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Your Bank > Education and Advice > CNB University

Finance Matters: Conserving Retirement Portfolios

James P. Terwilliger
James P. Terwilliger, PhD, CFP® is Senior Vice President - Group Manager, Financial Planning Strategies and can be reached at JTerwilliger@CNBank.com or (585) 419-0670 x50630.

Much attention has been paid in the financial press to accumulation for retirement. With a long time horizon, well-diversified portfolio containing 60%-90% stocks, a disciplined investment approach, annual asset allocation rebalancing, an ongoing (dollar-cost-average) savings plan, and discipline to live below one’s means in order to regularly set retirement money aside, accumulating a desired retirement nest egg certainly is doable.

Considerably less attention has been paid to the other side of the coin once accumulation is complete—converting to a withdrawal mode, using the portfolio as a key, sometimes primary, source of retirement income.

Many planners believe this to be a much tougher and much more important financial phase with which to deal.

The challenge is to:

  • provide a steady stream of income over a long but uncertain time period.
  • withstand the winds of investment performance volatility.
  • take continuing withdrawals during periods of extended market downturns.
  • never run out of money.

Fortunately, the financial literature is beginning to focus on this matter, and many useful planning concepts are emerging.

First, the same investment principles governing successful accumulation are useful here—namely a disciplined, well-diversified, annually rebalanced portfolio. However, given that volatility is the enemy of a portfolio in a distribution mode, the stock portion is generally recommended to be lower, typically in the 40%-65% range. Having a stock component is critical to staying ahead of inflation, allowing for increasing distributions to maintain purchasing power.

Second, it is recommended that a retirement portfolio in a distribution mode contain a liquid cash component equivalent to two to five years of expenses. This component serves to supply regular monthly income to the retiree. The cash can be replenished internally by interest and dividend income from the other holdings and by proceeds from occasional partial liquidation of appreciated stocks or stock funds. The reason for having such a large cash buffer is to weather bear-market storms. One does not want to liquidate stocks to supply income needs during periods when stock prices are down. The time to take partial liquidations to enrich the cash buffer is when stock prices are up.

Third, it is generally recommended that ongoing distributions be taken first from taxable accounts, leaving assets in IRAs and 401(k)s to continue to grow tax-deferred as long as possible. Of course, at age 70-1/2, distributions from the latter are required to begin. Depending on one's marginal tax bracket, it is sometimes advisable to begin these distributions earlier.

Fourth, and perhaps most important, how much money can be withdrawn annually from the retirement portfolio with reasonable confidence that the retiree will not run out of money?

If distributions are too high and/or if an extended bear market should hit at the beginning of retirement, running out of money is a very possible and catastrophic outcome.

According to William Bengen, CFP®, author of Conserving Client Portfolios During Retirement, the highest initial withdrawal rate that produces 30 years of longevity is somewhere between 4%-5% of the total retirement portfolio value in "year one," what he refers to as SAFEMAX—the "Maximum Safe Withdrawal Rate." In subsequent years, annual withdrawals are then adjusted upward to account for inflation. SAFEMAX is based on a study using actual historical investment returns and rates of inflation to test assumptions about withdrawal rates, asset allocation, and portfolio longevity.

Bengen notes that 4.15%—assuming a 30-year time horizon—is perhaps the ideal initial withdrawal rate when using a portfolio made up of two asset classes with a 2/3-1/3 ratio of large company stocks to bonds/cash and rebalanced each year. Including small and mid-company stocks in the stock portion produces a SAFEMAX of 4.4%.

Not surprisingly, the peak SAFEMAX increases as the time horizon shortens. For instance, the peak SAFEMAX for a person with a ten-year time horizon is 8.9%, about twice that for a person with a 30-year time horizon.

James Terwilliger, CERTIFIED FINANCIAL PLANNER™, is Vice President, Financial Planning, Wealth Strategies Group, Canandaigua National Bank & Trust Company. He can be reached at 585-419-0670-50630 or by email at jterwilliger@cnbank.com. This article previously appeared in Business Strategies Magazine.