Almost everyone approaching retirement will, at some point, ask the question: “will I run out of money?” It’s completely understandable to feel this kind of concern. You’ve worked hard to amass resources for your retirement years and returning to the workforce in your 80s or 90s is unfathomable. What can a person do to improve the longevity of their retirement savings without sacrificing their lifestyle? Can a strategy be put in place to help reduce the risk of outliving your money?
In 2006, two financial researchers by the names of Jonathan Guyton and William Klinger conducted a study in Financial Planning Association Journal titled “Decision rules and maximum initial withdrawal rates,” where they modeled four rules for a perfect retirement against a litany of market and economic conditions. These rules were designed to enable retirees to maximize withdrawals (especially in the early years of retirement), reduce the probability of running out of money, maintain purchasing power and avoid income cuts. Their methodology specifically aimed towards a retirement income pattern that could last for a minimum of 40 years! The rules are:
- Optimize Your Portfolio Management. When constructing your retirement income portfolio, Guyton and Klinger suggest a range of possible allocations, varying in level of diversification and equity/fixed income splits. They found, historically, more diversified portfolios allowed for higher early withdrawal rates, but fewer pay raises throughout retirement. Higher equity portfolios enabled higher withdrawal rates but decreased the probability of success. Ultimately, they leave the portfolio selection up to the retiree, based on their own personal investment objectives and comfort with risk. When deciding how to structure your portfolio, consulting with a professional Financial Planner can ease the decision-making process.
- Optimize Your Withdrawal Strategy. Guyton and Klinger offer a variety of initial withdrawal rates (dependent on portfolio selection) and some guidance on withdrawal strategy. For example, using their 65% multi-class equities, 25% fixed income, 10% cash portfolio, they were confident that an initial withdrawal rate of 5.3%, increasing with inflation, is a good investment strategy. Individuals with $500,000 at the start of retirement could comfortably withdraw $26,500 ($500,000 x 5.3%) in the first year. Choosing “where” to get that $26,500 from is important too! The authors recommend taking income, in order, from: 1) overweight equity holdings, 2) from overweight fixed income holdings, 3) from fixed income holdings, and lastly 4) from remaining equities, in order of prior year’s performance. While a great baseline, these rules do not account for taxation and potential investment fluctuations, making it imperative to consult with your Tax Accountant and Financial Planner, prior to executing on these orders.
- Apply the Capital Preservation Rule. This is the first guardrail for protecting your portfolio against over-redemptions in poor market conditions. In years where your portfolio has depreciated in value, Guyton and Klinger recommend an income freeze. Essentially no increase to match inflation. If your withdrawal rate is already 20% higher than you started, they implement a 10% income cut in these years to preserve your portfolio’s capital. The good news? If you are within 15 years of the end of your planning period (example year 25 out of 40), you can ignore the Capital Preservation rule!
- Apply the Prosperity Rule. Nobody wants a pay cut, but how about a pay raise? If market conditions have bolstered your portfolio such that your withdrawal rate would be 20% less than you started, the authors advise you can take a 10% income increase without jeopardizing your retirement!
The academic article itself contains lots of financial planning and statistical jargon that can make it difficult to decipher. The moral of the story is that proper portfolio management and sound redemption guidance can help produce the financial security of not outliving your assets. While investments are not guaranteed, having guardrails in place, going into retirement, can give you confidence you’ll be able to weather any financial storm.
The information provided is based on current laws, regulations and other rules applicable to Canadian residents. It is accurate to the best of our knowledge as the date of publication. Rules and their interpretation may change, affecting the accuracy of the information. This information is general in nature, and is intended for informational purposes only. For specific situations you should consult the appropriate legal, accounting or tax advisor.
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