Personal Finance Fails to Solve This Important Problem
By: Ben Le Fort
Tags: Personal Finance, Money, Life Lessons, Education, Retirement

Smart Money

Personal Finance Fails to Solve This Important Problem

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If you follow personal finance writers or financial experts on social media, you probably receive a lot of advice about accumulating wealth. It’s the number one topic in personal finance, partly due to how important building wealth is.

If I am being honest, finance bloggers like me focus too much on the wealth-building process, which in the world of finance is referred to as the “accumulation phase” of your life.

But, building wealth is only half the battle.

There is not nearly enough time spent discussing how to use wealth to create a life-long stream of reliable income, also known as the “decumulation phase” of your life.

In this article, I will discuss the decumulation phase of wealth management and discuss the biggest retirement risk for anyone who does not have a pension.

The two sides of the wealth management coin

Managing your finances is a lifelong process, and that process looks completely different depending on what phase of your life you are in.

While you are young and in your prime working years, you are in the accumulation period of your life. This is the period where you are trying to pay down debt, buy a home, have kids, focus on your career, and save for retirement.

It’s the aspect that most personal finance bloggers like me focus on.

Part of the reason I focus on the wealth accumulation phase is that it is the phase of my life I am currently living, and it’s always best to write from experience.

However, if I am being honest, the real reason I and so many personal finance writers focus on accumulating wealth is that it’s what readers want. An article about building wealth will get much more traffic and engagement than an article about managing the wealth you already have.

Demand dictates supply.

But, building wealth is only half the battle. How you manage wealth once you have it is equally important, even if it is much less sexy. A bit of bad luck compounded by some poor decisions in retirement can undo a lifetime of good financial choices.

That is where the concept of wealth decumulation comes into play. Wealth decumulation refers to the phase of your life where you are drawing down your wealth to cover your living expenses in retirement. The objective of wealth decumulation is to use your wealth to create a stream of reliable income that lasts the rest of your life.

Together the wealth accumulation and wealth decumulation make up the two sides of the wealth management coin.

Visual created by the author.

The 4% rule of thumb

A common method of managing the decumulation phase is figuring out a safer withdrawal rate, which tells you how much of your wealth you can sell to fund your lifestyle in retirement.

A common withdrawal rate is the 4% withdrawal rate or the 4% rule of thumb.

According to the 4% rule, you could withdraw 4% of your retirement savings to pay for your cost of living in retirement. If you had $1 million saved, you would withdraw $40,000 in year one of retirement and then increase that by the level of inflation each year.

Like with most rules of thumb, the 4% rule has many flaws. I discuss them in more detail here.

The biggest risk to your retirement plan if you are using the 4% rule is what is called the sequence of return risk.

Sequence of return risk explained

How the stock market performs in the first few years after you retire can make or break your retirement plan.

Let’s say you retire with $1 million invested primarily in the stock market and you plan on using the 4% rule and sell $40,000 worth of assets in year one of retirement.

Then, out of nowhere, the stock market crashes, and your portfolio loses 40% of its value a few months into your retirement. Add in the $40,000 you withdrew to fund your retirement, and after one year, your $1 million retirement nest egg is down to $520,000.

In year two, you increase that $40,000 withdrawal by the rate of inflation, and you keep increasing that withdrawal by the rate of inflation in each subsequent year.

By the time the market finally recovers, you may not have enough money left in your portfolio to ever fully recover, and your retirement could be in jeopardy.

Sequence of returns risk is the risk that you get unlucky, and your investments perform very poorly in your first few years of retirement.

Managing sequence of returns risk

The frustrating aspect of managing sequence of returns risk is that nobody knows how the stock market will perform in the first few years of their retirement.

That does not mean it can’t be managed; here are a few ideas on how to minimize sequence of returns risk.

Choose a conservative withdrawal rate. Construct a conservative portfolio. Have a variable spending plan in retirement. Plan for variable income in retirement.

Choosing a conservative withdrawal rate & portfolio

The simplest way to manage the sequence of returns risk is to choose a withdrawal rate that is so low you can withstand a market crash early on.

If you used a 2% withdrawal rate rather than a 4% withdrawal rate, you would be much less vulnerable to a market crash early in your retirement.

Even if you experienced a severe market crash in your first year of retirement, with such a low withdrawal from the portfolio, you would be much more likely to have enough money left to benefit when the market eventually rebounds.

The problem?

You would need to save twice as much money with a 2% withdrawal rate. If you needed $40,000 per year to fund your retirement, under a 4% rule, you would need $1 million saved, and under a 2% rule, you would need $2 million saved.

You might also consider investing in a conservative portfolio that is more weighted towards less risky assets like bonds and less towards risky assets like stocks.

A similar problem arises.

Part of the math behind the 4% rule is that it assumes a certain return on investment. Bonds are less volatile than stocks but have a lower expected return.

If you overweight bonds in a retirement portfolio, you may need to use a lower, safer withdrawal rate, which again means you need to save more money.

Have a variable spending plan in retirement

This is something that Micheal Kitces writes about quite a bit. A variable retirement spending plan means adjusting your spending in response to what happens to your portfolio.

Remember the situation where the market tanked, and your portfolio dropped 40% in your first year of retirement? This problem was compounded by the fact that you were withdrawing $40,000 in that same year and then increasing that withdrawal rate by the rate of inflation each year.

With a variable spending plan, you would adjust the amount you withdraw based on what happens in the market during the first decade of retirement.

If the market goes in the tank, you reduce the amount you withdraw from your portfolio.

If the market does really well, you can choose to increase the amount you withdraw from your portfolio.

It is a simple concept but to fully explain the intricacies of building and executing a variable spending retirement plan is its own article.

In fact, Kitces wrote a perfect article on that subject right here. I would recommend giving it a read when you are done reading this one.

Variable income in retirement

If you can’t or won’t cut your spending in retirement in response to market volatility, you may also consider a variable income plan in retirement.

If the market and your portfolio tanks early in your retirement, you might want to consider picking up some part-time or even full-time work to bring in more income until the market recovers.

Once it does, you can choose to quit the job and go back to your original withdrawal rate from your portfolio.

As you approach retirement age, you need to have a plan to manage the sequence of returns risk

The decumulation phase of your life is critical to managing your wealth. Think of it as “Sticking the landing” on your financial plan.

A figure skater could give the best impressive performance of their life, but they won't win if they don’t stick the landing.

The same is true for our finances. You spend a lifetime accumulating wealth and doing all of “the things you are supposed to do,” but if you don’t have a plan on how you’ll manage the sequence of return risks, you could ruin your hard-earned retirement.