If you think you’re confused about how best to de-accumulate assets to cover retirement expenses, you’re not alone. I’ve read countless articles about how to preserve capital while creating some sort of income stream to cover expenses in the golden years – but no two articles are alike. Unlike your asset accumulation years where there is some consensus related to maxing out your Tax Free Savings Accounts (TFSAs) and Registered Retirement Savings Plans (RRSPs) for decades on end (to financially secure your retirement), no such consensus exists for retirement withdrawal strategies.
Academic research seems to show thanks to William Bengen, a financial planner with a background in aeronautical engineering, that withdrawing 4% of your portfolio every year, and increasing your withdrawals with the rate of inflation, will ensure you not only have enough income to cover expenses but you likely won’t outlive your money over a 30-year retirement span.
My personal thesis is that this 4% “safe withdrawal rate” will be presented with some strong headwinds in the coming decade, thanks to major demographic shifts; causing rising healthcare costs, lower government revenues and consequently cuts to various government programs.
So, if I am correct – and I could be – what is a retiree to do? What is an appropriate asset allocation for retirement? More stocks than bonds? Mostly equities? Look at other fixed income options like GICs? How much of a cash reserve do you need? I’ll explore a few of these questions and more in today’s post. First, some data from a recent book I enjoyed The Real Retirement:
- Studies indicate government bond yields go through cycles lasting about 60 years: 30 years for the uptrend and 30 years on the other side. If the theory holds true, yields have “virtually no room to move further downward, thus no capital gain opportunities remain”. This means some sort of 70/30 portfolio split (equities/bonds) is a better bet for the foreseeable future.
- “Actuaries estimate that real returns on bonds over the next 25 years will average between 1 and 1.6 per cent depending upon the term of the bond”.
If actuaries are correct, and they are smart people, then basically returns from bonds will just outpace inflation (~2%) for the next few decades. This means many investors (including retirees) predominantly need to count on equity returns for growth going forward. With a larger bias of equities to fuel portfolio growth for retirees, this creates more financial risk; there is short-term volatility to withstand and capital losses can occur – at precisely a time when retirees are counting on and depending on capital withdrawals to cover their expenses. Needless to say I think this poses some serious challenges for retirees managing their portfolios.
What is the appropriate asset allocation for retirement? Is there a way to structure a portfolio to mitigate equity risks?
To answer these questions I’ll offer my thoughts on some potential portfolio structures and withdrawal strategies I’ve been thinking about lately. Before I share those portfolios, here are my assumptions:
- When it comes to fixed income, I consider payments from Canada Pension Plan (CPP) and Old Age Security (OAS) in that bucket. Regarding the former, I think CPP payments should be solid for retirees for decades to come. CPPIB also says it’s sustainable for 75 more years. OAS is a different beast since it’s paid from general tax revenues. Even though I think OAS changes should occur, I don’t think any government will dare touch it.
- I also consider any workplace pension plan “a big bond” although not all pension plans are created equal. (For example, I don’t have the “gold plated” variety like some friends I know who work for the government but its decent plan all the same, and I’m very thankful to have it.)
The “Keeping It Safe” Structure #1
- Assumes “average” Canada Pension Plan (CPP) and Old Age Security (OAS) payments. Maximum CPP right now for 2016 is about $1,100 per person per month although most retirees won’t get that much. OAS payments provide under $600 per person per month.
- The “keeping it safe” structure holds 50% of the portfolio (including CPP and OAS) as fixed income.
- You keep at least 3-5 years in cash as “buffer” for daily expenses.
- You keep all other assets in equities for growth.
This is a conservative “safety first” approach I think that should withstand most short-term market turbulence. The challenge for investors using a total return approach however will be to sell equities when markets reach modest or new highs, and move cash timely into the cash “buffer” zone; although the fixed income allocation is generous. Using this structure I think it would make sense for most investors to draw down their RRSP assets or RRIF, before any non-registered assets, and keep TFSA assets in a mix of bonds and equities intact for as long as possible.
The “I Can Handle Some Risk” Structure #2
- This structure also assumes CPP and OAS provide fixed income, but only 30-50% of the portfolio is in fixed income. As part of your fixed income portion there would be a GIC-ladder. When you “ladder” you have maturities on fixed-income investments at different times meaning each “rung” on the ladder represents a different term. A $10,000 GIC ladder for example could have maturities on $2,000 in years one through five. An additional GIC ladder say mid-year could provide additional interest rate safety and you can access funds a couple of times in the year. The benefits of laddering are you don’t have to guess what term will give you the best interest rate on your money and since you have money maturing regularly (maybe twice per year) you can smooth out interest rate movements.
- You use the maturing GIC-ladder to keep a cash “buffer” for daily expenses.
- You keep all other assets in equities for growth.
This is also a “safety first” approach but with more equities you’re taking on more risk. Equities of course could have a tilt towards capital appreciation (think low-cost indexed funds) or income (think dividend/distribution paying funds or ETFs) or a mixture of both.
The “Income Focused” Structure #3
- Again, CPP and OAS provide fixed income.
- Keep 1-3 years in cash as “buffer” for daily expenses.
- Buy and hold a mixture of equity assets that deliver mostly income, to keep cash fund afloat. These could be dividend paying stocks, Real Estate Investment Trusts (REITs) and dividend-oriented ETFs that provide monthly or quarterly distributions.
This income-oriented approach assumes more risk than structure #1 or #2 and it may deliver lower, overall, total returns. Of course it is possible though that with higher dividends/dividend increases, you avoid dipping into capital. You may prefer this approach if you’re investing in dividend paying stocks in a non-registered portfolio, since there are significant tax advantages for investors who hold Canadian dividend paying stocks in a taxable account. Dividends are a very important part of investment returns but there is nothing magical about them, they are part of an investor’s total return. An income-focused structure could see retirees drawing down their RRSP or RRIF assets first, then using the tax-friendly non-registered dividend income to help cover expenses, keeping their TFSA in place for as long as possible.
With what I believe are challenging investor headwinds coming in the decades to come, I’ll be striving to create something like structure #3. We aspire to “live off dividends and distributions” so we intend to:
- Treat any income from our pensions like it is: fixed-income. We will use the fixed-income for basic living expenses.
- At time of retirement we’ll keep one-year worth of living expenses in cash savings, maybe more.
- Split the portfolio this way for retirement income:
- 50% invested in dividend-paying stocks from Canada and the U.S. (about 30-40 stocks in total) and use the dividend income generated from these investments to cover expenses, and
- 50% invested in a couple of low-cost, diversified, equity ETFs that invest in thousands of stocks from around the world. We will spend the distributions from these investments and eventually draw down the capital from our RRSP accounts, first.
How to de-accumulate assets and keep asset allocations in line with your risk tolerance in retirement is just something I’ve started to mull over. I’ve barely scratched the surface today. I suspect there is no perfect solution for every retiree. (I haven’t even introduced the concept of annuities here.) However it’s something I’m getting more curious about. Given such strategies have no one-size-fits-all formula I’m curious if there are retirees out there who have managed to find something that works out well for them – so do share.
What’s your plan to wind down your assets? What is your asset allocation to fund your retirement? Do you have a plan in place? Will you just work forever and hope the government takes care of you? Tell me what you’re thinking about…