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Ray Unger: Pay attention to which accounts you draw down during retirement

Ray Unger  —  6/27/2008 11:02 am

In the book, "The Number," author Lee Eisenberg tells us that there's a specific number -- in terms of money -- each of us will need for retirement. Obviously, these numbers vary from individual to individual. Some can live comfortably on a $500,000 portfolio, drawing down roughly $20,000 a year, while others would be hard-pressed to make it on $5 million, drawing down $200,000 a year.

Stephen Horan, however, thinks these numbers leave out an important element in the financial planning equation: the timing of cash withdrawals from these nest eggs.

On Friday, June 20, Horan was in Madison and made a presentation to the Chartered Financial Analyst (CFA) Society of Madison. His talk, "Asset Allocation for Private Clients, Withdrawal Strategies, and Tax Efficiency," was a down-to-earth discussion of how retirees should determine their financial goals, adjust their asset allocation (stocks, bonds, money market accounts, etc.), and take into account market cycles and financial needs when withdrawing cash from their portfolios. His presentation was very broad in scope so we'll just tackle the withdrawal aspects in this column.

First let me introduce Horan. He has a doctorate and is head of Private Wealth and Investor Education at the CFA Institute in Charlottesville, Va. In that position he's discussed these issues with many well-known and experienced practitioners. He's also had the advantage of testing his theories using the robust quantitative resources available at the CFA national headquarters.

CFAs, by the way, are generally the managers of mutual funds, individual investment portfolios, and provide the majority of research on stocks, bonds and the markets. Certified Financial Planners, another title you might see, offer financial advice to people and prepare financial plans, while Certified Public Accountants audit financial records, assess the financial strength of businesses and prepare tax returns.

At his talk in Madison, Horan began the cash withdrawal segment with a quote from the late, Nobel Prize-winning economist Milton Friedman: "Never try to walk across a river just because it has an average depth of four feet." In other words, the notion of liquidating a set percentage of assets from a retirement portfolio is not a sound strategy. Inflation, variability of investment returns, and financial needs can upset the best of plans.

Inflation erodes the purchasing power of our future cash distributions. Horan suggests three ways of beating back this creeping thief -- keep the assets within the portfolio as flexible as possible, allocate the assets with an eye toward reducing volatility and don't sell all your stocks just because you're retired.

Variability of investment returns, as measured by the value swings of a retirement nest egg, is another issue that can't be completely avoided. We can, however, take steps to mitigate the extremes.

How much we annually withdraw from our retirement assets is also quite important. If we only need 4 percent to live on, Horan's research indicates that a 50-50 stock-bond portfolio should comfortably keep us in the chips for at least 33 years. While it may seem counter-intuitive, Horan's research also indicates that having small-cap stocks in the portfolio actually enhances the sustainability while having treasury bills has negligible impact. Unfortunately, if we need more than 4 percent of our financial assets each year, sustainability becomes harder to achieve.

Taking cash out of retirement accounts also means paying federal and state taxes, so tax planning is essential. If the retiree is in a lower tax bracket, then withdrawals should initially come out of taxable accounts such as traditional IRAs and 401(k)s. If the retiree is in a higher tax bracket and holds assets in Roth IRAs (distributions from Roth IRAs are tax-exempt) then initial distributions should come out of the Roth accounts.

Finally, and here's the most intriguing part of the withdrawal discussion, what do we sell each year to fund our living expenses? If the stock market is down and we're forced to sell stocks, we forfeit that portion of the portfolio from appreciating when the market recovers. To avoid that risk, Horan noted Paul Grangaard's research on withdrawal strategies. Generally, Grangaard recommends setting aside a year's worth of living expenses in cash. If the stock market is depressed, the retiree could live on this reserve instead of selling assets. If the market is up, then the retiree could raise the living expenses by selling a combination of stocks and bonds.

This approach provoked some discussion among my CFA associates. What if we designed a portfolio with counter-cyclical assets? Say, real estate (REITs), energy, technology, health care, finance, etc., and bonds of varying quality and maturity. Then if we assume that each of these segments is a "check" that we'll eventually cash in for living expenses, we start to think in terms when the checks have greater value. Today, for example, we might sell some of our energy "checks." Next year we might be selling some of our small cap "checks." And if all our stock "checks" are weak, we could sell a portion of our bond "checks." Even if the market suffered another three-year draught and we sold bonds during that period, it wouldn't appreciably distort our 50-50 stock-to-bond ratio because the lion's share of those distributions would come out of current income.

In essence, Horan's message on withdrawing cash from retirement nest eggs is quite simple: Own stocks and bonds, stay flexible, and use a bit of art and science when selling assets to fund cash withdrawals.

Ray Unger is chairman of Forward Investment Advisors in Madison. He can be reached at 833-9400.

Ray Unger  —  6/27/2008 11:02 am