well.

Bruno: Yeah, absolutely. That's a good point.

Glaser: And this question is maybe a bit of a mirror image, I think you use the same calculator but if you feel like at the retirement age that you'd like your portfolio is not really big enough, how can you decide how much way longer you have to wait until that portfolio is going to be safe? Would it be the same kind of process is that early retiree would go through.

Benz: Yeah, I would use some calculators and I know in our last session today, Jeremy, we're going to talk about some of the key levers that investors can pull. The interesting thing is when I play around with those variables like, OK, what happens if we make the portfolio more aggressive? What happens if we add to savings or stretch out the number of years before retirement and delay Social Security? A lot of the nonportfolio stuff, so the Social Security delayed filing, the few years of working longer, maybe reduced consumption in retirement, those are the things that you can really start moving the needle on making the plan more viable. The tweaks at the portfolio level, unless for some reason someone has a very conservative portfolio, there's not that much you can do to help make up for a shortfall. You've got to look at some of the other things that unfortunately touch some lifestyle considerations.

Bruno: Yeah, and I think I would just reinforce, Christine, we talk about tools and calculators and I think they're very good, but they're only as good as the assumptions that are built into the calculators. I often liken them to an input into the financial planning process. So it's good for individuals to use tools to get a better understanding what the key variables might be, but you always need to work through that with your own individual situation.

Benz: And don't stop with the tool that's telling you the thing you want to know, right or...

Bruno: Right, don't change the assumptions there. You know don't--and usually, it's the market return assumptions.

Benz: Right.

Bruno: Some of them have very rosy asset allocation assumptions, and it's not prudent to base a financial plan on that.

Benz: Right, exactly. Some of the calculators are pre-populated with, say, an 8% equity market return. I don't think that's realistic certainly over the next decade. So, I think investors need to pull those levers back to perhaps under 5% equity market returns for the next 10 years for sure.

Bruno: Right. But what is good though is that you can actually do a little bit of your homework in terms of you can see the impact--well, if I work another two years, because I'm working I'm potentially contributing more, and then I'm not drawing from the portfolio. You can see how that can have a much greater magnitude on the overall longevity, rather than you know each trying to eke out an extra 1% of return somewhere.

Glaser: You mentioned that it could pay to get help. This is kind of complicated. We have a question about, if you are going to pay a fee to a financial planner--Christine, I know you've done some work, Maria I'm sure you have too--about does it make sense to pay a flat fee, does it make sense to do a percentage of assets under management. I know there are some changes potentially happening there as well. But what would be the right way to go about finding good advice?

Benz: I think it really helps to take stock of what kind of advice you need. So, if you are someone who needs holistic ongoing financial planning guidance paying that percentage of assets under management year in and year out can be the right answer. Certainly, when I think of some of the best financial planners I know that's the way that they work, they levy, say, 75 basis points or 1 percentage point on their clients' balances year in and year out. And they might consult on a whole gamut of factors, maybe some of the more complicated charitable giving stuff that Maria was talking about. So more complicated situation perhaps that sort of advice is warranted where you're paying the AUM, assets under management, on an ongoing basis.

For a lot of investors, I think,especially when I think of some of our Morningstar.com viewers, paying an hourly financial planner might be a good way to go about it, where you are just writing that check at the end of the engagement perhaps for the hours that you worked with the advisor or perhaps just on the per-engagement basis where the advisor charges you a flat fee. Investors might be surprised when they look at some of those dollar amounts, it might be higher than they would think. But if you look at it, if your situation is where you need that kind of one-time, maybe once a year portfolio check-in or once every couple of years, that'll be for many people the most cost-effective way to go about getting financial guidance. So for someone who wants that face-to-face engagement, that might be a way to think about it.

Glaser: HSAs, health savings accounts, is the account type we haven't talked about yet today. But we do have a question about if they are a good choice for saving for retirement, saving for healthcare in retirement. Should that be part of your tool kit when building out your investment portfolio?

Benz: I think so. I'm a big fan of HSA's, health savings accounts. They have to be used in tandem with a high-deductible healthcare plan. So, you have to be covered by a high-deductible plan to use an HSA. You can't go out and just get an HSA unless you're in a high-deductible plan. But the tax advantages are three: you're able to steer pre-tax contributions into the HSA; the money accumulates on a tax-free basis; and assuming you pull the money out for qualified healthcare expenses, those withdrawals will also be tax free. So, it's a really attractive option, really, frankly, unparalleled in terms of the tax code and the tax benefits. So, I really like the HSAs and think they make a lot of sense.

When our colleagues at HelloWallet have analyzed HSA usage patterns, one conclusion that they have generally drawn is even people who aren't using the HSA as kind of a long-term retirement savings vehicle, the people who are sort of paying as they go for healthcare expenses, they are underutilizing their HSAs. So, I think it's a valuable thing to keep an eye on. Increasingly, we're seeing these high-deductible healthcare plans being at least an option on the company healthcare menu. In some cases, they're the only option now, and if you're using that high-deductible plan, you owe it to yourself to take a look at the HSA.

Unfortunately, it's a new landscape, costs are high in many cases, especially if you're doing investments within your HSA. So really read the fine print, know that you can periodically transfer money out of the HSA into another HSA of your choosing maybe one with lower costs.

Glaser: Maria, you also are fan of the HSA?

Bruno: Oh, I agree. Christine and I talk about this a lot. I think there's a lot of opportunity when you think about it in terms of a retirement plan vehicle. The flip side is that you could potentially be paying more out of pocket, but the value of the pre-tax contributions and the value of the deferral can really compound greatly over time.

Glaser: Let's leave our questions there, and just a quick recap of the session. We now see that the 4% guideline really assumes that you're going to spend 4% of your portfolio in year one and then adjust that dollar amount with inflation over time. And that does assume we have a 30-year time horizon and a pretty hefty allocation to equities. You may have to reduce spending during a portfolio downturns to help improve the longevity of your portfolio, that's something that could be important. And that the sequencing of withdrawals from your accounts also is going to have a big impact, on if it can actually provide that income that you need.

We've also prepared in that workbook, a retirement policy statement to help you really put down exactly your philosophy of investing, philosophy of how you're going to do these withdrawals, so you could have it in writing, something to go back into as you enter into retirement.

Up next, we're going to actually have a special presentation, which is a round table with some recent retirees who were in our office recently. Christine sat down with them and talked about some of the surprises in retirement, things that they weren't expecting, how they're finding the transition away from work. That will be a great segment and that's just up next.

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