Cash flow planning for retirement isn't a straight line process

Planning for reliable cash flow over the expected span of your retirement years is of particular concern to business owners and self-employed professionals who do not have the luxury of a third party pension plan. Your accumulated wealth will have to generate the income flow you are used to receiving from your active role in your business or professional worlds. Obviously, this is usually accomplished through a balanced investment portfolio.

Here’s the rub: when you’re drawing income from your portfolio during retirement, you’re in a different game than when you are making contributions pre-retirement. A well-constructed portfolio is designed to ride out periods of volatility in the market, but if you are making unadjusted withdrawals from your portfolio during down times, the original projections about how long your money will last will be adversely affected.

Retirement cash flow planning is more complex than it is often presented to be. Many financial plans are based on a series of straight line assumptions relative to historical norms and how much money you have (or are projected to have) at the outset of your retirement. Say, at age 45, you invest $1 million in a portfolio that is projected to grow to around $4 million by your chosen retirement age of 65. This assumes an average expected rate of return of 6.5%, factoring in a 3% inflation rate. The ‘safe’ withdrawal rate is 5%, and you think, great, I can retire on $200,000 a year.

The problem with these straight line planning assumptions is that they do not consider the range of probable outcomes. No one can predict the extent to which historical norms will be replicated in an unknowable future. Reflect how the internet has affected every facet of our lives in the brief decade or so it has been mainstream. We live in an increasingly complex world where accelerated change is the norm.

Uncertainty is factored into how your portfolio is constructed. If you speak to your portfolio manager, you will get a more complex perspective of what you can expect over time. You will hear about a range of outcomes, based on a standard deviation (an assessment of risk). If, for example, your expected rate of return is 6.5% with a standard deviation of 8%, about two-thirds of the outcomes will be within one standard deviation of your expected return (that is, 6.5% plus or minus 8%).

It is vital to the success of your retirement plan to integrate this range of probable outcomes into your financial planning process. We can say with certainty that there will be ups and downs in the market, but no one can say when they will occur or how long they will last. When the down markets come, though, it is crucial to adjust your spending patterns accordingly. This is particularly important if the downturn comes in the early years of your retirement when capital preservation is essential to the success of your plan. Here’s an example to illustrate:

Say the ‘safe’ withdrawal rate on your million dollar blended portfolio is established at 5%, so your assumption is that you can withdraw $50,000 every year. You hear 5%, but it’s that $50,000 figure that you focus on. Unfortunately, your first years of retirement coincide with the difficult markets of 2007 through 2008. In the first year, the return on your portfolio is roughly 0% and worth—after your withdrawal of $50,000—$950,000. In 2008, markets plummet and the value of your portfolio drops 20%. You again withdraw $50,000, taking the value of your portfolio to $710,000. Note that $50,000 actually represents a 7% withdrawal rate, rather than 5% or $35,500. Effectively, your withdrawals have increased a 20% market drop to 30%.

You can see how a protracted period of flat or negative returns would prematurely exhaust the principal of your portfolio, if you did not continuously adjust your spending rate to the 5% level your portfolio was designed to accommodate.

Someone who was making similar withdrawals but started their retirement a year ago would have had a very different experience, as portfolios have jumped in value over the past year.

There are various ways of managing these cash flow issues. We often organize portfolios into several compartments for different uses, for example:

  1. a compartment for basic financial needs throughout retirement;
  2. another which is intended to spend down to zero over the first 15-20 years of retirement, when spending tends to be higher
  3. an emergency account for, say, health care
  4. estate provisions

Realistically considering a range of probable outcomes will help you adjust your expectations and come up with workable solutions to the cash flow planning challenges presented by retirement.

This article was first published in the October 2013 issue of Sask Business, authored by Daryn Form.

Daryn Form is a Senior Financial Advisor with Assante Capital Management Ltd. providing wealth management services to principals of family-owned and privately held companies. Assante Capital Management Ltd. is a member of the Canadian Investor Protection Fund and is registered with the Investment Industry Regulatory Organization of Canada.  The information mentioned in this article is for general information only. Please contact him to discuss your particular circumstances prior to acting on the information above.  The opinions expressed are those of the author and not necessarily those of Assante Capital Management Ltd.  Rates are not guaranteed and are subject to change at any time without notice.