As the stock market and US economy struggled in response to the coronavirus pandemic, experts revised the 4% rule to 3%, or even lower. Advisors should look beyond traditional investments and include household assets in retirement planning.
Younger and mid-career workers who were lucky enough to keep their jobs during the downturn have the opportunity to benefit from lower stock valuations, but those who are later in their careers wonder if they will ever be able to retire. New retirees face the greatest threat. Sequence-of-return risk — being forced to sell depressed assets in a down market to finance their spending if they don’t have enough cash to weather the storm — could be devastating to their long-term financial security.
“If you are trying to meet a spending goal and assets are losing value, you have to withdraw a higher percentage from your portfolio,” said Wade Pfau, retirement income researcher and professor of retirement income at The American College for Financial Services.
“Unless investment returns earn at least as much as the withdrawal rate, the portfolio will spiral downward,” Pfau said. “Those first five to 10 years of retirement really drive about 80% of the outcome.”
New retirees who are relying solely on their investments for retirement cashflow may need to be stringent with spending to ensure they don’t run out of money later in retirement. Experts think that the traditional 4% rule, which says retirees can safely withdraw 4% of their nest egg during the first year of retirement and subsequently increase their annual withdrawals by the rate of inflation over a 30-year retirement without running out of money, may no longer applies, Pfau said.
Today’s market volatility coupled with record-low interest rates, returns from a diversified portfolio are lower now than when the 4% rule was established 25 years ago, Pfau said.
For a couple who both turn 65 today, the safe withdrawal rate from a diversified portfolio with at least a 50% stock allocation is closer to 2.29%, Pfau said. Consequently, his proprietary Retirement Affordability Index (see below) reached its lowest level ever last month.
Beyond traditional investments
For many retiring clients, a 2.29% withdrawal rate won’t be enough to fund retirement. Consequently, financial advisers may need to look beyond traditional investments and consider all of a household’s assets to generate sufficient cashflow. The goal should be to create a safe, inflation-protected cashflow floor that in combination with Social Security will cover essential expenses throughout retirement. Once the essentials are covered, invested assets can be positioned for growth to fund discretionary expenses and other financial goals.
For people nearing retirement, the nationwide stay-at-home orders during the pandemic may provide an excellent opportunity to practice retirement. With nowhere to go and few opportunities to spend money on discretionary expenses like restaurants, travel and live entertainment, it becomes abundantly clear which expenses are essential and non-essential.
Total household assets
“Consider all assets and liabilities on a household’s balance sheet,” Pfau said.
“The best strategies are not investment-only or insurance-only,” he explained. “Together these approaches can fund different goals with different risk levels and trade-offs.”
Such comprehensive retirement income strategies might include buying annuities to transfer some of the client’s market risk to an insurance company in exchange for guaranteed income; tapping home equity through a home equity line of credit or reverse mortgage to fund income needs without selling investments at a loss; or taking tax-free withdrawals from an existing cash-value life insurance policy or selling an insurance policy through a life settlement to serve as a temporary income bridge.
“By incorporating partial annuity use, having access to a buffer asset [such as a reverse mortgage or cash-value life insurance] and having some capacity to reduce spending, a reasonable withdrawal rate can still be possible and can provide some relief to those approaching retirement age at this unprecedented time,” Pfau said.
Not everyone gets to decide when — or if — to retire. Some of the tens of millions of people who lost their jobs during the steepest economic downturns in history may never work again. For the newly unemployed who are at least 62 years old, filing for Social Security may be necessary even if claiming benefits before full retirement age can result in a permanent reduction in monthly payments.
An uptick in individuals claiming Social Security benefits at the earliest possible age of 62 as a result of the COVID pandemic would reverse a nearly 20-year trend of workers claiming benefits at older ages. The percentage of men who claimed benefits at 62 dropped from 40% in 2000 to 22% in 2018, and early claims for women dropped from 44% in 2000 to 25% in 2018, according to the Social Security Administration.
However, claiming reduced Social Security benefits may not be enough to support clients’ income needs, particularly if they are unwilling to cash in retirement assets in a down market. Consequently, financial advisers may need to look beyond investible assets and explore other ways to generate income.
“Incorporating home equity through reverse mortgages can be an effective risk management tool during times of extreme market volatility,” said Steve Resch, a financial adviser and vice president of retirement strategies at Finance of America Reverse, one of the nation’s largest reverse mortgage lenders. Senior housing wealth reached an all-time high of $7.23 trillion in April, according to the National Reverse Mortgage Lenders Association quarterly index.
A reverse mortgage lets homeowners who are 62 or older borrow against the equity in their homes as long as they live there. It can help clients stay invested during the current stock market lows while creating an alternative income stream to ensure there is cash available to pay bills and address other important financial needs, such as paying off an existing mortgage to lower monthly expenses.
There are some steep upfront costs — including a mandatory 2% insurance fee based on the value of the home up to Federal Housing Administration lending limits — but those can be wrapped into the cost of the loan, and no repayments are required as long as the borrower or his or her spouse live in the home.
Resch runs an educational program for financial advisers, which qualifies for continuing education credit, on how to incorporate home equity into a retirement income plan.
“People are losing their jobs and they have an asset they can draw on without having to drain their investments,” he said. “It is a message we have been talking about for years, and it seems to be coming home to roost.”