Deriving income from your nest egg: One approach

Part of living in retirement is figuring out how to fund your expenses from year to year. There are any number of strategies that you can employ to draw from your nest egg, ranging from applying the rule of using 4% of your portfolio per year to multi-dimensional strategies that rely on actuarial projections of market behavior and life expectancy.
While it should come as little surprise that the mono-dimensional 4% approach doesn’t stand up to research1, that still leaves many complex alternatives to sort through. At Montoya Wealth, our solution employs a three-part approach for our clients where we evaluate their income needs, assess their risk tolerance, and deploy a segmented investment strategy. We’ll use a hypothetical couple in their mid-sixties, John and Patricia Rich, to illustrate.

Understanding our client’s whole financial picture
When working with our clients to design a drawdown strategy, we like to have as much financial information as possible to ensure the strategy is appropriate to the overall financial plan. Some of our clients, for example, are interested in leaving at least part of their retirement to their children while others are perfectly content to pass on no legacy at all. But even clients in the latter group might choose to end their retirement with a large portion of their principle intact in order to ensure they don’t spend down their retirement prematurely.
In the case of John and Patricia, their children are comfortable, but they’re interested in leaving money to help with their grandchildren’s college funds. Still, they’re not intensely worried about outliving their nest egg, which is valued at around $1,500,000 and would rather optimize how they spend it down so they can use their nest egg enjoy life. We use this information as a starting point.
From there, we assess how much income our clients are receiving from fixed sources and how much they need from their investments. We also look at whether that income is likely to vary throughout their retirement as they take fewer vacations or start drawing from other income sources. In the Riches’ case, they have money coming in from John’s pension and will use a 66/70 strategy2 to maximize their Social Security benefit: Patricia took her benefit at 66 and John is receiving a spousal benefit until he starts taking his full retirement at 70.
One we have an understanding of our clients’ income needs and have optimized fixed sources of income, we move on to conduct a three-dimensional risk assessment with our clients – how much investment risk can they tolerate, how much risk their portfolio can actually withstand, and how concerned they are about outliving their investments. The Riches have expressed they feel comfortable assuming a moderate amount of risk in order to be in a position to continue growing their portfolio. Their portfolio and time horizon, likewise, are both robust enough to withstand that level of risk. In addition, the Riches have long-term care insurance, which eliminates one very real source of risk of draining their income sources. What they don’t have is supplemental insurance to Medicare. We address that in their financial plan before moving on to their drawdown strategy.

Generating income throughout retirement
Once we have a good idea of our client’s financial picture and drawdown needs, it’s time to put together an investment strategy in support of those needs. In the Riches’ case, they have expressed that they would like to draw a total of $100,000 while living in retirement. With a pension that pays $10,200, rental property that yields $10,000 per year, as well as Patricia’s social security benefit of $31,200 and $15,600 for John’s spousal benefit, that leaves $33,000 to bridge using their retirement funds until John receives his full social security retirement benefit in another four years.  
We favor an approach of pursuing investment strategies in several different “buckets” based on fixed time frames. The first bucket is highly liquid and contains about a year’s worth of living expenses and, if the client desires, emergency funds for home repairs or other unplanned expenses. For the Riches, that amounts to $73,000: $33,000 plus a robust $40,000 emergency fund for things like rental improvements.
The second bucket contains five years’ worth of projected expenses, invested in lower-risk, medium-term income-producing equities like bonds and preferred stock. As these equities produce income, we move it the first bucket to keep it funded. We’ve invested around $165,000 of the Riches’ portfolio into a laddered bond strategy for this bucket.
The third bucket contains the balance of the portfolio, invested in equities. In this hypothetical scenario we have invested in low-cost index ETFs, with about 30% in bond ETFs of a lower grade (and therefore higher yield) than we used in bucket two. Because we ensured that our clients had six years’ worth of resources available in the first two buckets, we can deploy more aggressive strategies in the third bucket in order to attempt to capture market upside without putting our clients’ retirement at risk. For example, recovery from The Great Recession was complete in three years; this bucket strategy gives our clients plenty of breathing room if they need it while the economy recovers from a downturn. Adding in a sell strategy allows us to monitor specific sectors within the portfolio and realign to others or, in the event of a significant downtown in the broad market, we can also align to cash for a period of time.

Maintenance and adjustment
Even with a plan in place, drawing down can be tricky business. Income needs change as time goes on, and tax issues crop up every year. We meet with our clients quarterly to stay abreast of tax issues, including harvesting, and update our bucket strategy as their income needs change. Because the second bucket is built around laddered bonds, we also continue to make bond purchases with the potential to shift our strategy in response to issues like rising rates or inflation factors. Taken as a whole, the financial plan, investment plan and drawdown strategies we employ for our clients typically offer them peace of mind. There is no one size fits all and it’s important to make sure that your drawdown strategy aligns with your investment profile, your liquidity needs, and your long term goals. In the case of our hypothetical couple, they’re now able to travel and enjoy their grandchildren without worrying if they’re doing so at the expense of their later retirement.

1 - https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2201323
2 - http://www.forbes.com/sites/baldwin/2016/03/29/the-6670-social-security-strategy-for-married-couples/#208da142407b

Disclosure
This material has been prepared by Montoya Wealth Management Group, LLC.. This document is for information and illustrative purposes only and does not purport to show actual results. It is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action. Opinions expressed herein are current opinions as of the date appearing in this material only and are subject to change without notice. Reasonable people may disagree about the opinions expressed herein. In the event any of the assumptions used herein do not prove to be true, results are likely to vary substantially. All investments entail risks. There is no guarantee that investment strategies will achieve the desired results under all market conditions and each investor should evaluate its ability to invest for a long term especially during periods of a market downturn. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those discussed, if any. No part of this document may be reproduced in any manner, in whole or in part, without the prior written permission of Montoya Wealth Management Group, LLC., other than to your employees. This information is provided with the understanding that with respect to the material provided herein, that you will make your own independent decision with respect to any course of action in connection herewith and as to whether such course of action is appropriate or proper based on your own judgment, and that you are capable of understanding and assessing the merits of a course of action. Montoya Wealth Management Group, LLC. does not purport to and does not, in any fashion, provide tax, accounting, actuarial, recordkeeping, legal, broker/dealer or any related services. You may not rely on the statements contained herein. Montoya Wealth Management Group, LLC. shall not have any liability for any damages of any kind whatsoever relating to this material. You should consult your advisors with respect to these areas. By accepting this material, you acknowledge, understand and accept the foregoing.