Your boomer clients are retiring, so they’re going to be spending the money in their portfolios.
Most clients need to stay invested—and do well—if they’re to meet retirement spending targets. But some can’t handle the risk needed to fund all their lifestyle goals.
You’ll be the one who delivers this news. Here are some strategies for making the message click.
Match risk tolerance to spending
Planning has to begin with a distinction between the client’s essential and desired spending, says Don Ezra, director emeritus, global investment strategy at Russell Investments. “What counts as essential varies from person to person. They’re things [clients] cannot imagine living without,” and that could mean a golf membership or annual European vacations. Desired spending covers things they’d be unhappy without, but getting them means risk.
Ezra uses a case study (see “Nediva and Jean-Pierre’s options,” below) to show that clients have two options when their starting asset base doesn’t cover planned spending: change goals or elevate risk.
He suggests advisors adopt a similar approach when clients’ drawdown plans are too lofty for their risk profiles.
Nediva and Jean-Pierre’s Options
To meet their five-year income requirements, the couple can invest one of three ways: ultra-conservative (100% fixed income), moderate risk (82.5% fixed income, 17.5% equities) or high risk (30% fixed income, 70% equities). But only the high-risk portfolio hits their income target. (Fixed-income investments generate 0% annual real return.)
Note: All figures indexed to inflation.
- The couple isn’t worried about longevity risk because a deferred annuity kicks in if they live past age 85.
- Money needed in the next five years isn’t invested in equities. This is based on the idea that it takes time for the equity risk premium to kick in; and the longer you give it, the more reliable it is.
- We assume fixed-income investments keep pace with inflation, so annual real returns will be 0%.
- We assume long-term average equity returns at 4%.
Create income streams
Here’s another way to set up portfolios to distribute cash to clients.
Chris Buttigieg, senior manager, Wealth Planning Strategy at BMO Financial Group, suggests a bucket strategy. A retiree needs $1,000 per month in income, because her pre-annuitized income covers all but that amount.
Here’s what to do:
- Fill 10 buckets, each with a year’s worth of safe investments ($12,000)
- Bucket for Year 1: money market fund
- Buckets for Years 2-4: GIC or another money market fund
- Buckets for Years 5-10: GIC, money market and/or bonds
As each year ends, the next year’s bucket is activated to pay for the new year’s spending. This covers essentials.
Money not needed for 10 years goes into a reserve bucket. That money is invested according to an asset allocation based on the client’s risk profile.
*Bonds are set to mature when money is needed.
Susan Mallin, vice president of financial planning at Lorne Steinberg Wealth Management, stresses the relationship between withdrawal rate and performance. Say a client has $1.5 million and a 25-year horizon. With a 6% withdrawal rate, totalling $91,000 per year (after taxes and indexed to inflation), he needs an 8% rate of return. At this pace his money runs out the day he turns 89.
“Nothing can go wrong to maintain this withdrawal rate. If the rate of return goes down 2%, he would start running out of money at age 77. I explain at the outset that to avoid this potential problem he would either have to reduce withdrawals to $76,000 per year (from 6% to 5%), or restructure the portfolio to achieve 8%.”
Mallin notes most clients in this situation lower withdrawals instead of increasing risk. “They’ve gone through steep bear markets and their main focus is capital preservation.”
She adds that drawdown portfolios shouldn’t be rebalanced frequently. “Rebalancing may reduce risk but it diminishes the potential rate of return because it often means winners aren’t being allowed to ride out.”
Keeping income consistent
Bev Moir, senior wealth advisor and financial planner at ScotiaMcLeod, notes some clients have portfolios built exclusively with individual securities because they want to know what they own at all times and follow performance closely
She’s helping one such client who isn’t satisfied with his portfolio’s dividend income. “On a quarterly basis we’ll liquidate some assets and then hold [the proceeds] in cash. And we’re always trying to take a tax-sensitive approach.
“So sometimes we’ll harvest capital gains but take some losses as well, offsetting the [tax consequences of the] gains. Sometimes it makes sense to [liquidate] an asset that hasn’t appreciated, so there are no tax implications.”
Moir notes portfolios often don’t produce an even monthly or quarterly income stream. This can mean over $20,000 some months and only a couple thousand in others. This is because income from bonds and dividends gets paid out at different times. Some companies pay quarterly dividends, others monthly; bonds pay out every six months. Some clients don’t mind the uneven payments, notes Moir. “We give them a report at the beginning of the year and they’ll plan their cash flow based on that.”
But other clients want consistency and ask her to structure cash flow to mimic a pension plan. Moir funnels the income to the cash portion of the portfolio and distributes it in even amounts month to month based on the client’s income needs.
Some clients have enough that they don’t have to dip into principal, and fund all spending with dividends and other income.
“Those who do dip often do so reluctantly,” says Bev Moir, an advisor at ScotiaMcLeod. They become uncomfortable when they see withdrawals reducing their net worth, but Moir reminds them this is exactly what they’ve been planning for.
“I draw them a little hill and say, ‘You’ve spent your working career building up your savings and the whole reason they’re there is to draw them down,’ and that’s the downward slope on the hill.”
She adds clients may be more comfortable spending the majority of their unregistered savings in the early years of retirement if they knew that after age 72, they would have ample RRSP savings, plus the ability to generate additional cash from a primary residence or cottage.
“Some people want to spend a little more in the early stage of retirement when they have the energy and enthusiasm to travel,” she says.
Moir calculates future real estate value at 2% per year.
She adds all financial plans should be reassessed every three to five years to account for changing circumstances.
Dean DiSpalatro is a Toronto-based financial writer.