MANAGING MONEY FOR RETIREMENT INCOME

Overview

• The Accumulation Phase, where you are saving and investing for retirement, and
• The Distribution Phase, when you are using your accumulated savings to supplement your retirement income.

To maximize your financial security, the manner in which you manage your investments should be dramatically different during these two phases. The importance of this shift in investing strategy is often misunderstood by retirees. Many assume that the key difference is that retirees simply need to invest more conservatively since they cannot afford big losses. The reality is that there is more to it than that.

Consider this scenario: 2 investors each average a 9% rate of return over a 25 year period during the Accumulation Phase of their financial lives. The only difference between these two investors is the sequence of returns. Investor #1 had good years in the beginning and poor results at the end. Investor #2 had the opposite sequence of returns, poor results in the beginning and good returns at the end. (Remember that they both averaged a 9% rate of return over the 25 year period.) Who ends up with more money? They answer is they will have exactly the same.

However, what if these investors were now retired, in the Distribution Phase of their financial lives, and taking a 5% withdrawal each year and increasing their withdrawal each year for inflation? Do they each still have the same amount of money at the end of 25 years? No.

Investor #1 who had the good years early may have 2-3 times what he started with after 25 years of distributions. However, Investor #2 with the poor investment results in early years is likely to be out of money. Why is that? The sequence of returns matters when you are taking distributions.

You can’t control the sequence of returns, but you can manage your money differently so as to significantly increase your probability of not outliving your money.

The Problem

Studies show that many retirees have unrealistic expectations about money. For example, many retirees overestimate how much money they can safely withdraw from their portfolio each year and underestimate their life expectancy and the impact of inflation.

Three common mistakes retirees make are:

1. Thinking that an extremely conservative approach to investing (CD's and bonds) is the safest way to ensure that they do not run out of money. The reality is that this approach will not support a long retirement because these investments do not have the growth potential to replace withdrawals and keep pace with inflation.
2. Trying to live only on interest and dividends without touching the principal. This may work for a while. However, consider that with a 3% inflation rate, $ 5,000 worth of purchases today will cost you $ 6,500 nine years from now. Also consider that interest rates are not stable or predictable. What if you retired in the early 1980's and based your retirement plan on the then prevailing interest rates of 10% and now you are trying to live on interest rates of 3-5%. Your retirement income will have to be dramatically reduced if you follow this approach.
3. Building a portfolio of stocks and bonds and then taking systematic withdrawals proportionally from each of the investments. In 2007, Morningstar Inc. published a researched study (see chart below) which showed the probability of running out of money for various investment portfolios (conservative - aggressive) and various withdrawal rates (4-8%). For example, consider an initial withdrawal rate of 6% of the starting portfolio balance and each year your withdrawal would be increased to keep pace with inflation. If you had 100% of your portfolio invested in bonds, you would have only a 3% likelihood of your retirement account lasting for 25 years. Your probability of success shoots up to 69% with a 100% stock portfolio or 57% if you invested half in stocks and half in bonds.

   Probability of Not Totally Depleting Your Retirement Portfolio in 25 Years
   
   Conservative ------------------------------------------- Aggressive
   
   

   Withdrawal Rate	100% Bonds	50% Bonds / 50% Stocks	100% Stocks
   4 %	83 %	96 %	92 %
   6 %	63 %	57 %	59 %
   8 %	0 %	13 %	41 %

   * assumed inflation rate is 3.1%, assumed investment expenses are .94% for stock mutual funds, and .82% for bond funds. Analysis ignores taxes and transaction costs.

   Most retirees would not be comfortable with only a 69% probability of not outliving their money. Additionally, most retirees would not be comfortable having all of their investable assets in the stock market. Therefore, most financial literature and advisors recommend a lower initial withdrawal rate, such as 4%, to improve your chances.

   The Solution

   So, what is the best investment strategy to provide maximum retirement income through good times and bad without depleting your portfolio?

   This has been the subject of considerable research.

   We, at Kisner and Associates, utilize a strategy to produce retirement income which has been shown to produce a higher income stream, provides a higher probability of not outliving your money and has a higher ending portfolio value.

   We call this strategy "Income Harvesting. We have found its results to be superior to all competing investment strategies which we have analyzed. The strategy matches short term needs with short term cash availability and longer term needs with higher yielding, longer term investments.

   The research for our Income Harvesting Strategy is based on back tested data which analyzed every 25 year period between 1927 and 2004. The strategy was successful in maintaining the inflation adjusted income, which begins at 6% and increases by 3% per year for inflation, in 100% of the 25 year periods between 1931 and 2004. In addition, the ending balance was at least double what the client started with in 98% of those 25 year periods.

   The only time the strategy did not support that level of income were those 25 year periods that began between 1927 and 1930. As with all investment strategies, past performance is no guarantee of future results.

   Our "Income Harvesting" strategy is based on a 2007 Judges Grant winner in the Financial Frontiers Competition.

   This Income Harvesting strategy requires that your Retirement Portfolio be divided into four different accounts;

   Account #1 is the income guarantee account. It contains cash equivalents and a laddered bond portfolio. This account is used to provide a substantial period of guaranteed income. All withdrawals are paid out of this account.

   Accounts #2 and 3 are Investment accounts, which contain well diversified portfolios which include international and domestic stocks in large and small companies as well as real estate and alternative asset classes. These accounts provide the growth to replenish account #1 and to sustain the overall portfolio for 25 or more years. Some people will question why you need two different investment accounts, which may have the exact same investments in them. The two accounts play different roles in the overall strategy and are subject to different “Decision Rules” which dictate when certain actions are taken.

   Account #4 is an ultra-safe account, and is the glue to the strategy. This account can only contain investments where the principal is guaranteed and the maturity is one year or less (e.g. CD’s). Account #4 provides “portfolio insurance” for major market downturns by essentially sitting on the sidelines until a market downturn of 30% or more at which time it gets added to the investment accounts.

   The dramatically better results of our Income Harvesting strategy vs. competing income distribution models are largely attributable to the Decision Rules which dictate which asset classes get liquidated and in what proportion each year. Most retirement investing strategies take systematic withdrawals which come equally from all of the investments or the withdrawals always come from the same place, ignoring the prior year’s market performance.

   The Decision Rules eliminate emotional decision making and force the investor to buy low and sell high.

   Our Income Harvesting strategy is flexible enough to accommodate a range of risk tolerances from conservative to aggressive, a range of retirement horizons, and a corresponding range of desired withdrawal rates.

   For more information call: Jeremy Kisner, CFP, CRPS at Kisner and Associates (702)256-7400

   (Study results published in the August 2008 Journal of Financial Planning by Zachary S. Parker, also the March 2006 issue by Jonathan T. Guyton and William Klinger)