Retirement Floors and Implications for Evensky's Cash-Reserve Strategy
Does sensible retirement planning call for funding basic needs with less volatile assets and investing more aggressively for aspirational goals? Or, with client goals clearly defined and prioritized, does sensible planning call for a total returns approach? Multiple schools of thought have emerged, but there is not yet any consensus about what constitutes a proper retirement income floor. These lingering unresolved disagreements reinforce the benefits of Harold Evensky’s and Deena Katz’ popular cash-reserve strategy.
When the Financial Planning Association (FPA) surveyed member advisors about their retirement planning experiences and approaches, it divided retirement income strategies into three fundamental categories: systematic withdrawals, time-based segmentation, and essential-versus-discretionary income. (Note: the link above requires an FPA membership to access.) At the same time, the Retirement Income Industry Association (RIIA) argues that the fundamental goal of retirement income planning is to “first build a floor, then expose to upside.”
The RIIA’s goal can be reconciled with the FPA’s categories by remaining aware about the potential flooring available with current retirement assets. This highlights that there are two ways to think about retirement income flooring. Evensky’s and Katz’ cash-reserve strategy offers a middle ground, with the behavioral benefits of locking flooring for several years and potential upside for remaining assets. Evensky and Katz are the co-founders of the Florida-based financial planning firm that bears their name.
Let’s look at the different ways in which a floor can be defined and then at the implications for constructing a retirement portfolio.
Michael vs. Mike
In a recent blog entry, Michael Kitces of the Pinnacle Advisory Group argued that a safe withdrawal rate (such as 4%) represents a floor/upside approach for all practical purposes. For systematic withdrawals from a volatile portfolio, a 4% withdrawal rate survived the Great Depression and the Great Stagnation of the 1970s, and so it has so far weathered the worst of the worst.
The odds of wealth depletion with systematic withdrawals are exceedingly small, while clients retain full access to their remaining wealth and a significant probability that assets will continue to grow. Economic conditions dire enough to jeopardize 4% would surely also jeopardize the ability of guarantee providers (such as insurance companies that underwrite annuities) to fulfill their commitments. Kitces argues further against locking in a floor only to meet essential needs, because clients generally have an overall lifestyle in mind and will view their retirement as a failure if they cannot afford any of what are typically considered as discretionary expenses.
Mike Zwecher, author of the 2010 book Retirement Portfolios, takes another stance. He argues that retirees only get “one whack at the cat” with their retirement plans. Adopting a retirement strategy because it would have worked historically is not sufficient. Basic needs should not be exposed to the risk of wealth depletion, which is more likely to happen with sustained fixed withdrawals from a volatile portfolio. Rather, retirees are advised to adopt strategies designed to avoid exposure to volatility, though with a minimal allowance for credit and default risk. These strategies could include bond ladders or single-premium immediate annuities (SPIAs). As retirees aim to preserve their lifestyles over an uncertain lifespan, what is most crucial is to foreclose the possibility that essential needs cannot be met.