WHICH RETIREMENT INCOME STRATEGY FITS YOU BEST?
Flooring, Buckets, and Guardrails? These income strategies may sound like a foreign language now, but I promise they will make more sense soon! Below, I highlight three of the most popular income strategies and how you can potentially take the best from each of them. If one of these jumps off the page and speaks to you, you may have found your match!
But first, let’s review the “4% Withdrawal Rule” and why it may be on the decline:
Death of the 4% Withdrawal Rule?
The 4% Withdrawal Rule is widely recognized and accepted as a reasonable means for determining retirement income. This method is just as it sounds- you withdraw 4% of your initial portfolio each year, adjusted for inflation. In simple numbers, a $1 million portfolio would produce $40,000 of annual income increasing each year corresponding to inflation (or decreasing with deflation).
This approach was first developed in 1994, created by looking back at 30-year periods of the US stock market to find a 4.15% return was the worst-case scenario for a 50/50 blend of stocks and bonds.
While this approach offers an extremely high probability of success, there are some criticisms:
- It is a rigid approach- from portfolio composition and your retirement time horizon, to the ability to make one-time purchases in retirement. Life tends to be more fluid and flexible than this approach allows.
- It fails to address different phases of life- think of the first 5 years of retirement when you may want to travel and partake in more hobbies vs. perhaps 10 years later when you’re ready to stay closer to home or babysit grandkids.
- It fails to take behavior into consideration. Who wouldn’t want to take more than 4% income in a year when your portfolio returns 30%!?
- It fails to account for or leaves little flexibility with tax strategy, RMD’s, and additional planning opportunities.
- In its truest form, you are rebalancing annually, which can lead to unnecessary and costly trades, as well as an out-of-whack portfolio for 11 or more months!
The inability to pivot in such a rigid plan may lead to a 96% chance for success, but that doesn’t mean much to the 4% who aren’t so fortunate. Think of how likely you are to board a plane if the pilot said, “No worries, there’s a 96% chance we’ll get there safely!”
The 4% Withdrawal Rule gave us great insight on the past and its principles can still work for disciplined investors, but we think there is a better way. Let’s examine some additional methods below.
1st Method- Flooring Strategy
Prior to the 1980’s when 401(k)s and similar retirement plans became commonplace, the Flooring Strategy was king as the standard income plan for most Americans. In short, the Flooring Strategy consists of guaranteed income for life- you receive a guaranteed “paycheck” each month regardless how long you live or how markets perform.
This strategy is created using Social Security, pensions, and annuities to cover income needs. As long as your company can cover their pension obligations, while Social Security and insurance companies remain solvent, you don’t have to worry about outliving your money or losing your nest egg in the stock market. Along this same thought, rebalancing your portfolio is not a concern either (at least for assets dedicated to your Flooring Strategy).
Of course, this method still must account for inflation and other variables, and in many ways it’s even less flexible than the 4% Withdrawal Rule. When markets are soaring, you may feel “left out” when family and friends brag about their portfolio returns. What the Flooring Strategy lacks in flexibility, it attempts to make up for with predictability and peace of mind. This can be a great strategy for those who prefer a “set it and forget it” plan, as well as those who may not have the stomach for market swings that come with investing.
2nd Method- Bucket Strategy
There are different variations of the Bucket Strategy, but the idea is to divide your assets into different “buckets” depending on when you will need income.
Your 1st bucket is for short-term income needs. Roughly 5 years of income or less is common. Your 2nd bucket might be designated for years 5 through 10 or 15 of retirement, with a blend of safety and growth. Your 3rd bucket would pick up where your 2nd left off, years 15 and beyond for example. The long-term vision of this bucket allows us to be more aggressive and theoretically earn a higher return. Sometimes people have a 4th bucket considered “never money” that they don’t plan to spend. In this case, the last bucket serves as a safety net in case retirement needs dramatically change, while also considering how to transfer assets efficiently to future generations and/or causes and organizations you are passionate about.
Critics of the Bucket Strategy say it is a bit more challenging to operate and it is less efficient since assets are constrained to the rules of each bucket, which means they may not be earning as much as they could. This can make rebalancing a bit more tricky as well, so having “flexible guidelines” rather than hard and fast rules may be best.
The Bucket Strategy is great for people who like a visual representation of which dollars are earmarked for each specific purpose or timeline. This method often helps retirees stay the course when markets are not cooperating. Investors without a Bucket Strategy might panic when they see their account drop and make an emotional decision to sell. Conversely, those with a Bucket Strategy may do a better job compartmentalizing, seeing for example that only their “15 year and beyond” bucket dropped in value, giving them confidence to let it recover.
3rd Method- Guardrails Strategy
Others would argue that while the flooring and bucket strategies give you more predictability, the trade-off is that you have less money working for you in the stock market where you’ll historically earn the highest return. The Guardrails Strategy thinks of your investments as a whole rather than segregating for timelines, and seeks to earn the highest return possible. It is a close cousin of the 4% withdrawal method, as the Guardrails Strategy calculates a percentage to withdraw from your portfolio each year for income.
Where it differs is that it tends to allow for behavioral considerations, such as spending more in the first 10 or 15 years of retirement, sometimes referred to as the “go-go years.” It also accounts for market returns and how they impact your portfolio. Think of your income being the center line, with guardrails on both the top and bottom. If the market returned the same 7% year after year (or whichever percentage you’re comfortable using for your expectation), your income would always remain on the center line. However, life isn’t so predictable and perhaps the market would return three negatives in a row: -18%, -7%, then -15%. This may cause you to hit the bottom guardrail and force us to decrease our income moving forward. If the market were to do the opposite and those returns were all positive, we may hit the top guardrail and it’s time for a raise in future income!
The guardrails allow us to be more proactive and makes for more of a “living” plan that can adjust on the fly. Having guardrail rules in place specifying when to increase or decrease income also reduces emotional decisions, which could otherwise derail any income plan. In addition, it’s a bit easier to rebalance strategically since there are less constraints with this strategy.
The Guardrail Strategy is a great deviation from the 4% rule, allowing for some behavioral and situational flexibility, while still leveraging the stock market to its fullest! Increases in future income are more likely, and the probability of running out of money is drastically reduced. However, pay decreases are still possible, which can be challenging once retirees have become accustomed to a certain income and lifestyle. This is an effective strategy for most people, but once again, they must be disciplined to stick to the guardrail rules and have the stomach for market turbulence.
Dynamic Method- Flooring, Bucket, and Guardrails Strategy
And finally, the last method we will discuss we have coined the Dynamic Method, as it applies features of the flooring, bucket, and guardrails strategies all in one.
The Dynamic Method starts with a flooring conversation, as we categorize spending as either “necessary” or “discretionary.” Necessary spending includes anything considered essential- food, housing, medical needs, monthly bills, and so on. Discretionary spending includes anything you could live without if needed- vacations, gifts, a spa trip or golf membership. You will likely find a handful of spending falls somewhere in between, which is perfectly OK. Those who are more comfortable with risk may stop here and invest their remaining assets, while others may want more of their discretionary or “fun” spending covered by the guaranteed income offered with a flooring strategy.
Next, we jump forward to the guardrail strategy and leverage technology to set parameters on each side of your investment portfolio. These parameters serve as the guardrails that help us determine when we can take income raises, and when we need to cut back a bit. This portion is optimized for growth, investing as close to the efficient frontier as we can (this is more technical and warrants further conversation, but in short, this involves combining the optimal investments to maximize return based on your risk tolerance).
And last, we back our guardrail strategy into 3-4 buckets to account for the different time horizons of retirement. We have your short-term bucket that we like to call your “war chest.” This is your safety net you can always fall back on when markets aren’t cooperating. It’s easy to worry about investments when the economy and markets are pulling back, but ask yourself during these times, “Do I think the economy is still going to be struggling 5 years from now?” If the answer is “No” we can still rest easy knowing we have a fully stocked war chest!
We finish by tailoring the other 2-3 buckets according to your lifestyle and vision, designed to move money from one bucket to the other as we progress through retirement. In this sense, the strength of a dynamic plan is that it is always in motion and flexible to life’s changes, which also allows for strategic rebalancing.
In my opinion, many financial advisors do a good job of convincing people to move their money and become a client, but do not necessarily excel at managing retirement portfolios year after year. Unfortunately, advisors often drop the ball and fail to set up ANY income plan beyond a “take some out when needed” approach. The good news is that many registered investment advisors (RIAs) are starting to change this trend, and even though you may have to do some digging, there are plenty of great ones to choose from!
In any scenario, we recommend filtering out anyone who is not a fiduciary or a CERTIFIED FINANCIAL PLANNER™. To give yourself even more of a leg-up, you can look for firms who work solely with retirees, or advisors who hold retirement-specific designations (RICP®- Retirement Income Certified Professional; CRC®- Certified Retirement Counselor; CRPC®- Chartered Retirement Planning Counselor; etc.). We recommend interviewing multiple advisors or firms to see if they fit your style, and how each would help you create an income plan. For help interviewing an advisor, check out my article 10 Questions to Ask Your Financial Advisor.
If you made it this far, congrats! We didn’t even discuss how your taxable, tax-deferred, and tax-free accounts fit into the picture, but we’ll tackle that another day. This topic was a bit more technical, so I promise in two weeks we’ll have some lighter reading! Until then, feel free to schedule a call to explore your own retirement income strategy!
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