A Simple Retirement Income Process

Working or retired, the focus of most people is keeping their check book full of money for the monthly expenses they have.

While working, the source of the money is obvious … it is from you working.

While retired, the source of the money is less obvious … it is from your money working.

So how do you get money, that is working, into your checking account each month? I structure a process that has measureable metrics and pre-calculated decision points built in. This structure is based on research evidence on BOTH the markets, and on how to measure and monitor retirement income.

The focus remains on the check book above. However, the flow of the money through the structure begins at the top and ends at your checkbook for you to spend, just like you did while working, each month.

Note: You may hold the shift key and then click on the photo above to enlarge it.

Snow on the mountain.

Money is fungible and also does not know its’ source whether from dividends, interest, capital gains, principal, etc. Thus, money can and should come from all possible sources and the structure is then based on a concept called total return. The analogy here is that the snow on the mountain is your Long Term Portfolio (LTP) which is where the bulk of your money is invested according to your overall risk capacity and risk tolerance. Okay, this Long Term Portfolio is what most people think of when investing for retirement. The main difference in the structure here is that the focus is on both indexing for the long term (defined as the rest of your life), and total return.#

Many people simply structure the retirement distribution process as money going directly from their portfolio (snow on the mountain) into their checking account. Most of the time markets behave normally and this wouldn’t be a problem.

First of all, you should understand that everybody who invests, be they an individual, or an institution like insurance companies, mutual funds, or pension plans, etc., invests in the same markets. So when markets misbehave, all investors are affected the same by that misbehavior. Of course, the degree of being affected is proportional to their exposure to the markets, which gets to diversification and allocation., a separate topic that relates to the Long Term Portfolio above and the need for a distribution reservoir.

Secondly, understand that in order to get the money that you need to spend for this month’s expenses, you need to sell shares of your investments to do that. Indirectly, if you’re trying to use just interest, dividends and/or capital gains, you are essentially selling shares too. The difference is that you didn’t use those income sources to buy shares first as with most total return approaches. Instead, those income sources were kept as cash and then spent.

Rather, I suggest you let those new sources of money buy new shares today so these new shares are the ones that go up for you to sell in the future for future income needs. After all, the goal is still to buy low and sell high. Instead, during the normal course of funding your retirement expenses, you sell shares that you’ve bought long ago and have already gone up over that long period of time. Most people are heavily weighted in “qualified” retirement accounts in their Long Term Portfolio so the capital gains tax doesn’t apply because the tax deferral means all of the money, regardless of source, is taxed as ordinary income.

What about times when markets misbehave?

Enter the reservoir.

For simplicity*, I structure the reservoir using short term bond fundss because the shorter the maturity of the bonds, the less the price changes with interest rates and investor demand (flight to safety and/or quality when markets misbehave). There is no stock market exposure in this portfolio at all. The purpose of the stock market exposure is to get returns over and above inflation over long periods of time. Why not longer maturities for higher interest rates?

First, because those lead to greater price volatility which is what you don’t want in your reservoir as this would lead to selling shares into declining prices. Second, if you want stock like returns (higher returns), then you should seek to get those returns, and the volatility that comes with those kinds of returns, from the stock market rather than the bond market. Both of these points are important, especially in this distribution reservoir portfolio (DRP).

Why the need for a reservoir?

Simply put, to stop selling shares into declining prices … which leads to selling more shares to net the same amount of money. Hint: when you run out of shares, you run out of money!

So the fundamental purpose of the Distribution Reservoir Portfolio (DRP) is to continue funding your checkbook with money each month when the market misbehaves (how you measure and monitor this is through what I call “emergency procedures” … to stop selling long term shares into declining prices as the markets go down.

When you stop funding retirement, through the refill process discussed below, from the Long Term Portfolio, this does two things when markets misbehave and go down:

1. You stop selling shares into continually declining prices (stop the need of selling even more shares to net the same dollar amount), and
2. You stop selling shares to pay the taxes on the money withdrawn from “qualified” retirement accounts (because the Distribution Reservoir Portfolio has been structured with joint and or individual accounts that don’t have retirement income tax rules, and can take advantage of the more favorable capital gains tax rules).

Wait. Why the two portfolios again?

Notice the two blue arrows going from the Long Term Portfolio (LTP) into the Distribution Reservoir Portfolio (DRP), and then from the Distribution Reservoir Portfolio into your checkbook. Money flows out of the DRP into your checkbook every month. So this would deplete the DRP after a while depending on how many months the DRP is set up to fund your checkbook.

Every so often (I use a quarterly period so that normal market processes can be best captured), money is transferred from the LTP to the DRP to replace the money that was spent. So if money is transferred every month for three months into your checkbook, then the DRP is three months below its’ “full” level (I use 36 months as the “full” DRP level since most portfolio allocations for retirees historically go down, bottom out, and recover within that period plus the time it takes for markets to hit the “turn off refill” decision rule discussed below in “emergency procedures”). During normal times, every quarter, money is transferred from the LTP to the DRP to replace the money that has been spent.

Recall above the discussion about market misbehavior when the markets go down. The need to keep withdrawing money from the DRP into your checking account continues. That is the overall objective of the entire structure – to keep the checking account funded with money each month.

However, the transfer of money between the LTP and DRP stops when it reaches a predetermined decision rule (more on these later). Now, shares are not being sold at lower prices; income taxes are not required on money that has not withdrawn from retirement accounts, so those shares are also retained at lower prices waiting for market recovery. Thus – the structure becomes an inherent share management process as well.

A behavior then tends to kick in when the DRP begins to shrink in size, due to spending and not because of the stock market because the DRP does not have stock markets exposure. Remember how people started to cut back spending in the Great Recession in 2008. The certainty of their income became in question and people cut back. When people see their DRP shrinking they tend to cut back too.#

Ocean Wave approach to setting sustainable spending vs the economist’s approach.

The traditional approach to retirement income spending is to spend based on the current portfolio value. Spend more when it is high, and when the value goes down, spend less. Instead, I encourage people to set spending based not on the high point (peaks) of portfolio values along the way, but instead structure their spending and lifestyle expenses based on the low point (troughs) of their portfolio value which is calculated from each person’s specific portfolio characteristics. I call this the Ocean Wave approach to determining prudent sustainable spending over your remaining lifetime.

Why on the low points (troughs) and not on the high points (peaks) of portfolio values? Because the trough spending rate doesn’t require you to reduce your spending during market misbehavior while peak spending rates require you to reduce spending more quickly. During normal times, the difference in spending level can become discretionary spending. During stressed market times, your spending level is set to necessary expenses to begin with. Should markets hit the next decision rule level where spending does need to be reduced, it typically doesn’t have to be reduced as much; thus making monthly budgeting much more manageable regardless of what the markets might be doing.

Note, that this discussion is only about the portfolio component of your total retirement income picture. Other income sources such as Social Security and/or a pension are foundational to your income plan already. The above is a structure to measure and monitor the health of spending from the portfolio part of your overall income plan. Therefore, your total income would be the sum off money from all sources of retirement income you have.

There is research into what is called a bucket* approach to investing and there are complicated structures to put multiple buckets into place. At the end of the day, they are meant to do the same thing as I describe here, the other bucket structures sometimes have with less flexibility and are usually more complicated. I simplify the process by using two buckets targeting specific things. When you combine all the various “buckets” together, regardless of the bucket strategy you use, you ultimately arrive at a total return of the overall combined portfolio (associative property of math). This total return concept is no different for any structure … they ALL have a combined overall total return regardless if each piece is separate or combined in some fashion.

So the simple approach I describe above simply targets your comfort with uncertainty into a simple, easy to understand, structure to provide supplemental retirement income in addition to other sources you have such as Social Security and/or a pension.

Normal operations and Emergency Procedures.

A well designed process should be structured on normal operations of the economy and markets. However, sometimes things don’t go normally in the economy and markets. So emergency procedures based on math, not emotion, should be pre-determined and built into the process and structure.

Decision Rules are designed to recognize that markets go up and down all the time – so at what point during market declines should you make a decision and what decision should you make? When are you taking too much out of your portfolio?

The rules I use are discussed via the link at the beginning of this paragraph and the big picture is discussed more via the emergency procedures link in the prior paragraph … so I won’t discuss either in depth more here.

The is above built upon what evidence?

What is all of the above based upon? The LTP managed under the concept of evidence based research through which that is implemented in the LTP via a firm called Dimensional which I expand upon in blogs on Dimensional. The structure of the process is based on research focused on the measurement and monitoring of prudent and sustainable retirement portfolio income (expanding on this blogs) based on longevity based lifetimes you have remaining (not, a single fixed period calculation to some set end age).

Moral of the story: The Retirement Distribution Process I describe above incorporates the following: 1) recognition of the need for managing selling shares into declining prices with the ability to stop doing that, 2) stop paying taxes with a process that can stop selling shares into declining prices for taxation, 3) incorporate a behavioral function recognizing the ability to spend more when times are good, and reduce spending (discretionary first) when times are poor, and 4) structure a process that continues to add supplementary income from your portfolio in addition to Social Security and/or a pension.

So what if you’re not retired yet?

How much do you need to retire? When can you retire? The computation is to stochastically calculate how much capital you need to provide a supplemental income added to your Social Security (and/or pension if there is one) and comparing that to when the total income matches your total expenses in retirement. Basically it is much like working the problem backwards to determine what you may need to do that is under your control (markets are not under your control) that would impact the results so you may retire sooner if that is your desire. Risks such as injury or illness should also be evaluated because studies (EBRI Retirement Confidence Surveys, Expectations about Retirement) continue to show that many people are forced to retire sooner than expected.

#For an interesting discussion between Total Return vs “Buckets” please see “Managing Sequence Of Return Risk With Bucket Strategies Vs A Total Return Rebalancing Approach” by Kitces. While the above may appear to be a “bucket” approach on the surface, what the DRP’s purpose here is to behaviorally separate in the retiree’s mind what the market is doing to their portfolio from what is happening to the source of their monthly income for the number of months the DRP has been pre-funded. The retiree is able to see what is happening to either portfolio and make better decisions about their spending levels relative to what is prudently calculated from everything overall. Once periodic refills have been turned off temporarily, the DRP begins to shrink which encourages decisions related to how fast a retiree wants their DRP to deplete (e.g., retrench spending just a bit to make it last longer).

*Others structure what I call the DRP using bond ladders and/or multiple buckets, which stretch the time frame well beyond three years, and which add complexity to management of refilling and turning off that refill. The larger portfolio percentage to bonds may also tend to reduce the lifetime total return of the portfolio when the focus gets too tilted towards income. Often people confuse bond price declines (inverse to interest rates) as threatening the viability of their plan (they see their portfolio value decline). This behavioral reaction is another reason I simply the structure so that the short term (next 3+ years) source of their income tends not to have wide price swings in value. Those price swings are retained in the LTP and can be disconnected from their income source when times call for it. This helps people better visualize what kind of decisions they should make that matter during different market environments throughout their retirement.