Retirement Income Planning: How We Help Clients Prepare for an Uncertain Future

In this article, we’re sharing our approach to retirement income planning—and why we believe dynamic distribution planning makes sense for most retirees.  

As financial planners, one of our primary responsibilities is to help clients plan for a successful retirement. Of course, everyone has their own definition of success. Yet in our experience, most people are looking for an assurance that they can retire comfortably without running out of money.

The truth is there’s no magic number when it comes to your retirement nest egg. Despite various rules of thumb, there are countless variables and unknowns that can affect your financial resources in retirement. That’s why two individuals can retire with identical savings and end up having very different financial experiences.

However, that doesn’t mean you should leave your retirement to chance. With careful planning, you can minimize the risk of outliving your assets, so you can confidently retire on your terms.

Why Retirement Income Planning Matters

There are generally two phases of retirement—the accumulation phase and the decumulation phase (also known as the distribution phase). If you’re still working, you’re likely in the accumulation phase. In other words, you’re focused on growing your assets and building wealth.

The decumulation phase begins when you start taking distributions from your investment portfolios. Put differently, you start drawing down the assets that you’ve accumulated to date to fund your lifestyle and expenses in retirement.

Indeed, the size and frequency of your withdrawals can greatly impact how long your financial resources last. However, there are a variety of factors outside of your control that can affect the rate at which you draw down your assets. Some of these factors include:

  • Market returns during your retirement years
  • The sequence and variability of these returns
  • Future inflation rates
  • Your lifespan.

Thus, careful planning is necessary to account and prepare for the many unknowns that will inevitably shape your retirement years.

There are many approaches to retirement income planning. Three common methods are the 4% rule, Monte Carlo analysis, and dynamic distribution planning.

The 4% Rule

In 1994, William Bengen introduced the 4% rule. This rule has since become synonymous with retirement income planning in many circles.

Put simply, the 4% rule says you can withdraw 4% of your nest egg in your first year of retirement. Then, you can safely withdraw that same dollar amount each year in retirement for 30 years without running out of money.

The beauty of the 4% rule is its simplicity. Most people can understand it, and the supposed guarantee of not running out of money over the course of 30 years is indeed appealing.

However, the 4% rule isn’t without its shortcomings. For one thing, the dollar amount you withdraw each year is highly dependent on where the market is when you retire.

For example, if you retired in 2021 when the S&P 500 recorded 70 record highs, your annual withdrawal amount would be much higher, theoretically, than if you retired in 2008. Therefore, retiring after a big market runup can be problematic for those following the 4% rule.

In addition, the 4% rule assumes that over half of the retiree’s portfolio is invested in stocks, which may not be the case for everyone. It also assumes that spending only varies with the cost of living. To account for these potential limitations, some financial experts are now saying a 3.3% rule may be more appropriate.

Monte Carlo Simulation

More recently, many financial advisors have relied on Monte Carlo simulations for retirement income planning. Unlike the 4% rule, which projects one portfolio outcome based on an average rate of return for the market, Monte Carlo provides a range of potential outcomes in real dollar terms.

Using a complex mathematical model, Monte Carlo simulations incorporate a variety of variables—for example, market returns, inflation rates, and distribution rates—that can impact your investment portfolio in retirement. The model then calculates an estimate of how long your financial resources will last based on thousands of possible scenarios.

In some cases, Monte Carlo simulations are useful in that they can help investors visualize a variety of potential scenarios in retirement. This can be comforting when planning for an uncertain future. However, as a retirement income planning tool, Monte Carlo has limitations.

For example, any mathematical model is only as good as its inputs. Financial advisors must make several assumptions when running a Monte Carlo simulation. Examples include how markets will perform, how various asset classes will behave, and how long a retiree may live. If their assumptions are unrealistic, the outcomes will be just as unreliable.

In addition, some critics of Monte Carlo argue that because of limitations with the model itself, some of the scenarios it predicts are too extreme and unrealistic to even consider. Others contend that the model cannot accurately predict infrequent events such as major market crashes.

Lastly, Monte Carlo simulations help investors determine a safe withdrawal rate today based on a range of future scenarios. However, the outcomes the model predicts are based on static withdrawal rates. In other words, Monte Carlo doesn’t account for the possibility that retirees may adjust their spending habits as market conditions—and therefore their portfolios balances—change.

Dynamic Distribution Planning: A More Adaptive Approach to Retirement Income Planning

Indeed, Monte Carlo simulations provide an effective way to quickly generate multiple future scenarios. Yet it falls short of considering actual investor behavior. Therefore, we believe a dynamic retirement income planning approach is more useful.

A dynamic distribution approach assumes that most retirees will adjust their spending as their circumstances and market conditions change. Rather than planning for a static withdrawal rate throughout retirement, we reassess retirees’ spending rates each year. In years when retirees are at risk of drawing down their account balances too quickly, they can reduce their spending to improve their probability of success.

For example, let’s say your initial distribution rate in retirement is 5%. In years when market returns are positive, you may be able to sustain this rate or even increase it slightly with little risk of running out of funds.

On the other hand, there will likely be years when the market is negative, and your portfolio balance decreases meaningfully. Unfortunately, making large withdrawals in a down market can be risky. Doing so leaves you with less capital to recoup your losses when the market recovers. As a result, you may decide to lower your distribution rate to 4.5% to preserve your nest egg in negative market environments.

Ultimately, a dynamic distribution approach helps you plan large expenses based on how the market performs. That means you can still buy a new car or go on extravagant vacations if your retirement funds allow for it. You just may want to do so in years when the market and your portfolio are performing well.

A Trusted Advisor Can Help You Plan for a Successful Retirement

At Milestone Asset Management Group, our team of experienced financial planners and tax professionals can help you plan for a successful retirement and financial future. To speak with an advisor about developing a personalized financial plan, please schedule a call. We’d love to hear from you.