| live Well While the mar­ket tanks

HERE’S A SPEND­ING FOR­MULA TO PRO­TECT YOU IN RE­TIRE­MENT FROM PANIC AND FROM PENURY.

Forbes - - CONTENTS - By wil­liam Bald­win

Here’s a spend­ing for­mula to pro­tect you in re­tire­ment from panic and from penury.

Anail-biter for new re­tirees: What if the next mar­ket cor­rec­tion ar­rives soon? Even if stocks and bonds do well over the long term, a bear mar­ket early on can do per­ma­nent dam­age to a re­tiree’s living stan­dard. The ex­perts call this se­quence risk. “It’s not the av­er­age re­turn but the tim­ing of the re­turns” that can kill you, says Dan Keady, who over­sees fi­nan­cial plan­ning strate­gies at TIAA.

Say you have $1 mil­lion in your IRA and quit your job at age 66. If you knew there would be no down markets and knew you and your spouse wouldn’t live past 91, you could live pretty well. You could draw out $40,000 the first year, give your­self an­nual raises to keep up with the cost of living, and be rea­son­ably as­sured of never run­ning out of money.

But you don’t know how long you’ll live and you don’t know about the tim­ing of the next cor­rec­tion. What if stocks re­treat from their lofty level to a his­tor­i­cally nor­mal mul­ti­ple of earn­ings? What if in­ter­est rates spike, de­stroy­ing a bond port­fo­lio? If such mis­for­tune oc­curs early in a re­tire­ment last­ing 30 or 35 years, those $40,000-plus-COLA with­drawals will evap­o­rate your sav­ings.

There are ways to cope with these un­cer­tain­ties. Learn them and you won’t over­spend. You also won’t make the op­po­site mis­take of living penu­ri­ously and hav­ing re­grets.

The cure for se­quence wor­ries lies partly in port­fo­lio leg­erde­main, partly in psy­chol­ogy. If you can adapt to the mar­ket’s vi­cis­si­tudes by mov­ing your spend­ing up and down, you can spend more. If you can’t adapt, you have to be very fru­gal.

“Some­one who has to have a cer­tain amount of money ev­ery year needs to be more con­ser­va­tive with the with­drawal,” says David Blanchett, head of re­tire­ment re­search at Morn­ingstar. If you want a very pre­dictable in­come keep­ing pace with in­fla­tion, and a high con­fi­dence in not out­liv­ing your sav­ings, then your draw from $1 mil­lion has to be more like $30,000.

At the other ex­treme: the rare re­tiree con­tent to have an in­come rid­ing up and down as vi­o­lently as the mar­ket. For such a spender a 5% with­drawal rate is not too lav­ish. But this means draw­ing 5% out of as­sets that might go down sharply in value. The for­mula starts you off at $50,000 on a $1 mil­lion ac­count but then, af­ter a 40% bear mar­ket (what we’ll get if mul­ti­ples re­treat to their nor­mal level), chops you back to $30,000.

There’s a happy mid­dle ground be-

tween these ex­tremes, be­tween star­va­tion and volatil­ity. The key to find­ing it, Blanchett says, is to com­part­men­tal­ize your spend­ing. Some spend­ing, for hous­ing, medicine and food, is manda­tory. The rest is dis­cre­tionary. Cover the first part with low-risk sources of in­come, he says. Cover the sec­ond with risk as­sets.

You have, po­ten­tially, four sources of low-risk in­come. So­cial Se­cu­rity is in­fla­tion-pro­tected and, de­spite the sys­tem’s fund­ing short­fall, pre­sum­ably re­li­able. A mar­ried cou­ple, both high earn­ers and both de­fer­ring ben­e­fits to age 70, can pull down a com­bined $88,750 a year.

Next on the list of fixed-in­come gen­er­a­tors is the old-style monthly pen­sion, if you’re lucky enough to have one of those.

Third on your list of po­ten­tial sources of fixed in­come is a bond lad­der. Buy a col­lec­tion of Trea­sury bonds ma­tur­ing at an­nual in­ter­vals over the next 30 years and you have a very pre­dictable flow of cash. For the ul­ti­mate peace of mind you could make them in­fla­tion­pro­tected. A $1 mil­lion TIPS in­vest­ment buys ap­prox­i­mately $36,000 a year in spend­ing power for 30 years, af­ter which there is noth­ing left.

Last to be con­tem­plated is a fixed an­nu­ity. You plunk down, say, $100,000 at age 66 and an in­sur­ance com­pany vows to hand you $550 a month for as long as you live. (That’s about what a male res­i­dent of New York would get.) The 6.6% pay­out is high but not in­dexed for in­fla­tion.

There are a lot of rea­sons why re­tirees aren’t in love with fixed an­nu­ities, in­clud­ing a lack of in­fla­tion pro­tec­tion and a rot­ten re­turn for the buyer who dies young. But an­nu­itiz­ing a por­tion of your IRA, thereby mak­ing it an ac­count you can’t out­live, does have this pos­i­tive re­sult, Blanchett says: It al­lows you to take more risk with the rest of your port­fo­lio.

Let’s pre­sume that, with or with­out help from those un­ap­pe­tiz­ing an­nu­ities, you have your manda­tory spend­ing cov­ered with sta­ble in­come. Now you can ven­ture the rest of your sav­ings in some­thing riskier, per­haps a clas­sic 60/40 blend of stocks and bonds. How fast should you pull money out of the risk pile?

Needed: a sys­tem for spend­ing that stretches those risk as­sets over a life­span and also takes some of the edge off their volatil­ity. There are a lot of formulas that do that, some rather com­pli­cated. Here’s a method that is easy to fol­low.

The start­ing point is a se­ries of di­vi­sors pub­lished by the IRS as part of tax rules re­quir­ing min­i­mum dis­tri­bu­tions from a tra­di­tional IRA, be­gin­ning at age 70 ½. The first num­ber in the se­ries is 27.4. If you have $274,000 in risk as­sets, you’d liq­ui­date $10,000, putting the cash in a money mar­ket fund.

The IRS di­vi­sors de­scend a scale, at a rate a lit­tle slower than one notch with each pass­ing year. Note: The IRS di­vi­sors re­late to life ex­pectan­cies be­gin­ning at age 70, but you can bor­row them to cre­ate a stretch-out plan that works fine be­gin­ning in your 60s.

The next num­ber is 26.5. (For the full se­quence, see forbes.com/RMD.) If the risk money re­main­ing af­ter the first liq­ui­da­tion grows 5% to $277,200, in the sec­ond year you sell off $277,200/26.5, or $10,460. Again, the pro­ceeds go into the money mar­ket bucket. Con­tinue ev­ery year, mov­ing an ever-larger frac­tion of what’s left of the risk ac­count into cash.

Do your spend­ing from the cash bucket. Be­gin­ning four years in, draw off a fourth of the bucket an­nu­ally for high living. So if you want to re­tire at age 66, you’d start mov­ing money out of the risk ac­count at age 63.

What kind of a pay­out pat­tern does this de­liver? We ap­plied the for­mula to his­tor­i­cal re­turns on a mod­er­ately risky in­vest­ment ac­count to see what a typ­i­cal pay­out looked like (see chart). There is un­cer­tainty here—there’s no get­ting around that—but un­cer­tainty is tol­er­a­ble for dis­cre­tionary spend­ing.

At this point Blanchett jumps in with the ad­mo­ni­tion that his­tory paints too rosy a pic­ture of what we can ex­pect from Wall Street now. He’s right. So we added the red line. For that we did some dice-throw­ing for 2018 to 2048 us­ing greatly low­ered ex­pec­ta­tions for stock and bond re­turns. The chart dis­plays the ran­dom pay­out that came clos­est to match­ing the me­dian re­sult.

Cover your ba­sic needs with safe in­come, take a chance with the rest of your as­sets, and sit tight through the next crash. You don’t want to out­live your sav­ings. But nei­ther is it your ob­jec­tive to be the rich­est per­son in the ceme­tery.

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