Forget the 4% rule: The art and science, not rule-of-thumb, of decumulation

For many years, retirees have relied on the endowed wisdom of their financial planners and wealth managers.?The reality is that when the current is pulled back, the genius is only rules of thumb and popular word-of-mouth strategies lacking any real rigor.

The fast-food industry dispensed with a one-size-fits-all approach years ago, why doesn’t the wealth management world?

Historically, experts have said to draw 4% of the total value of your investment portfolio each year.?The logic is that the dollar amount will increase with the cost of living (a/k/a inflation) year after year.??However, while many of us can disagree about when and how deep, few will disagree that a downturn in the market is coming.?In such circumstances, the 4% rule won’t work because portfolios will be contracting.?Fortunately (with irony), a research paper was published stating that we should replace the 4% rule with the new, vetted, and incredibly scientific 3.3% rule.

This new rule is essentially building in an approx. 18% drop in portfolio value.?I do think the authors of the paper are smart, well-meaning people, but they are again propagating a one-size-fits-all approach.?The fast-food industry dispensed with a one-size-fits-all approach years ago, why doesn’t the wealth management world?

A more rigorous approach is needed.?Enters the science of decumulation.

Decumulation is the deployment of your savings to fund retirement and is the opposite of accumulation, or building of wealth during your working years.

We spend so much time talking about saving for retirement, discussing our needs, wants, goals, and desires with our advisors. Yet, few people talk about what to do in retirement with their advisors. In fact, there is this perception of a magical ”retirement bank” that you somehow draw from each month when you reach retirement.?Nothing could be further from the truth.

There is no reason to introduce the added risk of an advisor not having the right tools and knowledge to aid you in your retirement years.

The truth is far more complicated. Like most of us, you likely have tax-deferred assets, tax-exempt assets, and taxable assets. And, further complicating this is that some of your assets have required minimum distributions (RMDs). In an ever-changing world of taxes, tax deductions, interest rates, capital gains and losses, and more, how do you decide from where and how much to draw from during retirement?

The greatest threat is not planning for taxes.

Clearly, first and foremost you need to understand your spending habits, goals, needs, and resources in the financial planning approach. We need to ensure that healthcare costs, long-term care costs, and lifestyle are adequately considered. Moving beyond you need to maximize your retirement to fully enjoy the lifestyle of your choice while also meeting any of your legacy goals. Only careful planning with a high degree of certainty can ensure those goals are met.

It has been said that the greatest threat in retirement is taxes. I would suggest a more refined answer is that the greatest threat is not planning for taxes, as taxes are unavoidable as are other things in life. In my opinion, the threat of taxes is amplified by our greatest desire--longevity. Living a long and healthy life is important and that is the true tax on your retirement. As healthy living and modern medicine prolong our lives we tax our portfolios to an ever-increasing degree.

So, as we contemplate decumulation, there are three things that we are juggling:

1. Managing for longevity:?The best is to continue investing for growth.?Often people will shift to a very conservative approach and just harvest their portfolios.?By investing for growth, we can achieve returns that offset longevity.?Remember 65 is now still quite young and many people today will live to 95 or longer, that is plenty of time to benefit from growth in your portfolio.
2. Maximize retirement benefits:??We want to fully exploit the value of our retirement benefits, so it is important to consider the effects of waiting to age 70 in order to maximize Social Security.?Other options such as taking lump sums or annuities (with or without survivor benefits) can affect our maximizing behaviors.?Collectively, these decisions make decumulation planning even more important.
3. Managing for inflation risk:?inflation risk is ever-present, we struggle with it as we are accumulating wealth, and we suffer from its effects when we move to fixed income during retirement. This risk has the potential to undermine our investment returns through a decline in purchasing power, and in retirement, the risk is greatest as we are no longer earning an income and saving at a rate that can outpace inflation. So as we consider decumulation, we also have to reevaluate on a yearly basis the current state of inflationary risk.

The challenge and goal of decumulation are to efficiently turn wealth into income.

Decumulation is more complex than accumulation (saving for retirement). There are many considerations you can think about, for instance: spending less versus more, spending less over time, the willingness to go back to work part-time or as needed, the willingness to move to a new locale with more affordable housing, the willingness to use debt, and the risk you would be willing to take in your investment portfolio. The challenge and goal of decumulation are to efficiently turn wealth into income.

Decumulation is also something that gets very little attention in wealth management. According to Nobel prize-winning economist Bill Sharpe, a decumulation strategy should segregate assets by year-end design an investment plan for each year. The point is that each year is different because of the different sources of income, stressors (risks and considerations), and ever-changing tax climate.

The reality is that in retirement planning there really is no rule of thumb.

I have seen research estimating that 55% of individuals working with financial advisors do not have a retirement income plan, and of those individuals not working with an advisor 82% did not have a retirement income plan.?With such failures on the part of financial advisors and investors, it is no wonder that few people discuss income and decumulation when they enter retirement.

We are all familiar with the concept of the rules of thumb. However, when you go to the doctor you look for a rule of thumb approach or medical science? In the world of investment management, I have seen two rules of thumb used. The first is the spend down taxable assets first tax-deferred assets second and tax-free assets last.?The second is to spend down lower earning assets first and higher-earning assets subsequently. The reality is that in retirement planning there really is no rule of thumb.

I believe that the best approach is one that on an annual basis reevaluates the investor’s portfolio performance, the current state of taxes, the current state of inflation, taking into account capital gains or losses, considering RMDs, gifts, and then considering what other options might exist for the investor. These options might include strategies such as ad hoc distributions, annuities that provide a guaranteed level of income, and other cost-effective options.

But what does it mean to conduct an annual reevaluation of the decumulation strategy for an investor? The answer is, detailed analysis that considers prior tax returns, tax projections, and careful evaluation of the various asset buckets using computerized simulations that prepare multiple strategies in a side-by-side manner. We don’t use a rule of thumb, rather we create a personalized strategy that optimizes:

• income generation and most importantly all the sources of income like interest, dividends, rental income, royalties, company and partnership distributions, etc.;
• the investors' income needs;
• the investors' expenditure needs (increasing and decreasing needs;
• timing, claiming, and collecting Social Security;
• around the lifespan of the retiree, not a 30-year average like the4% (or 3.3%) rule;
• for tax brackets and withdrawing two dedicated tax brackets.

Finally, our penultimate goal is to create the greatest longevity possible in your portfolio, while reducing your tax liability not just for this year but for future years as well, to maximize your Social Security earnings, while reducing Medicare and other surcharges. This is your personalized retirement income plan or decumulation strategy.

If your advisor is not willing to invest in the sophisticated tax modeling tools necessary to properly complete this analysis and to do it on an annual basis for you, then you should strongly consider finding an advisor that will. There is no reason to introduce the added risk of an advisor not having the right tools and knowledge to aid you in your retirement years.?Remember, investing is only one part of an advisor’s role.

Luka Erceg is a disabled investment manager at Dynamique Capital Advisors, LLC, with experience as a turnaround, restructuring, distressed and special situations investment and asset management professional. His experience includes energy finance, the founding of Simbol Materials, and substantial board advisory engagements. He holds a Juris Doctorate (J.D.) from South Texas College of Law, Master of Laws (LL.M.) from the University of Houston Law Center, Master of Business Administration (M.B.A.) from Rice University, and Bachelor of Marketing (B. Com.) from the University of Guelph. He is a Certified Turnaround Professional (C.T.P.) through the Turnaround Management Association and a Certified Insolvency and Restructuring Advisor (C.I.R.A.) through the Association of Insolvency and Restructuring Advisors.?On January 11, 2018, Luka suffered a left shoulder disarticulation (amputation) due to a flesh-eating bacterial infection brought on by bad oysters, Scientific American published his blog article “I lost my arm to microbes but they can save the world”, on his tragic experience but the nonetheless ongoing importance of nature and microbiology in addressing global waste problems.