‘Goldilocks’ Retirement: Is your distribution rate just about right?

Retirement distribution planning is one of the most challenging areas facing financial advisers.
Regardless of the difficulty, clients want to know how much income they can expect each year. Telling clients that “it depends” probably means they will be looking to another adviser for more clarity.
While distributions do depend on market returns, you can give clients clear guidance by setting a base distribution rate that has a high probability of success, and increasing distributions thereafter in accordance with account profitability.
While we know that past performance is no guarantee of future returns, the history of the financial markets is our best source of knowledge regarding sustainable distribution rates. When analyzing distribution rates over 30-year cycles in the U.S. financial markets, a hypothetical 4% inflation-adjusted distribution has a very high probability (but not a guarantee) of lasting at least 30 years.
At a hypothetical 50% stock and 50% bond allocation, using a 4% inflation-adjusted distribution, the failure rate approaches 0% for all 30-year cycles starting in 1926. At 5%, the failure rate jumps to more than 30%. And at 6%, it is more than 50%.
Given this data, a rational adviser would recommend a base distribution rate of 4% and move up from there depending on account performance. Even though the base rate is 4%, it is reasonable to advise clients that they could expect 5% and with some luck may get to 6%. At 5%, around 70% of the historical cycles have been successful, and at 6%, there has been roughly a 45% chance of success. However, at the beginning of each cycle, we don’t know what distribution rate the cycle will support, which is why we need to start with a base rate.
For instance, let’s look at the 30-year historical cycle from 1955 to 1984. Using a 4% inflation-adjusted distribution and starting with $1 million, the ending value of the portfolio in 1984 was about $2,800,000. Therefore, a 4% distribution rate would have been a bit low. At 5%, the ending value of the portfolio approached $1,050,000, which looks about right. The income stream is growing and the capital base is maintained throughout the entire cycle. But at 6%, the account is empty by 1982, which is clearly too aggressive for this market cycle. While clients could expect 5% and hope for 6%, they need to be prepared to live on 4%.
This approach is similar to the cash management strategies used by people who operate their own businesses. Most business owners establish an annual compensation draw that they believe the business can support through good and bad cycles. Then, on an annual basis, owners take additional bonus distributions that are in line with the company’s profitability. In a bad year, they forgo the additional distributions, because the key is to stay in business. Eventually, the good years come, and the bonuses flow.
Although we call it retirement, attempting to live off of a static pool of capital is a business. Like any other business, it is subject to ups and downs based on economic cycles. The strongest businesses are the ones that have the ability to weather severe economic downturns because their normal cash flow is substantially above their required expenses. A reduction in cash flow generally does not create a financial crisis.
Advisers should approach retirement income planning with the same disciplined philosophy. In addition to maximizing the distribution rate, it is equally important to motivate clients to clean up their balance sheets prior to retirement. Clients with the strongest financials will be the ones who enter retirement with the largest spread between their fixed costs and the 4% base rate. With a little luck, they should live a much richer retirement. But they may never reach the good years if they can’t make it through the bad.