As baby boomers retire, more focus on investment income is needed. The objective is simple: “don’t let me run out of money.” There is no substitute for spending less, but this is an unsatisfactory answer for most. In this example, we use the popular “rule of thumb” of 4% annual spending. In a soon-to-be-published paper in the Rotman International Journal of Pension Management (April 2013), we study this challenge in greater detail using different investment and spending strategies. Here, we offer three observations that may be useful to retiring individuals and their advisors.

  1. Good news! A 4% per annum drawdown rate is quite sustainable. This rule-of-thumb withdrawal rate is from the famous “Trinity Study” by Cooley, Hubbard and Walz (1998), professors at Trinity University in Texas. The authors showed that a mix of 50% equities and 50% bonds coupled with a 4% withdrawal rate in the first year, with the amount adjusted for inflation in subsequent years, resulted in a high probability of the retirement portfolio lasting over a 30-year time horizon. Our research confirms this finding. For a 65-year-old, the probability of running out of money, spending 4% of capital annually, is only 2.7% for a 50% equity/50% bond portfolio. On the other hand, 4% represents only $10,000 per annum in this example with a $250,000 portfolio; not much for those without additional sources of income. A dynamic asset allocation strategy that extends capital for more aggressive drawdown rates is possible (upcoming Rotman paper).
  2. Annuities reduce liquidity, diminish the opportunity to leave a bequest and are expensive. Unforeseen expenses from healthcare to divorce to adult children “failing to launch” explain why these insurance vehicles are not popular. Although annuities address longevity risk, inflation protection is often not included. Heightened credit risk in recent years has not encouraged consumer confidence in the insurance industry.
  3. Sequence risk, or the potential impact that the sequence of returns can have on a portfolio in the presence of withdrawals, has been explored by many researchers. Moshe Milevsky, in his book, The Calculus of Retirement Income: Financial Models on Pension Annuities and Life Insurance” (2006), points out that the first seven years of retirement affect the probability of ruin the most. Our research suggests that initiating portfolios with a more conservative mix early in the post-retirement period, followed by a gradual ramping up of risk during the first five to seven years after retirement commences, is a way of mitigating sequence risk.

Income portfolios in a low interest rate environment are true tests for the investor and her advisor. On one hand, there is a need to generate income but the threat of higher interest rates threatens the principle of fixed income instruments in a portfolio. We have used dividend income as the primary offset in each of the three investment strategies below.

Caution, holding non-Canadian dividend paying ETFs can have a significant withholding tax cost. Even if they are held in an RRSP account, there is no way to recoup these taxes. We chose ETFs that hold outright securities rather than ETFs of ETFs to minimize this problem. Although the U.S. Internal Revenue Service exemption has been extended for 2013, we focused on ETFs that avoid the problem to minimize rebalancing costs in case the situation changes in 2014.