The earliest members of the baby boom will turn 60 next year, and that generation, born between 1946 and 1964, adds up to more than 75 million people. And there is a common thread that concerns baby boomers — how to meet cash-flow needs when they reach retirement.
Many soon-to-be retirees benefited from very strong stock market returns in the 1980s and 1990s. After a lifetime of saving, their focus is shifting to drawing down their investment portfolio to supplement Social Security and pension income, replacing their paychecks with portfolio withdrawals.
While news of Social Security’s financial woes is currently front and center, it is unlikely that retirees and soon-to-be retirees will see dramatic benefits reductions. Nevertheless, Social Security and pension benefits may make up a relatively small part of their retirement spending needs.
Thus, it is vital to have a prudent retirement cash-flow plan that allows them to enjoy assets while they are willing and able, without prematurely depleting them.
Retirement once occurred closer toward the end of life, but today’s retirees are shattering that mold. It is possible that some individuals will spend more time in retirement than they did working. A sound retirement cash-flow plan takes into account a long-term horizon, the effects of inflation and the uncertainty that is inherent in the financial markets.
Financial advisers increasingly focus on developing retirement cash-flow plans for retirees. Sophisticated advisers integrate a retiree’s cash-flow plans and their overall financial plan — taking into account tax planning, investment planning and estate planning — to develop a roadmap for the decades following retirement.
A sophisticated statistical technique, Monte Carlo Simulation (MCS) analysis, is helpful in developing a retirement cash-flow plan.
Consider the following example: John and Mary, both aged 60, have a $4 million portfolio and are contemplating retirement. They are both healthy and looking forward to enjoying the fruits of many years of hard work. They also expect that Mary will live in to her 90s, given a family history of longevity. Thus, it is important to balance their current income needs with a long horizon — perhaps 35 years. Whether their portfolio lasts that long is a function of two things — their spending levels and investment returns. John and Mary expect that their balanced portfolio of stocks and bonds will return about 7 percent to 8 percent annually. Most important, they recognize that this average return will not remain static and their returns can vary from year to year.
So, what initial spending rate will allow them to maintain a healthy portfolio that will sustain them through retirement? Keep in mind that an annual inflation rate of just 2.5 percent will cut the purchasing power of the couple’s money in half in about 28 years.
In light of the above assumptions, MCS determines the likelihood that John and Mary will have assets remaining at age 95 based on initial spending levels (assuming an annual 2.5 percent increase in spending), as seen in the graph above.
An initial distribution of $160,000 (4 percent of the portfolio value) is projected to offer an 85 percent probability of having assets remaining at age 95, whereas distributions in excess of 5 percent of the portfolio value offer a reduced probability of success. It is vital for a retiree to have a properly balanced and diversified portfolio and spending plan to ensure a long and comfortable retirement.
M. JAY WERTZ, CFP is a portfolio manager and shareholder of Johnson Investment Counsel Inc., one of Greater Cincinnati’s largest investment management firms. Johnson Investment Counsel manages more than $3.2 billion in assets and has been serving clients nationwide since 1965 through three divisions: Johnson Wealth Advisors, Johnson Institutional Management and Johnson Trust Co., Greater Cincinnati’s only independent trust company.
