Adjustments to the current strategy

My advice first focused on improving their current withdrawal strategy. They were comfortable with this strategy before the recent market volatility. So it made sense to reiterate the reasons that was the case. However, there were also several adjustments I recommended to help them reduce fees and taxes:

• Asset allocation: Their overall allocations seemed sensible, but there were instances of what I call faux diversification within their portfolio. For example, they had accumulated a variety of funds over the years and some of them basically added up the whole market (e.g., small + medium + large-cap funds = the whole market). So it was more cost-efficient and simpler to replace many of these holdings with a single total market fund.
• Asset location: I spotted some tax-inefficient investments (e.g., bond funds where interest is taxed as ordinary income) in their taxable accounts. So I recommended moving (i.e., locating) them in retirement accounts to shield them from such taxes.
• Low-income period: Perhaps the most important suggestion I made was to delay their Social Security (SS) income. Not only would this likely increase the amount of SS income throughout their retirement, but it would also provide them with a higher baseline of inflation-adjusted income. However, the biggest benefit would likely come from converting IRAs to Roth IRAs during this period of lower-income and lower tax rates.

Big savings

I estimated the potential benefits from the above adjustments could save them at least six figures in taxes and fees throughout their retirement. This was welcome news as it increased their withdrawal rate by almost 15%. While this helped to install more confidence regarding their financial security, they still felt vulnerable to market volatility knowing they would be at the mercy of the market each time they withdrew from their portfolio.

Note: I do not repeat them here, but this approach would still utilize some of the above adjustments (especially the delaying of Social Security and Roth conversions).

Pre-chiseling

My second suggestion was to proactively structure much of your retirement income upfront – rather than wait to chisel away from the portfolio each year. This pre-chiseling approach involves two key adjustments at the outset.

The first adjustment is to the fixed income or low-risk side of the portfolio. Rather than maintaining a percentage allocation to portfolios of bonds or other low-risk assets, our goal would be to establish a baseline of guaranteed income throughout retirement. For example, we could first purchase bonds and CDs that mature over each of the next 15 years. Then we could purchase a deferred income annuity to extend this baseline of cash flows throughout their retirement.

Annuities?

Barry and Denise were surprised to hear a financial planner mention annuities. They had heard horror stories from others and assumed annuities were bad. So I took the time to explain. While stigmas exist around some annuity products (for good reason), our research and other academic studies show how income annuities can add significant value in the context of retirement income. In this case, the deferred income annuity would only be a fraction (<10%) of their overall portfolio. So our estimates indicated it would add just 0.035% in costs per year over a typical 30-year retirement.

Having explained how this first adjustment would establish a baseline of income that was guaranteed to last throughout their retirement, we moved on to the next adjustment. It was to the stock side of the portfolio. I proposed using stock portfolios comprised of only high-quality companies that had paid and raised dividends for at least 10 years. Historically, this approach has helped to reduce stock volatility. However, our primary goal here was to leverage the stream of dividends for income.

Dividend confusion

Many people conflate the notions of stocks prices and dividends. So I pulled out two charts to illustrate an important distinction. The first was a chart of market prices for a portfolio of dividend-paying stocks. The second chart showed the history of dividends paid by those companies. It was like night and day. The stock chart showed a wild squiggly line, but the dividend chart was smooth and increasing.

Update: The primary fund I use for high-quality dividend stocks raised their dividends in Q2, Q3, and Q4 of 2020. These increases occurred despite the COVID19-related market volatility. Also FYI – its expense ratio is just 0.06%.

I proceeded to share some intuition regarding the dividends. In particular, they would just stack up on top of the baseline of fixed income. So this would target a natural and growing stream of income. Et voila! The portfolio did not need to be rebalanced. This would allow the stock portfolio (plus its dividends) to grow unconstrained. It also meant less (or no) rebalancing and fewer capital gains taxes.

Looking at the whole portfolio, I estimated this approach would reduce their investment-related taxes by approximately 30%. Moreover, it would keep the total costs of their retirement income right around 0.10% per year. They liked hearing this. They liked it more when I told them it included fees from the investment funds and income annuity.

Exciting simplicity

Barry and Denise were getting a little excited as I showed them variations of this building blocks approach to income. Never before had they seen such a simple, low-maintenance strategy with such benefits. In addition to the cost and tax benefits, they particularly appreciated how this relied on guaranteed income and dividends. That was a welcome break from chiseling away from the portfolio and being at the mercy of the market. Instead, we targeted a stable and increasing stream of income for them. This effectively transferred the market risk away from their retirement and to the eventual heirs of their portfolio.