If you’ve been following the discussion about safe withdrawal rates, you’ve probably been a bit discouraged by the latest news on the topic. Thanks largely to very low bond yields, which portend weak returns from bonds over the next decade, retirement experts like Wade Pfau argue that new retirees need to be very careful when deciding how much to take out of their portfolios.
Rather than starting with the oft-discussed 4%, which back-tests have shown to be sustainable over rolling 25- to 30-year periods in modern U.S. market history, Pfau thinks the years ahead could be more challenging. For that reason, he believes that a 3% initial withdrawal rate is more like it for new retirees.
Seeing a $1 million portfolio translate into a $30,000 cash flow in year 1 of retirement can be discouraging. But the good news is that few retirees are reliant on portfolio income alone. Most retirees will have CPP/QPP/OAS as an income source in retirement, and lifetime benefits can be enlarged by delaying and/or harmonizing benefits for married couples. And while pensions are ebbing away in the private sector, about a third of today’s retirees have some type of pension income, or RRSP. Annuities, while controversial, diverse, and sometimes costly, can be another tool for boosting income and in turn shrinking portfolio-withdrawal needs. Finally, retirees may bring other sources of cash flow into retirement, including rental income from properties, royalties, or income from part-time work.
In short, a key task when developing your retirement plan is figuring out how to enlarge that baseline of nonportfolio income and ideally finding a way to stretch it over your basic household expenses: food, utilities, rent or property taxes, insurance, and so on. Armed with that information, you can then determine the impact on your portfolio withdrawals and in turn your portfolio’s positioning.
As you take stock of these income sources, here are the key steps to take.
• Develop your CPP/QPP/OAS strategy.
This is incredibly valuable for a few key reasons. One is that it’s a lifetime source of income; it will pay you for as long as you live. Another big plus is that the income you receive isn’t subject to market volatility but it is inflation-adjusted. .
That's why maximizing your benefits is so important. Run the numbers based on your own situation and earnings history; married couples with different anticipated retirement dates and earnings records may find that claiming benefits at different times makes sense.
• Take stock of any pension income.
Of course, most of us will have a big old zero on this line, as pensions have been ebbing away for several decades. But for those retirees lucky enough to have a pension, the lack of market risk and lifetime income inherent in pension income is attractive.
A key fork in the road for people with pensions is whether to take the benefit as a lump sum or an annuity. As Morningstar contributor Mark Miller notes, the lifetime income and lack of market risk makes taking the stream of payments through the annuity option attractive in many situations.
• Evaluate the appropriateness of an annuity.
If you opt for the annuity, you’ll typically have the option to choose the benefit for your life only or for your life plus that of a survivor. You may also be able to opt for a benefit over a certain period of time rather than your lifetime. If you were to die prematurely, your survivors would still be able to receive benefits. Because decisions related to pensions can have such a big impact and lump-sum buyout offers can be complex, getting some professional advice can be money well spent.
In general, the academic literature indicates that adding a very simple, low-cost income annuity, either immediate or deferred, can help improve the longevity of a retirement plan. If you're venturing beyond these product types, it's crucial to understand what you're buying and what it will cost, as well as any trade-offs associated with the product.
• Assess how other income fits in.
While benefits, pensions, and annuity income all provide lifetime income streams, retirees may also be able to lean on other nonportfolio sources of income. In this idiosyncratic category of cash flow sources I’d include income from working, to the extent that you care to do so in retirement, as well as income from passive nonportfolio sources such as property rentals or royalties. Of course, whether you count on any of these cash flow sources depends completely on your situation and your personal preferences.
Additional nonportfolio cash flow sources may include cash values on life insurance as well as reverse mortgages. Retirement researcher Wade Pfau calls these "buffer assets," meaning that they’re most advantageous in periods when pulling from a portfolio is a bad idea because the holdings are depressed.
• Add them up to determine portfolio impact.
The last step in the process is to total up your expected annual cash flows from these nonportfolio income sources. For some of us, this will be a single line item: how much we expect from enefits. Armed with that information, you can then subtract out that annual dollar amount from your anticipated yearly in-retirement expenses. (Of course, it may not be quite as simple as that, in that you may not have all of these sources to rely upon in each year of retirement.)
The amount you’re left over with is the amount that you’ll need your portfolio to replace annually. Divide that amount by your expected portfolio balance in the first year of retirement, and that’s your withdrawal rate.
