ADVISERS put a considerable amount of effort into talking to clients about accumulating a life savings. But advisers and their clients tend to devote less thought to how to spend that money when it’s time.
Some sort of conversation generally happens when clients approach retirement, but it may need to start happening earlier and become much more sophisticated.
“If I have $1 million in my retirement account, how I’m going to distribute it is ninth out of 10 steps,” said David A. Littell, director of the retirement income certified professional program at the American College of Financial Services.
Mr. Littell has actually drawn up a list of 18 risks that people have to consider. These include some you can control — spending too much — and some you can’t, like living longer than expected, needing expensive health care and not being able to work as long before or in retirement as planned.
There are two basic ways to calculate what people can spend, though both are less helpful in practice than in theory.
There is the linear calculation, based on a set percentage of the principal taken each year. This is commonly expressed as the 4 percent rule, though recent research has reduced that number to 3.5 or 3 percent. It is simple but fraught with risks.
On the investment return side, it requires people to be lucky and stop working just before their investments are set to rise. If they stop working and their investments fall, they are subject to what is called sequence of returns risk. It means their annual draw is going to be lower if their account value falls.
“The systematic withdrawal strategy can be inefficient in some environments and dangerous in others,” said Aaron Thiel, senior wealth planner at PNC Wealth Management.
On the spending side, that strategy fails to account for how people spend when they stop working: Freed of the need to go to an office every day, most splurge in the early years of retirement and cut back later.
A more advanced method is probability analysis. Advisers often present this strategy to clients by talking about Monte Carlo simulations that test thousands of probable outcomes to come up with the likelihood that a strategy will succeed. It is effective but can be difficult for people to understand.
Of the many other ways to help people manage their spending when income is not coming in, two in particular try to nudge people into the right behavior: the time-segmented approach and the use of funded ratios.
The first works by getting people to think of money lasting for certain time periods: the first 10 years, the next 10 and so on. Mr. Thiel says he advises clients to set up a series of accounts that will be liquidated over that period and replaced by the next account. “A structure like this creates a long-term focus,” he said. “It matches assets with current and future liabilities.”
Yet it still requires people to stay on a budget for those years and not spend beyond what the account has in it, which can seem like a diet.
A newer and more dynamic approach is to borrow the concept of funded ratios from the pension fund world. This number is a measurement of the assets in a pension fund versus the payments it will eventually have to make. The closer to 100 percent it is for a pension, the better.
Timothy Noonan, managing director of capital markets insights at Russell Investments, said using funded ratios with individuals would help take the focus off returns and account balances and put it on how long a person expects to live with the money he has. The funded ratio is calculated by doing a present-value calculation of the amount of money someone has saved or will receive — say, from Social Security or a pension — and comparing it with basic and desired expenses and life expectancy.
Since it gets represented as a percentage, it gives advisers and clients a way to check how they’re doing. “When you consider, what percentage of my portfolio is it safe to distribute, most people believe mistakenly that it must be related to the amount of my wealth,” Mr. Noonan said. “But in fact it’s related to the length of my life.”
In his book, “Someday Rich: Planning for Sustainable Tomorrows Today” (Wiley Finance, 2012), Mr. Noonan gives the example of a couple trying to calculate their annual spending, having saved $775,000 by their early 60s and counting on $38,000 a year from Social Security. They’re debating between needing $60,000 a year and $72,000 a year (including Social Security) for their expected life expectancies. With the former, they’re 152 percent funded; with the latter, that number drops to 98 percent.
In his own situation, Mr. Noonan, 50, said he was 95 percent funded if he retired today. In two years, with his earnings and savings continuing, that number rises to 114 percent. Two more years and it hits 125 percent. Ideally, he said, people should aim to get to 135 percent funded, which would insulate them from most shocks.
But it is still an art, not a science, since people don’t know how long they’re going to live. To compensate for living longer than expected, Mr. Noonan said people needed to continually assess their funded ratio. If it goes too low, and it looks as if they’re going to run out of money, the funded ratio would dip below 100 percent. At that point, people have a choice: reduce spending to get the ratio back up or buy an income annuity to cover basic expenses.