In this post I want to share a strategy for retirement savings, one that starts with the end in mind rather than with what products are currently available on the market.
The strategies for distributing retirement assets have been created only in regards to what must be done given the basic financial tools conveniently available. Here's what I mean: the advice that I hear given in the industry is based on the way most people save money rather than based on how money should be saved. In a world where “groupthink” paralysis takes over the minds of most, we thoughtlessly follow the patterns of the majority when it comes to how we access funds in retirement. I would like to offer a more researched view – one that has a better mathematical outcome – and provides insight into the strategies physicians should be using.
If you’ve spent much time around me, you’ve heard this from me before: most of the answers we search for around what to do with our money can be answered definitively by mathematics. Is it best to buy a 15 year mortgage or a 30 year mortgage and invest the difference? What type of accounts or tax benefits are best for me at my income level? Most of the time, we research these questions only to find vague opinions defining the pros and cons of each but I rarely see anyone undertake the needed math to prove the answer under the terms of a defined scenario. These general opinions are based on a wide audience and remain vague in an effort to reach the masses. If you take a specific set of assumptions and limit the audience to one, then you can easily find a definitive answer for the one and furthermore, you can see the necessary mathematical equation needed to apply it to the masses. I hope to evade the general in an effort to actually help rather than confuse.
Most physicians have an employer 401k, 403b, Roth IRA, or IRA plans that they max out each year with contributions during their lifetimes. None of these accounts are guaranteed to grow because the sub-account investment options all have some inherent risk with the exception of a money market option; therefore, they are subject to the rise and fall of the markets. These risks must be considered when executing retirement income distributions because the volatility of the market affects the success rate of your assets lasting until an assumed age of death.
We have various modeling tools that tell us what would be a reasonable withdrawal rate each year if a volatile sequence of returns takes place over the 30 or so years of your retirement. These tools look for a 90% or higher success rate to determine the so called “right” withdrawal amount for your level of savings. Most will hear that they should withdraw money at a 4% withdrawal rate, and they thoughtlessly do so over the course of the next 30 years, whether it rains or shines in the markets. My hope is to help you avoid this risk, create a system that builds asset endurance, and for those that are young, this is critical to understand as you decide where to position money during the accumulation phase of your life.
Withdrawing money every year at a specific withdrawal rate would require that you sell assets when the market is negative for the year. This statement may seem incredibly simple, yet it is rarely considered and often mindlessly ignored. In fact, it would require you to withdraw money even when the market is down two or three consecutive years in a row. The impact of these withdrawals during negative years is more than you could ever imagine. Here is the data to prove it.
Consider a range of years such as 1973-1992 when the market was thriving. The market averaged 12.63% during this time period.
Most would say, "That’s great, I’d love for that to be the case during my retirement years," but is this really a good way to view the performance of your retirement funds? First, we speak in terms of the market’s average return all the time but it’s really a misleading and inaccurate way to judge the success of a portfolio, especially during the withdrawal years. Second, the market averaging 12.63% during this time period represents the geometric mean, not the arithmetic mean, which involves using the central value of a set of numbers by using each individual value rather than the sum to determine the average. That may sound complicated, but the graph below provides a good illustration of the difference.
The volatility of the market makes a difference, and as you can see the geometric mean is not indicative of the portfolio’s actual yield during that time period. Volatility creates a lower actual yield, which is important to understand during the accumulation phase; however it is more essential to be aware of this in the distribution phase because the actual yield will be diluted even further if you withdraw funds every year from your market based portfolio.
The chart below illustrates the effect on the actual yield if withdrawing $80,000 every year from a $1,000,000 portfolio regardless of whether or not the market was positive or negative in the preceding 12 months:
Notice that the once significant $1,000,000 has reduced to $401,619 and the actual yield during the 20 years is 6.45%. Again, the data here is meant to illustrate that a retired individual severely depresses their potential long term rate of return by withdrawing during down markets. So you may ask, "what is the better suggestion?" My suggestion would be to do the opposite as you may logically guess. I would never withdraw money from the market if the preceding 12 months realized a negative return.
Few indeed can go 12 months in retirement and not withdraw from the market, so how do I avoid this when clients need money every year? The answer to that is the same wise counsel that investors have given for centuries: diversification but in the context of market correlation rather than asset classes or sectors. We distribute a client’s assets into correlated and non-correlated positions. By this I mean accounts that take risk and therefore have innate volatility (correlated), and accounts that are guaranteed to grow over time regardless of market volatility (non-correlated). We always carry the conservative portion of your assets in a liquid, non-correlated account. This provides the client with a bucket of money to draw from when the market is having a down year. It allows them to hold the volatile asset until it cycles back in value, at which point the individual could sell that asset at a market high and reimburse the non-correlated asset for the few years of income that was needed. The chart below illustrates the effects of implementing this strategy for the first two negative years in the market during the time between 1973-1992. Notice the impact it has on the ending balance after these two decades.
This is under the assumption you only avoid selling shares from the volatile asset for two years and withdraw enough to replenish the non-correlated asset after those two years. Utilizing this strategy adds 1.39% each year to your actual return during the withdrawal phase, which is a difference of $591,363 over a 20 year period. I am merely demonstrating the difference it makes in doing this during one cycle of negative years, so you can only imagine the dramatic impact it would have on your total assets if you were to employ this strategy during every negative cycle over the course of your retirement.
Furthermore, we believe such a strategy is more efficient when you layer in two additional pieces. The first is what we call “The Income Bridge Philosophy”. We would use an immediate annuity with a 10-year payout and a guaranteed interest return. The reason for this is to provide a base level of income for your known fixed expenses, similar to the role Social Security income would play if it continues to exist. If the market decreases dramatically, we know we have a guaranteed income to meet our fixed living expenses. We would pull this from a taxable account of sorts, whether it’s in the form of your 401k, profit sharing, 457 plan, or brokerage account. These funds would be the only taxable income you have from withdrawals each year.
We would then use the strategy detailed above for withdrawing the remaining discretionary expenses each year, which reduces the amount that needs to be withdrawn from a variable or at-risk component. These funds would be drawn from Roth 401k's and Roth IRA’s to avoid withdrawing any additional taxable income. This allows you to live on the much-needed higher income, but pay taxes at the effective tax rate of the annuity distributions that are covering your fixed expenses each year, which ultimately means we are paying taxes at a much lower effective tax rate per dollar than the effective tax rate we avoided when contributing to the plan. The 401k plan loses its luster if when we saved the dollar, we avoided an effective tax rate of 35%, just to later pay a 50% effective tax rate during retirement. The objective with a 401k plan is to avoid paying taxes at a higher tax rate so you can withdraw those dollars in the future and pay a lower tax rate.
The only way this can happen for the average physician is by minimizing the amount of taxable income withdrawn each year during the retirement phase. We would cover the discretionary expenses from the tax-free accounts unless the market is experiencing a negative cycle, in which case we would pull income from the non-correlated asset as previously mentioned until the holdings of the account cycle back in value. The portion of taxable accounts that were not annuitized to create the fixed income for 10 years will have that entire decade to grow. This is typically a positive outcome if you consider ten year periods in our markets history and allows for the account to recover the funds used to create the ten year annuity payout. Again, to be specific, if you consider every 10 year period since 1935, the market has been positive 95% of the time.
After ten years, we assess the financial needs of the client and the impact of inflation, and consider what the fixed income needs will be for the following ten years. Hopefully interest rates have increased, which will require less of a lump sum in a fixed annuity to create the needed income. We then take another lump sum from the taxable accounts to create enough income to cover the clients’ fixed expenses for 10 more years. We use an immediate fixed annuity to guarantee the income over the 10 year period just as we did during the previous 10 years. If by chance the market is in a negative cycle at the time the lump sum would be annuitized for income, we will pull all income needed from the non-correlated asset until the correlated accounts recover. Once the accounts recover, we can initiate using the lump sum to create the guaranteed income for the following 10 years.
As you can tell, this takes discipline, time, and mental effort to follow, even more so to implement. You may have to read this twice before it really sinks in or makes sense. The information is technical, but for the prudent investor, the mathematical outcome of following this strategy is well worth the energy required. This will be hard for those who typically say, “Just tell me how much money I can take this year.” If apathy or ambivalence determines the outcome of how you handle and think about money, then expect the way your money operates to return the favor in later years. A prudent investor understands and has the awareness to know that we live in a world with a complex tax code, infinite investment options, risk lurking at every corner, and anything but a simple framework to retire within.
83% of physicians under age 40 claim that they have unique or more complicated financial needs than other professions. I believe this to be true as well, but you have to find the time to address the unique or more complicated financial needs – otherwise you’ll resort to a “get rich quick” scheme in later years because it will be too late to fix. For this reason, I want to encourage everyone, especially physicians, to thoughtfully consider the need for intelligent design in their financial strategy. You would expect intelligent design for a watch or a computer to properly function, so I would also suggest that it should be expected in a financial strategy if you wish to see your retirement plan function properly. The U.S. Physicians Financial Preparedness Report from AMA found that 56% of physicians under 40 had less than $100,000 saved for retirement, and that 34% of physicians age 61-65 are very concerned about having enough money to retire. My hope is that you’ll respect the need for planning and be adequately prepared for your retirement.