A Deeper Discussion

• The "Wealth Rule" is deceptively simple. However, the ongoing research shows that it is far from simple due to the dynamics of life, economy and markets.
  • This is not to say that the rule doesn't work. On the contrary, it does work. What is also required is actively managing resources in retirement just as income and assets are managed during the working years.
    
• Results of various studies concerning withdrawal rates have ranged between a conservative 3% to an aggressive 8%, depending on the study's assumptions:
   
  • Portfolio's mixture of assets. Often stocks extended the time a portfolio lasted due to historical higher returns than other asset classes.
  • Age of retiree. Older retiree's have shorter life expectancies; hence, a shorter period of time the portfolio is required to support them. This results in the ability for a higher withdrawal rate than would be possible for a younger retiree.
  • Point in the Market Cycle when withdrawals began. Withdrawals started in a down market shortened the life of the portfolio (other factors remaining constant) since the values were lower to start with.
  • How do you establish your "wealth rule?"
    
    
• Do you start with a constant withdrawal rate based on initial value, regardless of the subsequent portfolio value? Or do you adjust the withdrawal amount as the value changes?
   
  • Portfolio management similar to endowments or foundations with differences mainly in declining market conditions.
  • Constant withdrawal rate posses no problems during a rising market and in fact would provide increasing withdrawal amounts over time.

Better to take most of the gains and position them in a reserve portfolio discussed below.

o Constant withdrawal rate during a declining portfolio value would result in reducing amounts over time.

o Reduced payouts often posses a problem for retirees since it is hard to adjust living expenses downward.

o Necessitates a hybrid approach to manage declining market conditions

• Beyond the scope of this discussion but highlights include:

o Pre-establish a "trigger point" where withdrawals from the main portfolio stop to reduce the "stress on the portfolio" due to withdrawals that now represent a higher percentage of value.

o Pre-establish a reserve portfolio constructed more conservatively and with sufficient assets, for a predetermined time, from which to start the withdrawals.

o Begin to look at what living expenses can be reduced to further reduce the stresses on both portfolios.

o In reality, this is exactly what people do when they are in their working years during changing (declining) economic conditions; they will reduce their expenditures when their income is reduced.

 

Different Expense Categories to Plan for in Retirement (also helpful while you are working).*

Once you recognize these three categories of expenses, you can see how to make sensible adjustments to your income during your working years as well as during retirement. You should make these expense categories part of your budget or cash flow by placing your expenses into each of the three. Once you have done this, it becomes clear which category you should cut back first, and then second, etc., with income reductions during your working years, and weathering a market decline during your retirement years.

1)      Survival Expenses.

This expense category is the absolute necessary expenses required to keep you sheltered, clothed, and fed. They include utilities, rent, or mortgage including the property insurance and taxes, proper seasonal clothing for your climate and finally, food you eat at home. This would also include the necessary transportation expenses for you to get to essential locations like work, medical, grocery store, etc.

 2)      Desired Expenses.

This expense category consists of those that bring you a higher quality of life such as eating out, entertainment and the additional travel expenses associated with these activities. This category would also include more transportation than you need basically, such as a more expensive car or a second car 

3)      Supplemental Expenses.

This expense category consists of additional things that are nice to have such as travel, a boat or other water vehicles, etc. This category also includes those unexpected expenses that having reserves saved/invested conservatively for makes sense.

During the working years, the income flows through these expense categories without much thought. This needs to change so people can make smarter planning decisions in preparation for either ceasing or declining income while working. This habit of “giving it no thought” is what causes people problems during the transitional years and retirement years. Let’s look at the retirement income sources and apply them to these expense categories to see how this can be helpful. This discussion is in the order or cutting back and/or eliminating the expenses.

Supplemental Expenses are, by definition, unnecessary expenditures when markets are not doing well. Eliminate the expenses as soon as possible to maintain the retirement assets so they can support expenditures that are more important. 

Desired Expenses are a category that could be reduced or eliminated should the need arise due to market declines (or reduced working income). In retirement therefore, rather than get an annuity to support these expenses and use those assets to try and support a higher standard of living permanently, the assets can be kept in a properly diversified portfolio. While the portfolio is doing well these expenses can be funded; when the portfolio does not do well, these expenses can be reduced or skipped to the extent possible so these assets are available for more important expenditures. You get the sense of “stressing the portfolio” for Desired and Supplemental Expenses when the withdrawals from the portfolio begin to exceed the “Wealth Rule” percentage you established. Example, you established your withdrawal rate as 5%; and due to market declines, that same withdrawal amount in dollars now represents 6% which says you are withdrawing more as a percent of assets, hence putting stress on the portfolio to be able to sustain this over a great length of time.

Obviously, it is critical that you support your Survival Expenses while retired. The income sources to do this are Social Security, and/or a pension if one is employer provided. This is also a very good expense category to look into purchasing an annuity to insure that you can fund these expenses that you can not support through Social Security or a pension. Annuities are constantly changing and are beyond the scope of this discussion; however, the pooling and insuring mechanisms are helpful for this category.

Structuring your thoughts in this manner provide you the most flexibility to be able to adjust your resources as time goes on. Setting something up in concrete today may feel good, but it is not flexible enough to adjust to changes that inevitably happen over a period of 10, 20, or more years in retirement.

*Note: This concept is not discussed in the book. It is a helpful concept and will be included in a future edition of the book.