My primary (career) role is as an investor, no doubt evident by the plethora of nerd laced posts. Simply put, my job is to work with fellow asset management teammates to optimize our portfolio holding, balancing their inherent risks and rewards. However, I am thankful for the structure of Financial Enhancement Group, which forces the intersecting of my role with the financial planning side as well.
Gratitude
It might be helpful to paint a small picture of what it means to intersect with financial planning – which may sound like an odd statement to those outside the industry. That picture of FEG firm structure starts with a state-of-the-art financial planning team built over the years at FEG. A team that has deep roots and origin through the thought leadership from our managing partner Joe Clark and organized around his curriculum for years of teaching financial planning at that other big ten university in northern Indiana. The team and its planning curriculum has grown from those roots and blossomed under the leadership of the team Director, Aaron Rheaume. The team also wouldn’t be complete without the nurturing development of individuals by Grant Soliven.
Part of the intersection I have to this team is through the role I continue to carry as a financial advisor to a small number of client relationships. Perhaps the best way I can complement this team and describe the job they have done is that over the past several years it became evident that it was no longer possible (at least for me) to do both – be fully in tune with the investment side AND keep up the training necessary to carry out a financial plan. What’s great though is that this financial planning team is there to sit on those client meetings for the long-held relationships I cherish and ensure that not only their investments are in line, but their financial planning bases are covered as well.
Separate Functions? (financial advisor sounds fairly ubiquitous to me)
I understand it may sound odd or confusing to talk about these two roles (planning and investing) so separately. A “financial advisor” can easily be seen from outside the industry simply as the one who does it all (investing and planning). Sure, that can be true, but planning and investing each have their own deep sets of skillsets and knowledge banks to master. As a result, a number of shops in our industry are planning-oriented and outsource the investment to shops that are strictly asset managers. The other choice is to do both in house, which is the model FEG has used for over two decades now. My biased opinion is that this is a great choice (Yes, primarily because this means I have a job as CIO). But also think it works better in general to have it under one roof, especially when taxes are involved. Recently, I shared some thoughts with Grant and Aaron for one area where my investment focus and their financial planning squarely intersect: retirement income projections.
I’ve spent my entire career at FEG, so I say with the conviction that we have always taken distribution seriously. For those of you reading for whom we currently have the pleasure of serving – you’ll be acutely aware of this. Specifically, Aaron, Grant and I were recently working through the dynamic part of the process of factoring in (very rapidly) adjusting investment assumptions into methods that serve to both safeguard AND optimize spending. This is no small task as these are often competing goals (“safer” levels of portfolio income will mean leaving spending on the table) and different people have different preferences; but keeping realistic and up to date investment assumptions is key. An essential consideration to keep in mind is that investment assumptions are critical for the distribution phase. Investment assumptions that aren’t as key to those still accumulating or have distribution further off because for them long term averages will tend to smooth things out.
Distribution types (different strokes for different folks)
I like to keep it simple by categorizing a few different types of distribution for investors.
Type 1: for many, their goal is straightforward and is to generate a smooth level of income that can be withdrawn each year and increased over time with inflation. As straightforward as this sounds, it does carry the major drawback of leaving a good chunk of principal behind. For those with heirs that have bequests as a secondary goal, this isn’t a drawback at all. Otherwise, this is an often-overlooked result, which leads us to the second type.
Type 2: which I’ll simply call “cautious principal spenddown”. Cautious because this is a tricky and inherently imperfect goal due to the wide uncertainty around life expectancy, inflation, and ever looming potential for unknown expenses. But it remains imperative to reach beyond the relatively simpler safe withdrawal rate methods if the goal is more about maximizing spending than it is about leaving money behind.
Type 3: a more obscure method I call a bridge period; whereby the investor is simply going through a temporary period of large portfolio withdrawal percentages before reverting back to one of those first two types. Commonly this method is employed when the goal is to maximize social security income, so benefits are delayed, relying on that extra portfolio income until those benefits kick in.
Dynamism (Adjust to market conditions and update personal distribution outlook)
First, let’s start with a deeper look at the safe withdrawal rate method where it’s imperative that the conversation has some dynamism. That may sound peculiar given the amount of academic research that has gone into validating and testing the durability of that 4% withdrawal rate (at least for a portfolio well balanced between stocks and bonds). Our view over the prior few years has been to be respectful of the uniqueness of the then investment environment. An environment characterized by a long period of ultra-low interest rates coupled with historically high stock prices. We had to at least consider that a lot more juice had already been squeezed from markets. As a result, we began guiding the initial withdrawal rates lower.
The math can be complicated or simple, but they all pointed at the same risk. Sticking with a preference for the simple, we’ll look at a 60/40 balanced portfolio (which is simply going to be 60% of the dividend yield of the S&P 500 plus 40% of the yield on long term treasury bonds).
Yield certainly isn’t everything since part of distributions will likely come from capital gains too, but it’s a beneficial starting point. In the early 90s, the 60/40 yield was well above 4%, then spent the better part of a couple decades around 3%. Think about that for just a second, at 4% -the full distribution is being kicked off from income. But look at what happened in ‘20/’21…the yield plunged near 1% on the backs of soaring stock prices and rock bottom interest rates, which we could think of as akin to buying a pig in the poke. With the double whammy happening this year to stocks and bonds, the yield has moved back up near to its norms of the previous decade.
Distribution Danger Zone (confronting and managing the fear of running out)
Being dynamic doesn’t mean adjusting income or spending with every ebb and flow of the market. We do, however, want to recognize seismic shifts and adjust if necessary. Think about how the adjustment process in terms of how it likely played out this year:
-You enter distribution phase with $1M on December, 2021 invested in a balanced 60/40 portfolio and commencing the standard 4% withdrawal ($40,000)
-That split was down around 20% at the end of last quarter, making that $1M worth around $770,000 (assuming ¾ of the withdrawal also made).
-Now, had you taken the withdrawal rate down to a starting rate of 3.25% – the balance would have been closer to $775,000
This $5,000 difference in balances in these examples may not sound like a lot, but when you look at the updated withdrawal percentages the initial 4% withdrawal amount would now be 5.2% vs. 4.2% rate for the lowered initial draw amount. If the markets were to rebound quickly, say as they did in 2020 then this episode would have turned out to have been just a scare. On the other hand, if markets were to stay down here for a while (or worse, take a next leg down) then the higher withdrawal rate against a lower balance could continue to grind against that underlying principal and carry too high of a risk of you running out money before you run out of time. In finance, that risk is called sequence risk. The lower withdrawal rate is not a guarantee of survival either, but the updated 4.2% withdrawal rate with today’s fatter dividend yield and higher interest rates looks to be right in the comfort zone.
Alternate Ending (how would you have handled an earlier, more lucrative start to distribution phase)
Another way to look at dynamism is to flip the script to look at a scenario where you started this process a few years earlier. Instead of losses on that initial $1M, you’d have substantially more because the gains had far outstripped the distributions in ’19 – ‘21. Perhaps that initial 4% income (plus inflation increases) started in years prior had trekked down to something like 3.25% or 3.5%. In this case, it would not have been recommended to boost the income beyond the inflation bump. Naturally then, it would stand to reason that it works the same for someone starting out distribution and accounting for those recent gains.
Dynamism for Type 2
So, what may be dynamic about that type 2, the one who wants to cautiously spend down principal? That is a lot more challenging scenario, but just because it’s challenging doesn’t mean it’s not worth the effort. After all, for the same $1M starting portfolio this different ending goal means that $32,000 -$40,000 income you’d have using a safe withdrawal method could be something closer to $50,000 or $60,000. And since that’s over the rest of your life, I’d venture to say it’s worth the finesse. The full scope of that effort is better handled in individual one-on-one meetings with our planners and involves using computer simulations and updating them frequently (i.e. = dynamic). In fact, it bears repeating, no substitute exists for any of these methods for a full plan and simulation.
Annuities should always be in the conversation for this type of Distributee and warrant a couple key words about annuities (esp. as a product that over time I have thrown a lot of shade at). I really wished we had different words for the different annuity products. When I use the word, I am talking about them in the traditional sense. I am talking about using an insurance vehicle to do what investment portfolios cannot do: pool risks with others. Annuities are not a one sized fit all solution (With health, family history, bequest preferences all being factors), but with the right needs to those factors, a portion of the portfolio in a product that perfectly matches the competing risks of you outliving your money and your money outliving you is not only sensible but will be hard to beat in terms of maximizing income. It also highlights the underlying theme of dynamism. It’s been a few years since annuities should be strongly considered, because buying such a product over the last few years effectively meant locking in ultra-low rates for the rest of your life. But with rates back up, you once again have an option to incorporate them into an optimal winddown scenario.
Conclusion
Coming back to gratitude – one of the great things about having investment and planning intersect under the same roof is for the math heavy and cold analysis of investing to be parlayed into the real lives of those we serve. This industry doesn’t come with many perfect answers and is often more about recognizing and balancing inherent tradeoffs. Tradeoffs such as balancing higher portfolio withdrawals against lower odds of survival probability. Most importantly, it’s important to know what it is you are trying to get done (creating a sustaining income or maximizing principal as well). With goals identified (and in this case type of distribution) we then stay dynamic, adjust, and employ all tools at our disposal.