By Jim Terwilliger
Those of us offering advice in the financial planning world like to identify two primary time periods in our clients’ financial lives:
• Accumulation Phase — the multi-decade period in which folks work and set aside excess cash flow into savings earmarked for retirement.
• Distribution Phase — the (hopefully) multi-decade period in which folks take ongoing distributions from their retirement savings in order to supplement regular income from Social Security, pensions and other income streams.
During accumulation, it is common to use a variety of vehicles to build up retirement wealth — 401(k)-type retirement plans, IRAs, Roth IRAs, investment accounts, savings accounts, CDs, etc. It is also common, and advised, to have significant exposure to the global stock market — somewhere in the 70 percent to 100 percent range — with the remainder invested in bonds (or bond funds) and cash.
The accumulation phase generally exhibits a rocky ride, given the high exposure to stocks, but such exposure provides the best opportunity for asset growth. Throughout this phase, volatility is your friend if you dollar-cost-average in to your accounts. This means adding constant dollars to your accounts on a regular basis so that you buy more shares when the market is down.
In the distribution phase, it is generally advised to simplify and consolidate the myriad number of accounts that seem to multiply during one’s lifetime. This makes the tracking of such accounts easier. It also allows for a more focused and cohesive investment strategy.
Typically, in retirement, we recommend maintaining a healthy exposure to the global stock market, say, in the 50 percent to 70 percent range, in order to keep assets growing at a rate greater than inflation.
In this phase, portfolio volatility is your enemy. This is because you are negative dollar-cost-averaging — removing constant dollars, adjusted for inflation, on a regular basis. Here, volatility can reduce your effective rate of return.
Another factor of extreme importance during this phase is to control the distribution rate such that retirement savings are not exhausted during your lifetime.
Finally, most planners agree, it is important to organize accounts in a distribution mode into three “buckets” — stock, bond and cash buckets. The idea is to draw all distributions from cash, and bonds if necessary, but not from the stock bucket. The stock bucket can then be partially liquidated, from time-to-time, to the extent necessary to replenish the cash — but only when the market is up.
Such a strategy can give you peace of mind by minimizing the impact of volatility on the long-term health and viability of your retirement portfolio.
Many financial planners suggest having two to four years of cash in the cash bucket to weather long market cycles. Unfortunately, this produces a “cash drag” on portfolio performance.
To counter this drag, we recommend the following distribution strategy as optimal:
• Establish a macro stock/bond-cash allocation that has an adequate level of stocks but with a volatility that allows you to sleep at night — say around a 60/40 allocation.
• For monthly distributions, to generate the cash bucket, rebalance the portfolio back to, say, 60/40 and extract one year’s worth of cash at the same time. If the market is up, the cash will come mostly or entirely from stocks. If the market is down, the cash will come mostly or entirely from bonds. Distribute cash from the replenished cash bucket during the year. When the year ends and the cash is depleted, repeat the process, including the portfolio rebalance. Average cash level in the account during the year is one half year’s worth.
• For annual distributions, rebalance the portfolio and extract one year’s worth of cash at the same time. Again, if the market is up, the cash will come mostly or entirely from stocks. If the market is down, the cash will come mostly or entirely from bonds. Distribute cash from the replenished cash bucket in a lump sum. One year later, repeat the process, including the portfolio rebalance. Average cash level in the account during the year is essentially zero.
• Note that cash set aside for emergencies is not considered in this strategy.
The key to making this work is the disciplined act of rebalancing the stock-bond portfolio at the time cash is extracted through partial portfolio liquidation.
Even in the occasional years when this strategy results in partial stock liquidation in down market years, the realized capital loss is minimal.
Skeptical? Do the math, then let’s talk.
Much of my time with clients is spent walking them through and helping them manage a deliberate retirement distribution strategy. Making it work correctly takes patience and discipline. Don’t try this on your own. The stakes are too high.
James Terwilliger, CFP, is senior vice president, financial planning officer at Wealth Strategies Group, Canandaigua National Bank & Trust Company. He can be reached at 585-419-0670 ext. 50630 or by email at firstname.lastname@example.org.