Be smart: Revisit critical decisions about generating retirement income from savings.
As a result of the recent decline in economic activity and the stock market due to the coronavirus epidemic, retirees might want to revisit their strategy for making systematic withdrawals from invested assets. “Systematic withdrawals” refers to a formal plan to invest retirement savings and calculate the amounts that retirees periodically withdraw from these savings to meet living expenses.
The reason to revisit a systematic withdrawal strategy now is to mitigate a “sequence of returns” risk; this happens when investors continue making fixed withdrawals from their invested assets during a significant stock market drop. In this case, their savings may become so depleted that there aren’t sufficient assets remaining to recover if and when the market bounces back.
There are two aspects of a systematic withdrawal strategy that retirees might want to revisit:
- Their withdrawal amounts
- Their allocation to stocks
Let’s look at each one of these features.
Readjust withdrawal amounts
Periodically adjusting withdrawal amounts to reflect recent investment experience was identified as a best practice by recent research conducted by the Stanford Center on Longevity in collaboration with the Society of Actuaries. This adjustment can work both ways: Retirees would reduce withdrawals to respond to investment losses but increase withdrawals to reflect positive returns.
Under normal circumstances, retirees might readjust their withdrawal amounts by applying a withdrawal percentage to the value of their assets as of the end of a calendar year. However, our current investing environment is not “normal,” and retirees might be experiencing asset declines of 20 percent or more since December 31, 2019, depending on their allocation to stocks. If that’s the case, they might want to consider readjusting their withdrawal amounts for the remainder of 2020 by applying their withdrawal percentage to asset values as of March 31, 2020.
One commonly used and easy-to-determine systematic withdrawal method is the IRS required minimum distribution (RMD). This method calculates the minimum amount that retirees must withdraw from their savings in taxable IRAs and 401(k) plans and then include in their taxable income. The RMD calculation applies a withdrawal percentage to year-end asset values to determine the minimum withdrawal amount for the following calendar year.
To illustrate how this works, let’s use the RMD rules to see how a readjustment of withdrawal amounts could work. Suppose a 71-year-old retiree had assets of $500,000 as of December 31, 2019. Under the rules in effect for 2020, this retiree would normally calculate their minimum withdrawal amount by applying 3.7736% to $500,000. The result would be a withdrawal amount of $18,868 for 2020, which would need to be withdrawn any time during 2020 and also be included in taxable income for 2020.
Now suppose this retiree’s assets have declined 20 percent in value—to $400,000—as of March 31, 2020. Applying the RMD withdrawal percentage to this amount would result in an annual withdrawal amount of $15,094. Readjusting the withdrawal amount could help this retiree preserve their savings for future years.
In this specific example, reducing the withdrawal amount would not cause the retiree to violate the RMD rules that apply for 2020, because the recently adopted stimulus package suspended RMD requirements for 2020.
Revisit asset allocation
Retirees might also be tempted to revisit their exposure to stocks due to this new investment environment. Whether that’s an appropriate response depends on which of these three distinct narratives about the future of the economy and investing that they believe:
- Conventional investing wisdom encourages investors to stay the course during a market downturn, counting on a relatively quick recovery. This narrative would suggest doing nothing in response to the current crisis and not shifting their allocation to stocks.
- This market downturn could be different, and we could have a serious depression on our hands. This would call for retirees to salvage current asset values and reduce their exposure to stocks. Retirees then need to decide where to invest this money, which itself is a challenge in this ultra-low interest environment.
- The recent market decline gives investors a buying opportunity, which would call for increasing their exposure to stocks.
Unfortunately, it’s way too early to tell which of these narratives will be the right one, so making a judgment call here could mean taking on some unavoidable risk.
The good news: There’s an overall retirement income strategy that can really help nowadays. With this strategy, retirees cover their basic living expenses with guaranteed sources of retirement income, such as Social Security, pensions, annuities, and systematic withdrawals from fixed income investments. Then they can pay for discretionary living expenses with the money they receive from systematic withdrawals from assets that are significantly invested in stocks. They should always be prepared to reduce their discretionary spending during financial crises, like the one we’re in the midst of today.
This strategy reduces the stakes of the bet on which narrative about investing and the economy that you think will play out over the next months and years.
A thoughtful retirement income strategy can help keep your sanity during trying times like today. Good luck, and please take care of yourself!