Spending money is easy. Saving and investing is supposed to be the difficult part. But there’s a reason why Nobel laureate William Sharpe called “decumulation”, or spending down your retirement savings, the nastiest, hardest problem in finance.
Indeed, retirement planning would be easy if we knew the following information in advance:
- Future market returns and volatility
- Future rate of inflation
- Future tax rates and changes
- Future interest rates
- Future healthcare needs
- Future spending needs
- Your expiration date
You get the idea.
We can use some reasonable assumptions about market returns, inflation, and interest rates using historical data. FP Standards Council issues guidelines for financial planners each year with its annual projection assumptions. For instance, the 2020 guidelines suggest using a 2% inflation rate, a 2.9% return for fixed income, and a 6.1% return for Canadian equities (before fees).
We also have rules of thumb such as the 4% safe withdrawal rule. But how useful is this rule when, for example, at age 71 Canadian retirees face mandatory minimum withdrawals from their RRIF starting at 5.28%?
What about fees? Retirees who invest in mutual funds with a bank or investment firm often find their investment fees are the single largest annual expense in retirement. Sure, you may not be writing a cheque to your advisor every year. But a $500,000 portfolio of mutual funds that charge fees of 2% will cost an investor $10,000 per year in fees. That’s a large vacation, a TFSA contribution, and maybe a top-up of your grandchild’s RESP. Every. Single. Year.
For those who manage their own portfolio of individual stocks or ETFs, how well equipped are you to flip the switch from saving to spending in retirement? And, how long do you expect to have the skill, desire, and mental capacity to continue managing your investments in retirement?
Finally, do you expect your spending rate will stay constant throughout retirement? Will it change based on market returns? Will you fly by the seat of your pants and hope everything pans out? What about one-time purchases, like a new car, home renovation, an exotic trip, or a monetary gift to your kids or grandkids?
Now are you convinced that Professor Sharpe was onto something with this whole retirement planning thing?
Changes To Your Retirement Income Plan
One solution to the retirement income puzzle is to work with a robo advisor. You’ll typically pay lower fees, invest in a risk appropriate and globally diversified portfolio, and have access to a portfolio manager (that’s right, a human advisor) who has a fiduciary duty to act in your best interests.
Last year I partnered with the robo advisor Wealthsimple on a retirement income case study to see exactly how they manage a client’s retirement income withdrawals and investment portfolio.
This article has proven to be one of the most popular posts of all-time as it showed readers how newly retired Allison and Ted moved their investments to Wealthsimple and began to drawdown their sizeable ($1.7M) portfolio.
Today, we’re checking in again with Allison and Ted as they pondered some material changes to their financial goals. I worked with Damir Alnsour, a portfolio manager at Wealthsimple, to provide the financial details to share with you.
Allison and Ted recently got in touch with Wealthsimple to discuss new objectives to incorporate into their retirement income plan.
Ted was looking to spend $50,000 on home renovations this fall, while Allison wanted to help their daughter Tory with her wedding expenses next year by gifting her $20,000. Additionally, Ted’s vehicle was on its last legs, so he will need $30,000 to purchase a new vehicle next spring.
Both Allison and Ted were worried how the latest market pullback due to COVID-19 had affected their retirement income plan and whether they should do something about their ongoing RRIF withdrawals or portfolio risk level.
Furthermore, they took some additional time to reflect on their legacy bequests. They were wondering what their plan would look like if they were to solely leave their principal residence to their children, rather than the originally planned $500,000.
What would their maximum attainable after-tax income be going forward under this new scenario? Lastly, they wondered about the risk of their assets being prematurely depleted if they were to follow this strategy.
Providing Alternative Strategies
Wealthsimple pairs human experience with artificial intelligence to produce an updated and tax-optimized withdrawal strategy that is tailored to their clients’ goals and ever-changing circumstances.
In this instance, Allison and Ted should withdraw the $50,000 required this year from their $150,000 non-registered portfolio, as well as the $50,000 needed next year from the same bucket.
“Luckily, the market downturn of December 2018 allowed us to systematically implement tax-loss harvesting strategies on Allison’s and Ted’s joint non-registered account, and the majority of the unrealized capital gains accumulated since can be offset using prior realized capital losses.”
Furthermore, the $100,000 which will be needed over the next 12-18 months can be temporarily parked in a Wealthsimple Cash account earning a competitive interest rate while eliminating any downside risk associated with funding of their new short-term goals.
This would allow Allison and Ted to fund their new expenditures without increasing their overall taxable income, therefore not risking any Old Age Security (OAS) clawbacks or sacrificing tax-preferred growth in their RRIF or TFSA accounts.
Despite being invested in a balanced portfolio at Wealthsimple, Allison and Ted felt uneasy during the most recent market pullback in March 2020. It was the velocity of the market downturn which took them by surprise.
Conversely, they were pleasantly surprised when comparing their performance with that of their previously owned bank brokerage portfolio.
“More importantly, however, their new estate goal allows them to explore some interesting options which may enable us to better align their true risk tolerance to their new aspirations.”
If they were to leave $280,000 in liquid assets to their children instead of the originally planned for $500,000, they would do just fine with a more conservative 35% equity and 65% fixed income portfolio. Alternatively, they could increase their annual after-tax spending from $80,000 to $90,000 per year with the same conservative allocation and deplete their investable assets by age 95.
Probabilities of Success
The first alternative would offer a higher probability of success, since the portfolio’s returns would be less volatile over Allison’s and Ted’s retirement horizon, due to the more conservative asset allocation.
This would reduce the dispersion of potential outcomes and lower the risk of experiencing a significant drawdown of investable assets, especially during their early retirement years.
A steep market correction in a retiree’s early days can have an amplified impact when examined over a 30-year retirement horizon (a concept known as sequencing risk).
Under the first scenario, the probability of success would be approximately 90% with a 10% risk of ruin (i.e. depletion of investable assets before the age of 95).
In the full asset depletion scenario, with a $90,000 after-tax retirement income, the probability of success would be closer to 70%. The latter may not be acceptable to Allison or Ted as they feel strongly about not having to rely on their principal residence to fund any shortfalls (aka the nuclear option).
Furthermore, they believe that the associated longevity risk is too high (i.e. living past age 95) – based on their family’s history of a long and healthy lifestyle.
Retirement planning can be hard enough in the initial stages. It also takes great care to tackle changes to your retirement income plan as you move through retirement.
In my conversation with Wealthsimple’s Damir Alnsour, we agreed that highlighting case studies and analyzing other scenarios can provide invaluable information – not only to clients like Allison and Ted, but also to any Canadian currently faced with the “nastiest, hardest problem in finance.”
He said risk-based insights help empower their clients to make more informed, educated, and statistically backed decisions, resulting in a set of clear trade-offs.
I agree, and when my own fee-only planning clients end up moving their investments to Wealthsimple I know they will be presented with options that are sensible and objective for their unique circumstances, enabling them to achieve what truly matters to them and their loved ones.
Curious about moving over to a robo advisor? You can book an appointment to speak with a Wealthsimple portfolio manager today about your personal retirement scenario.