A portfolio withdrawal strategy is essential to retirement planning, but it doesn’t paint the whole picture of retirement for clients. Each investor’s portfolio withdrawal rate may differ from another’s, depending on the size of the portfolio, planning horizon and spending needs, as well as inflation and market returns. But those investors who are too reliant on an investment portfolio for income may be more susceptible to outside risks. Understanding the portfolio reliance rate can help you and your clients plan for these risks and consider whether additional protected income is needed.
The portfolio reliance rate, which is the inverse of the protected income percentage, shows how much an investment portfolio is relied upon for retirement income. As reliance on the investment portfolio for income increases, so does the potential sensitivity to market volatility, sequence of returns risk (e.g., the risk of market declines in the early years of retirement), as well as the longevity of a withdrawal strategy.
Portfolio reliance and withdrawal rates are connected in that if an investor has a more conservative withdrawal rate — for example, 3% or less — then they may be able to rely more heavily on their investment portfolio to meet their retirement income needs. But if an investor has a higher withdrawal rate, then this increased reliance on the investment portfolio may make them more sensitive to market fluctuations, among other risks.
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The withdrawal rate from a portfolio can help determine how long retirement income may last. The rate is affected not only by the income that is needed to live (including taxes and inflation), but also by the protected income sources a client has such as Social Security, pension income and/or annuities. Various other factors will also affect a withdrawal rate, such as an investor’s retirement planning horizon, inflation and market volatility. The length of retirement is a major factor in determining a withdrawal rate. Clients who plan on shorter retirement lifespans may be able to spend more while those with longer planned retirements may want to be more conservative in their withdrawals.
Fluctuations in the market will also affect how much clients can withdraw. Naturally, lower market returns will support a lower withdrawal rate and could impact the longevity of the portfolio. And a higher withdrawal rate may be supported by some combination of a shorter life expectancy, strong market returns and modest inflation.
Retirement risks come in many forms. The process of building a retirement income strategy that instills confidence includes helping clients determine if they want to incorporate or protect from various risks.
Incorporating risk could include, for example, a reduction in the withdrawal rate to plan for a longer time horizon or higher inflation rates, or to provide more flexibility of spending.
Starting with a client’s expected spending needs and outside sources of protected income, financial professionals can use a tool like Capital Group’s Portfolio Reliance Calculator to provide a point-in-time estimate of the amount needed to withdraw from a retirement income investment portfolio.
Seeking a balance of retirement income sources — protected and investment income — may help to provide stability and reliability for a retirement income strategy. By helping investors understand how reliant they are on the investment portfolio to meet their retirement income needs, as well as the options available to reduce this reliance, you can prepare them to better withstand inevitable market downturns among other risks.
While additional protected income may not be needed for some clients, sources of protected lifetime income, such as Social Security, pensions and annuities, can be important tools for retirement spending and may be used to cover essential expenses that are fixed and not flexible. By helping to reduce some of the withdrawal stress placed on the investment portfolio, these sources could also help reduce the risk of outliving assets due to some combination of a long life and/or poor market returns. For many retirees, the confidence that comes from knowing they have a stable income stream no matter how long they live is of utmost importance.
Managing longevity risk with insurance can be an alternative to asking retirees to spend more conservatively to account for living longer or dealing with rising health care costs, and it can help protect against the impact that a poor sequence of market returns early in retirement can have on a strategy. Even in cases where longevity risk is not a concern, exploring opportunities to increase their level of protected income may help improve their overall confidence in retirement.
There is no way to be certain what the future will hold, but higher levels of protected income can help instill confidence that clients are prepared for what’s ahead. Depending on an investor’s unique situation, they may look to increase their outside protected lifetime income to provide more predictable income, regardless of market performance or longevity, and reduce the reliance on investment income.
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