The single most important question of a client close to or in retirement is, “Do we have enough money to retire?” To measure the financial capacity of a client, I categorize him into one of the three zones: Red, green and grey. For more information on the Zone Strategy, see our CE Course, Lifelong Retirement Income: The Zone Strategy.
Once you figure out your client’s zone it becomes a lot easier to suggest the right retirement income strategy. Usually, clients in the red or grey zone have tough choices to make: keep working or spend less; save more or rent out part of your house; and so on. However this article is not about the red-zone or grey-zone clients. It is about those who have made it successfully to retirement and are already deep in the green zone.
Green-zone clients are mostly high-net-worth. During retirement, they might have ongoing income from other sources such as rental income, royalties, and business or consulting income. Typically, they only need to take out small percentages of assets, well below the sustainable withdrawal rates. If this happens to be a RRIF portfolio, they take out the minimum mandatory withdrawal amount, pay the income tax on it, and reinvest some or all of the remaining money.
If a client is in the green zone by virtue of a retirement plan, tell him not to worry about retirement income. However, to distinguish yourself from other run-of-the-mill advisors, you need to go beyond soothing words. Many worry about black-swan events and want a precise answer to, “Do I have large enough cushion in my retirement assets to overcome unexpected or unforeseeable events?” They deserve better than, “Hey! Don’t worry about it. You’ll be all right.”
And this is where the concept of stress test comes into play. For my green-zone clients, I run a series of stress tests. I tell them exactly how much “cushion” they have in their portfolio for different stress factors. Often, I get a “wow” in response. These tests are not only educational, but they also increase clients’ confidence in me as their advisor.
There are many different types of stress events. This lesson will cover the most important ones:
- Sudden and permanent loss of assets
- Need to increase the income taken from the portfolio
- Future inflation higher than historically experienced
- Living longer than planned for
- Future equity returns lower than historically experienced
- Future conventional bond yields lower than historically experienced
Our process is simple—for each stress factor, calculate the maximum allowable number which still allows the client to remain in the green zone. For example, if a client has $2 million in assets and he needs to withdraw $30,000 from his portfolio each year, he can suddenly lose half his assets and still remain in the target area. Or, he can increase his periodic withdrawals by 100% and still fall within green-zone parameters. Or, he can live until age 108 instead of 95 and still be within the green zone.
We define this collection of numbers as the “Stress Envelope.” Let’s use an example to demonstrate how the process flows: My new clients, Bob and Jane, are both 65 and have just retired. They need $125,000, indexed to CPI, annually from their investment assets. Their asset mix is 40% equities and 60% fixed income, rebalanced annually. We use the TSX/S&P index as our equity proxy. As for the bond portfolio, they hold conventional bonds which pay a 1% premium above the historical 6-month GIC rates. Their total investment assets are $5 million.