Sara and John Fisher are in their mid-50s. Their professional careers are successful and they've amassed about $5 million in assets. While they could keep working, they're ready for something new. They want to start making their dreams come true — now.

With the first Baby Boomers approaching 60, advisors are seeing a lot of clients interested in retirement. Even more aren't quite ready to retire but do want to make some lifestyle change; to leave their primary careers and ease into the next phase, possibly with part-time work. As clients begin to imagine new goals, advisors need to help them plan to fund the rest of their lives. And that's no easy task for two reasons: people are living longer, and “retirement” is no longer a monolith.

The U.S. Department of Health and Human Services reports that the average 65 year old in the United States in 2003 will live to be almost 85 years old.1 One in three will probably live past 90. In other words, advisors and their clients need to plan for many more years than ever before.

Just as importantly, people are experiencing a variety of post-career stages. Roughly speaking, there are at least three stages: the Liberation, Leisure and Legacy years.

In the Liberation stage, those first years post-career, people embrace postponed dreams. For some, it may be seeing the world, for another it may be finally owning a fire engine red sports car. The Liberated have the time and energy to catch up on experiences, projects and acquisitions, but do they have the money to do it? The Liberation years can be emotionally rewarding and financially expensive. Many of the Liberated will supplement their lifestyle with some employment income both for financial strength and personal satisfaction. Advisors must help the Liberated adequately plan for the post-Liberation years before the spending begins.

As the Liberated pass 70, they are likely to embrace a more Leisurely lifestyle. The Leisurely might consolidate residences, downsize or move to an active community setting. Their living expenses stabilize and their investment portfolios may even get a boost from real estate transactions. Advisors must help the Leisurely feel confident that they can live comfortably for many years while beginning to consider legacy goals.

At various ages after 85, Leisurely people enter the Legacy stage of life. The Legacy-minded are likely to focus on their children, grandchildren and future generations. They will want to be sure their financial legacy is well-structured. Their expenses may decline as their activities slow, but they face potentially huge medical costs if their health begins to fail. At this stage, advisors must help Legacies evaluate estate-planning options while maintaining the financial flexibility necessary to address medical needs.

Because spending levels change dramatically during these phases, advisors must create dynamic funding plans for five-to-10 years at a time and revisit these plans regularly — always keeping an eye on the long-term.

In other words, “retirement planning” is no longer that. These days, advisors and their clients need to talk about “longevity planning” and “decumulation strategies.”

LIBERATION

Sara and John, like many of today's Liberated think that, post-career, they may pursue a new career or some form of income-producing employment. But first they want to relax for about six months and fix up their home. They've been meaning for years to add a full-scale English-style greenhouse/conservatory. It's perfect for the gardening hobby they hope to have more time to enjoy now. Plus, they've always wanted to add an indoor/outdoor pool, create a small gym and enlarge the deck. After all, they'll be spending a lot more leisure time at home and regular exercise is a priority as they age. But they are concerned about such large expenses just as they eliminate their primary source of income.

In the Liberation years, spending is likely to increase slightly. Of course, there also are simultaneous savings on work expenses such as gasoline costs, tolls, parking, bus or train tickets, lunches out and work clothes. These savings can be surprisingly large, although they're unlikely to offset your client's world travel plans or Sara and John's home renovation.

Traditional thinking about retirement funding taught Sara and John, like many clients, that when they leave their primary career, they must immediately start scrimping. So they feel guilty about their large renovation dreams and fear they will run out of money to support their lifestyle.

It's time to change this thinking. You can help clients take a hard but realistic look at the cost of their dreams, and the various ways these can be funded by taking a lifestyle stage approach to their longevity. This approach to longevity planning will help your clients understand both the potential long-term cash flows they can expect from their portfolios as well as how those cash flows might reasonably change over time. Your guidance will help them consider the ebb and flow of their spending over the long haul, and how that all might fit with long-range charitable giving and legacy plans.

WEALTH DECUMULATION

A key concept here is decumulation, that is to say, how long a client's assets can last, given different spending plans and different assumptions for future growth. Of course, if spending levels are set too high, a client's heirs may not receive the planned-for inheritance and, worse yet, the client's daily lifestyle can suffer.

The rule-of-thumb in retirement planning comes from work done by a variety of academics as well as professional planners such as William P. Bengen. In the 1990s, Bengen concluded that retirees can withdraw just over 4 percent of their portfolio annually to safely live on their assets. His analysis assumed pre-tax withdrawals that were adjusted for inflation from portfolios invested with a range of 50 percent to 75 percent in equities. Bengen defined “safe” as a portfolio that could last at least 30 years. He made this determination by analyzing potential cash withdrawals through some of the worst down markets in the 20th century.2

More recently, another financial planner, Jonathan T. Guyton, tweaked this rule-of-thumb upward to almost 5.5 percent in certain circumstances by suggesting specific rules be applied each year given the markets' performance and varying inflation experiences. For example, Guyton suggests that no withdrawal be made from an asset class that has declined in value during the year. In such a case, if stocks went down, the annual withdrawal would come out of fixed income investments and cash balances.3

Both approaches are useful for investment professionals managing a decumulating portfolio. In addition, advisors have computerized Monte Carlo simulators and optimization modeling techniques to help plan for the funding of retirements. The combination of these tools leads to a higher probability of planning success.

But more can be done. Neither the simple pronouncement to withdraw 4 percent annually nor even the sophisticated computer model outputs generated today help clients thoughtfully consider their post-career spending and lifestyle.

Sara and John look at a 4 percent spending flow, which for them means $200,000 pre-tax per year, and feel they can't ever do their renovation. The renovation alone is projected to cost at least $200,000. Armed with a 4 percent withdrawal guideline and a computerized model of their current portfolio's future returns possibilities, Sara and John feel deflated and cannot be drawn out to fully discuss their future plans. As their advisor, you are left to assume their priorities and likely spending needs over the next 30 or 40 years, leading to investment portfolios that are unlikely to satisfy them.

If, instead, Sara and John are presented with options that more simply illustrate future spending possibilities, they can begin to think about an evolving longevity plan. That will help them more easily articulate their lifestyle and legacy goals. They might go ahead with their renovation — so long as they carefully balance other expectations. More importantly, they will begin to better explain their financial expectations. Drawing clients like Sara and John into this kind of discussion requires a thoughtful, holistic talk in terms all can understand. That means discussing three aspects: asset allocation, portfolio depletion, and annuitization. Let's see this in action:

  1. Asset Allocation — Sara and John have been well-trained in the total return approach to their portfolio. Total return is the combination of the income generated from investments as well as the capital appreciation: Total Return of Portfolio = Dividend and Interest Income + Growth in Asset Values.

    But this is one time that you may want to limit discussion to the income component. When you begin discussions of longevity planning, it may be useful to help clients first look only at the dividend and interest part of this equation to understand how much income their portfolio might reasonably and naturally generate. Like many clients, Sara and John have begun thinking they won't touch the principal of their investment portfolios. The principal value has been committed in their estate plans and is part of their legacy goals. Yet when they make this pronouncement, they do not actually know how much income their portfolio is generating. Neither have they considered the prevailing and future dividend and interest rates in the current market and what that means to their potential income.

    Therefore, a very simple way to start the conversation is to look at their portfolio and the current income it generates. Until now, Sara and John have had their portfolio oriented toward conservative growth and have had 70 percent of their assets in equity investments. Based on a 10-year Treasury bond yield of 5 percent and a market dividend yield of 1.7 percent on the Standard & Poor's 500, the after-tax income from their $5 million dollar portfolio today is only $99,325. If they change their asset allocation dramatically to 40 percent in equity, and orient the portfolios toward income instead of growth, they still will only generate about $126,400 in after-tax income. (See “Portfolio Income,” p. 39.)

    Sara and John are surprised and a bit disappointed by these numbers. Like many clients, they've spent years building their portfolio and have not been taking withdrawals from their portfolio. They recall that their $5 million dollar portfolio has grown perhaps $300,000 to $500,000 a year, so they have not internalized that this growth has only included perhaps $130,000 or so in pre-tax income. While employed, John and Sara lived comfortably on about $300,000 per year. Their initial response to this analysis is to ask whether they should move to a higher fixed income allocation. Indeed, the point of this approach is to help clients thoughtfully address the trade-offs in the asset allocation decision. Seeing the actual income numbers may help shape both Sara and John's asset allocation comfort and their lifestyle and spending plans.

    You remind Sara and John that you are not only thinking about the next 30 or 40 years, but also focusing initially on the next five years in which they wish to live fully and enjoy time off from their demanding careers. It may not yet be time for them to accept the lower overall growth expectation from a portfolio with a higher fixed income allocation. To put the disappointing income in perspective, you review the long-run average total portfolio returns from various basic asset allocations. They range from 8.6 percent to 10.1 percent. (See “Historical 10-Year Returns,” this page.)

    When discussing the range of asset allocations, you can introduce the idea of different stages of their future income needs. Together, you can begin to balance the comfort and need for growth in their portfolio with their current and projected spending needs. This is a good starting point to frame an ongoing discussion of how spending plans and portfolio strategy will interact.

  2. Portfolio Depletion — Sara and John now realize that the natural income from their portfolio may not meet their hopes for the next few years. Instead, they may need to use some principal, give up some growth, or consider a combination of both. Another way to help John and Sara consider their potential spending is to look at how long the portfolio might last when some assets are purposefully withdrawn each year.

    This decumulation approach differs from traditional retirement planning by analyzing how many years it will take to deplete a portfolio at different withdrawal and growth rates. For example, if Sara and John withdraw $500,000 (or 10 percent) of their $5 million portfolio in the first year and continue to withdraw $500,000 annually, the portfolio would be zero in about 13 years if the annual total return is 5 percent.

    However, if Sara and John withdraw at a 5 percent initial withdrawal rate and 5 percent after-tax returns, the portfolio can last 62 years. After 40 years, they will still have a $3.5 million portfolio to leave to their heirs. This analysis does not take into account any growth in the withdrawals for inflation, and the $200,000 is pre-capital gains taxes.

    It's important to walk them through the different possibilities. (See “Years to Portfolio Depletion,” p. 39.) In fact, portfolio depletion analyses can often show clients that they are likely to live comfortably on their assets for many years. Sara and John see that if they forgo the renovation project, they can live on over 80 percent of their current income, or $250,000, for many years.

    But Sara and John do not have to give up their dream. This analysis can be adjusted to help Sara and John consider their renovation project as well as a higher spending level in the early years of their longevity plan. While an annual withdrawal of $500,000 at a 5 percent return may only last 13 years, the $250,000 annual withdrawal can last more than 60 years. Using these values as the starting point, you can customize the analysis to show two to three stages of different spending levels and how the funds might last. (See “Multi-Stage Withdrawal Plan,” this page.)

    For example, they can spend at an initial 10 percent withdrawal rate of $500,000 for five years, reduce their spending to $375,000 for the next five years and spend $250,000 a year for another 11 years. In this way, they will have comfortably funded more than 20 years of spending. The rub is, that 30 or more years may be necessary, given that they are only in their 50's and they're expected to live into their 80's, at least.

    Alternatively, they might spend $750,000 in the first year and $500,000 in the next two years before dropping back to $200,000 a year. This approach might fund the renovation and a wonderful lifestyle for the next couple of years while still leaving almost $3 million in their portfolio in 30 years.

    But when discussing such approaches with clients, it's critical to stress that this is a dynamic process and unlikely to follow any model perfectly. The examples an advisor gives might be revisited in three years, after Sara and John have spent more or less than the allocated amount.

    This analysis might help them to reconsider how long they want to keep working, or how soon they might seek employment after leaving their primary careers.

  3. Annuitization — Sara and John want to be sure that they have money to leave their family in 30 or 40 years. So they wonder if they should use some funds to purchase an annuity that can assure income for them during their lifetimes while letting their remaining assets grow. There are many kinds of immediate annuities that promise regular income guaranteed for life. But most offered by insurance and financial companies have some additional costs imbedded in them, however, those costs might be hard to analyze.

One way to understand annuities and consider fixed portfolio withdrawals from another approach is to annuitize a 30-year Treasury bond. There are no hidden costs in purchasing a 30-year bond and the U.S. government is a secure investment.

If Sara and John redeployed their entire $5 million dollar portfolio today in the 4.7 percent prevailing 30-year Treasury bond, they would be assured of 30 years of risk-free income. With a combination of annual interest payments and supplemental withdrawals, they could withdraw a little over $312,000 a year. After 30 years, the investment would be depleted to zero (See “Annuitization of a 30-year Bond,” p. 40.) Over the 30 years, the $5 million investment would provide almost $9.4 million paid back. This, of course, is very similar to the depletion analysis, but it helps clients ask the question a different way: What is the income I can enjoy by depleting my portfolio over 30 years in the current market? At different prevailing interest rates, the total return and the annual cash available will increase or decrease: at 4 percent, the annual cash available for withdrawal is $287,679; at 5 percent it's $323,533; and at 6 percent it's $361,329. Sara and John are still uncomfortable with a plan that depletes their current portfolio, but wonder what kind of income they might enjoy by annuitizing a portion of their portfolio.

If they choose to annuitize $1 million, their annual cash flow would be $62,500. This is much less income than they want. But they realize that if 20 percent of the portfolio is in a guaranteed, depleting investment, they might consider a higher allocation to growth equities from which they can withdraw more growth. Now they are back to their discussion of portfolio depletion strategies.

DECISIONS

These approaches are not a substitute for our planning models and, of course, they use simplified assumptions that are unlikely to adequately predict the future. But using these concepts to frame the discussion has helped Sara and John voice their concerns and consider in very tangible terms, different ways of funding their future. As their advisor, you now have a much better feel for their short-term priorities, their long-term goals and their values.

Based on this exercise, Sara and John decided to maintain their current asset allocation of 70 percent equities and 30 percent fixed income for the next few years, favoring a growth approach to their portfolio. Further, they feel more comfortable with their up front spending plans, as they believe that within 10 years they may move to a smaller home and a lower cost-of-living area of the country where they can comfortably live on $200,000 or less a year. In the future, they are thinking that they might choose to annuitize part of the portfolio, but they do not see a need for it just yet. Now, their advisor can help model their portfolio with a much deeper understanding of the couple's view of the future and can analyze more sophisticated simulations for achieving their long-term goals.

Endnotes

  1. National Center for Health Statistics, United States, 2006, Chartbook on Trends in the Health of Americans. Hyattsville, Md., 2006.
  2. Jonathan T. Guyton, “Decision Rules and Portfolio Management for Retirees: Is the ‘Safe’ Initial Withdrawal Rate Too Safe?” Journal of Financial Planning, October 2004, at pp. 54-62.
  3. William P. Bengen, “Determining Withdrawal Rates Using Historical Data.” Journal of Financial Planning, October 1994, at pp. 14-24.

PORTFOLIO INCOME

Low dividend and interest rates don't pay much

Asset Allocation 70/30 percent equity/fixed 60/40 percent equity/fixed 50/50 percent equity/fixed 40/60 percent equity/fixed
Pre-tax income $134,500 $151,000 $167,500 $184,000
After-tax income* 99,325 108,350 117,375 126,400
* Assumes 15 percent dividend tax and 35 percent ordinary income tax on interest
Elizabeth K. Miller

HISTORICAL 10-YEAR RETURNS

Growth versus income

Asset Allocation 70/30 percent equity/fixed 60/40 percent equity/fixed 50/50 percent equity/fixed 40/60 percent equity/fixed
10-year average returns* 10.1 percent 9.6 percent 9.1 percent 8.6 percent
* Based on rolling returns Jan. 1, 1995 to March 31, 2007 of 5-year Treasury bonds and S&P 500
Crandall Pierce & Company, 2007

YEARS TO PORTFOLIO DEPLETION

How long can you live comfortably?

If a couple starts with a portfolio of $5 million and makes a….

Annual after-tax portfolio total return
6 percent 5 percent 4 percent
$500,000 annual withdrawal 14 yrs 13 yrs 12 yrs
$250,000 annual withdrawal Never 62 yrs 37 yrs
$200,000 annual withdrawal Never Never 83 yrs
Elizabeth K. Miller

MULTI-STAGE WITHDRAWAL PLAN

Meeting current dreams and living comfortably

Multi-Stage Depletion Summary at 5 percent
Withdrawal Years End Portfolio Value
$500,000 5 $3,480,000
375,000 5 2,266,000
250,000 11 0
Elizabeth K. Miller

ANNUITIZATION OF A 30-YEAR BOND

Guaranteed income for 30 years!

Bonds pay every six months. So let's look at the interest paid and the additional withdrawal that could be made at various points in the life of a bond.

Six Months Opening Balance Interest Payments Additional Withdrawal End Balance Six-Month Cash Out
Opening 6 months $5,000,000.00 $117,500.00 $38,782.94 $4,961,217.06 $156,282.94
6 months ending year 10 4,084,424.62 95,983.98 60,298.96 4,024,125.65 156,282.94
6 months ending year 20 2,567,154.18 60,328.12 95,954.82 2,471,199.36 156,282.94
6 months ending year 30 152,694.62 3,588.32 152,694.62 0.00 156,282.94
Total Income Withdrawn $4,376,976.57 $5,000,000.00 $9,376,976.57
Elizabeth K. Miller

SPOTLIGHT

Visions of Romance: In an expression of childhood love, portrait artist Arthur John Esley depicts a childhood enactment of a wedding ceremony in “The Happy Pair (A Royal Procession).” This oil on canvas dating back to 1894, fetched $768,000 on April 18 in New York at Sotheby's “19th Century European Art Sale.”