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Create Your Retirement Paycheck: Lessons from Harvard and Yale

Got enough money for retirement?  Do you know how you’ll create your retirement paycheck? How do you turn that 401(k) or IRA into a sustainable stream of income? Now’s the time to go back to school and learn a lesson or two from the Big Boys and be like Harvard.

Whether or not you went to an Ivy League school like Harvard, you sure can invest like you did.  One thing that Harvard and a retiree both have in common: Both want their money to last over their lifetimes. In Harvard’s case it’s a much longer lifetime but the principles apply nonetheless. Following these examples will help any retiree turn a portfolio regardless of size into a retirement paycheck source.

Balancing Retirement Spending with Portfolio Performance

One of the biggest concerns for any retiree is running out of money. Considering that a couple reaching the age of 65 has a high likelihood of at least one spouse living into their 90s (we’re talking better than 50%), it is important to have a thoughtfully prepared spending plan in place.  Once you know what your base line income needs are, then you can build out a portfolio that may be positioned to generate sufficient income and gains to cover your retirement needs.

The Lifestyle Approach:

The typical rule of thumb is to peg portfolio withdrawals at a set percentage somewhere between 4% and 5% each year. This is a rule of thumb developed by a financial planner in the 1990s and been the source of much financial research ever since. Each year a retiree plans on using a fixed number – typically 4% – as a distribution rate.  So if you have $400,000 in your portfolio, you’d  plan on drawing down $16,000 to supplement your retirement income needs.

One modification to this “rule of thumb” is for the retiree to give himself a “raise” by increasing the amount withdrawn by the rate of inflation. In this case, you might draw down $16,320 instead if the inflation rate were running about 2% per year.

The downfall of this approach is that it does not tie spending to the actual performance level of the investment portfolio.  And in periods of high inflation, the amounts withdrawn may increase too rapidly.  And if there is an extended bear market coupled with significant inflation  as occurred during the 1970s, then there is a risk of premature depletion—ending up broke in retirement.

Endowment Spending Approach: Pretend You’re Like Harvard or Yale

To help minimize the risk of outliving your money, consider a different approach used by large organizations and endowments like Harvard.  They plan on being around a long time so they target a spending rate that allows the organization to sustain itself. This approach combines the previous year’s spending amount with a percentage of the portfolio’s performance.  This approach is designed to “tighten the belt” when market performance has been down so that the portfolio can be sustained over the long term.

To use this approach, a retiree works with his adviser to determine what the first year spending is expected to be. Then you can determine the initial withdrawal rate to use which is typically between 3% and 5% . The next factor needed is the “smoothing rule” to be used which determines how quickly to increase or decrease annual spending based on portfolio performance.

For example, a 90/10 rule would mean that 90% of the current year spending will be based on the total for the prior year plus 10% of the portfolio’s performance.  For someone who is more conservative or concerned about making the portfolio last longer, then consider an 80/20 rule instead.  Same principles apply.

So for the 90/10 option if the portfolio has gone up 10%, then the amount allowed to be withdrawn will be another 1% on top of the original spending target.  You can even add an inflation adjustment factor to the final number as well. For my example above, that means that if $16,000 was the first year’s withdrawal rate and the portfolio went up 10% from $400,000 to $440,000, you would draw out 90% of the initial distribution rate ($14,400) plus 10% of the 10% gain ($40,000) or 1% for an additional $4,000.  If inflation was running at 2% per year, then increase this total by the inflation rate.  This translates to a planned withdrawal of $18,768 for the current year (4.27% distribution rate based on the portfolio of $440,000) or about 15% more than the “lifestyle approach” based only on the fixed “rule of thumb.”

In each succeeding year, the total previous withdrawal amount becomes the baseline to apply the 90% factor.  In this example, we’ll use $18,768 as the withdrawal amount and use a base of 90% of that or $16,891.  If the portfolio in the succeeding year has gone up 5% (from $421,000 remaining after distribution to $442,294), then $1,065 is added bringing the estimated payout to $17,956.  Add in inflation (assume 2%) and the new withdrawal amount becomes $18,315 or about 4.14% of the portfolio.

Not much of a difference from the previous year but enough to make a difference to sustain the portfolio long-term.

For simplicity of use, you can round the projected withdrawal amounts to the nearest $500 or $1,000.

If the portfolio has stayed flat or gone down, then the spending will be held in check requiring a bit of belt-tightening in the near term. Because in the short-term it’s hard to lower fixed expenses, you may find it difficult to do too much belt-tightening.  This is why you couple this – or any retirement withdrawal plan – with a cash reserve.  I’ve detailed this in several other posts but here is one that will provide a good outline of this overall approach to retirement income.

Having a cash bucket of at least two and preferably three years of living expenses set aside in cash or near-cash types of accounts (like money markets, short-term laddered CDs, and ultra-short bond funds) will help you avoid selling from your investment portfolio when the market is down.  Using three years as a number is pretty conservative since it covers the typical business cycle (from expansion to contraction to expansion again) and we haven’t had a bear market in stocks that has lasted that long for a while.

Using this approach compared to a simple “lifestyle” rule of thumb has shown the retiree’s portfolio can outlast by several years and even have extra wealth to pass on without any dramatic change in asset allocation.

To improve the portfolio’s odds, there is a strong case for using dividend-paying investments such as stocks and convertible bonds and other alternative sources of income like Master Limited Partnerships (MLPs), REITs and preferred stocks as part of your total allocation.

Following this approach may help sustain retirement income and be a lot less expensive that “guaranteed income” products like annuities.  It just takes a little more work but that’s what a trusted retirement planner can do with you.

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