Planning for retirement requires taking a lot of factors into consideration and is individual for each client. Advisors need to assess how much income their clients will need, determine how long of a time horizon their clients are planning for income, estimate what future inflation will be, and calculate what sum will be left as inheritance. There are a variety of methods to build a retirement income strategy, and Krisna Patel, CFA, investment advisor representative at Woodbury Financial Services, discusses several in a recent article for Advisor Perspectives.
The Certainty Strategy
An approach that many large financial institutions utilize when planning for future financial liabilities is to invest money up front while being fairly certain of the future liability. This type of strategy is also called asset-liability management (ALM) and invests for future obligations based on a certainty of interest rates and principal. This can be done by either calculating backwards from the desired amount to find out how much needs to be invested today while being vulnerable to inflation, or else investing the desired amount into a TIPS product that will adjust for inflation.
Drawbacks to this approach include that predicting the exact number of years for which a client will need retirement income can be difficult, if not impossible, and also that this investment strategy means a very sizable investment at the beginning, which many investors cannot or will not be able to supply.
The Static Strategy
For clients who do not have the up-front capital for an ALM approach, or who are uncertain as to how long they will need retirement income for, a more viable approach can be to calculate a set withdrawal rate. This approach has been used for decades now; William Bengen surmised that in an evenly divided portfolio of half stocks, half bonds, a 4% withdrawal was the best starting percentage. There has been a recent revisit to this number, however, with life expectancy increases meaning that retirees need money for longer, but when following these guidelines, the yearly withdrawal rate would be based on 4%, with an adjustment for inflation.
A main drawback to this strategy is that it’s based on a portfolio that is a 50/50 split, something that advisors are increasingly moving away from, particularly given current inflationary pressures. It also assumes a set time horizon, in this case 30 years, as well as market drawdowns impacting investment.
“The challenge for retirees is rebalancing back into stocks after a large drawdown due to loss aversion, potentially derailing the strategy,” Patel writes.
The Bucket Strategy
This particular strategy plays into a cognitive bias of assigning different groupings of money different values. It’s one that is generally employed in bear markets and creates a bucket of money for short-term use that contains a few years’ worth of income needs that a retiree would pull from, while also creating a bucket for long-term investment that is more diversified and contains the rest of the retirement funding. The short-term bucket is refilled from the long-term one at set intervals or balance thresholds, and is an approach that can provide some flexibility within market downturns.
Challenges for the bucket strategy are that bearish markets generally promote much more conservative investing from retirees and those contributing to retirement plans. By allocating in a conservative manner, the strategy can diminish the opportunity to recover losses realized as well as negatively impact future income.
Nationwide offers a variety of actively managed ETFs for advisors that cater to a range of investment exposures and strategies for those seeking retirement income options for their clients as part of their bigger retirement planning picture.
For more news, information, and strategy, visit the Retirement Income Channel.