A Plan To Not Run Out of Money
Years ago, we at Efficient Wealth Management coined a marketing term, Gratifying Harvest, and it fell flat. My wife hates the graphic and prospective clients were never able to make the connection to their finances. I am going to try again with the technical term: Decumulation.
Decumulation, also known as de-accumulation, is the process of using your savings to fund your lifestyle in retirement. It’s essentially the opposite of accumulation, or the saving and investing to building wealth during your working years. How you decide to decumulate your assets is the most important decision you’ll make prior to and during your retirement.
Consider some of the most challenging problems in finance… none compare to what Nobel laureate William Sharpe, 82, calls “decumulation,” or the use of savings in retirement. It is, he says, “the nastiest, hardest problem in finance.”
The problem is hard and nasty for one simple reason. We cannot see the future. We thus cannot know how long we shall live, nor do we know the future of investment outcomes. We spend a lot of time and effort accumulating assets to provide cashflow after our income earning years are over. If we knew when we were to die, we could plan for the consumption of some or all of the capital with much greater certainty and live as richly as possible. If we conserve our assets because we hope to live well past average and then we pass away early, we have missed an opportunity to spend more during our shortened life. Likewise, if we plan for a long life hoping for average or above investment returns to allow us the required cashflow to enjoy all of our life, only to be crushed by unforeseen market volatility, we likely run out of money before we die. We may live long but be impoverished.
What can you do?
First and foremost, recognize that your most desirable outcome, living long, is also your greatest risk. Deceased people do not have financial problems. Seek a decumulation plan that respects BOTH your need to enjoy your life while alive and fund your possible long life. Remember, you are all alive today but only a few will be alive at 95 or 100. Most retirement plans assume a withdrawal rate that is rising during retirement, due to inflation. Consider a pattern of declining spending as you age. Spend while you are very active and plan to reduce activity when you are older. Yes, plan to be poorer later and achieve your plan.
Second, be fearful of market return patterns. We all expect long term average returns when making investment decisions, but unfortunately your investment returns will never be average from year to year. Your sequence of returns can drastically change the length of time your portfolio can support you. Many experts have noted that the probability of whether you run out of money during retirement is based primarily on the sequence of investment returns in the first 4 or 5 years of retirement. Since you cannot know those returns at or before retirement, it is simply a matter of luck that you chose a good or bad time to retire. It is easily demonstrated that a portfolio earning an average return higher than the average rate of withdrawal can be severely damaged in bad return years. Why? Because your withdrawals to support you will be very similar year to year, thus close to their average, but investment returns will not be similar year to year. They will be random, widely differing and likely never average. In short, in down years of negative returns, you will likely still need to withdraw the same as the year before. Extended down periods can see great reductions in capital at just the wrong time. Thus research has suggested use of a dynamic withdrawal strategy that would see you making withdrawals based on how your portfolio did the previous year, but this is impractical for most of us who have similar expenses year to year. Try a buffer strategy of being prepared for bad years and a dynamic portfolio allocation to take advantage of any sell offs or corrections.
Third, be mindful of future inflation. One large bout of inflation without a corresponding jump in investment returns at the same time or earlier, will devalue you portfolio spending power for the rest of your life. Make sure your portfolio is organized to combat inflation. Home country equities and inflation protected bonds provide some insurance here.
In summary, plan to not run out of money by recognizing the problems caused by decumulation. Plan and prepare for the worst, starting 5 years before retirement and continuing 5 years after retirement. Use savings products to buffer against down markets and assure needed withdrawals. Lastly, realize you are mortal, not invincible, but hopeful. Sounds like a Gratifying Harvest to me.
Merry Christmas and Season’s Greetings from all of us at Efficient Wealth Management!