You’ve worked hard all your life. At retirement, it’s time to kick back and relax, right?
Not so fast.
You still have to get THROUGH retirement.
That means knowing how to draw down your portfolio to:
- meet all your monthly cash flow needs
- cushion against unexpected expenses
- minimize tax liability
- ideally help your kids / grandkids, give to charity, or leave a legacy
- ensure your retirement nut doesn’t run out before you do
This is very challenging because you have to forecast things you simply can’t know with certainty. Inflation rates. Market returns. Sequence risk. Tax rates. Your health condition and anticipated healthcare needs.
So, how can retirees plan their retirement portfolio withdrawals to actually enjoy retirement and not worry about running out of money?
This week, I sit down with Steve Parrish, Co-Director of the Center for Retirement Income at The American College of Financial Services, to talk about tax-efficient portfolio withdrawal strategies in retirement.
- Key principles retirees should understand when deciding which assets to draw down and in what sequence
- How those principles change when you have alternate monthly income sources (like rental real estate, pension, etc)
- Why your wealth bracket determines what is the most tax-efficient sequence of portfolio withdrawals
- How soon-to-be and current retirees can protect themselves against sequence of returns risk
- When it makes sense to use legal tools like tax-free gifts, GRATs, etc, to reduce tax liability on retirement assets
- Why you might want to pay taxes now to do annual Roth conversions to ratchet down your IRA/401ks and the ticking tax time bomb attached to them
- Portfolio withdrawal advice for early retirees (FIRE)
Do you worry about running out of money in retirement? If so, what is the biggest reason why – not saving enough, spending too fast, market tanks during retirement, something else? Let me know by leaving a comment.
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- Steve Parrish
- Steve’s Forbes posts on retirement drawdowns – 1, 2, 3
- The shockingly un-simple math behind retirement safe withdrawal rates (HYW035)
- How to FIRE with confidence, step by step (HYW060)
- Asset allocation: How to use a bond tent to reduce sequence of returns risk (HYW068)
- Retirement withdrawal calculator: How long will your savings last in retirement?
- Schedule a private 1:1 consultation with me
- HYW private Facebook community
Read this episode as a post:
Andrew Chen 01:22
My guest today is Steve Parrish.
Steve is the Co-Director of the Center for Retirement Income at The American College of Financial Services, where he also serves as an Adjunct Professor. He is also an Adjunct Professor of Estate Planning at Drake University Law School.
He has over 40 years of experience as an attorney and financial planner, focusing on retirement and estate planning, financial planning, and tax strategy to help individuals and business owners build up and draw down their retirement portfolios tax-efficiently.
He is a contributor to Forbes and Kiplinger and has also been cited in MarketWatch and US News & World Report, among other publications. He speaks frequently to attorneys at bar associations and estate planning councils and to CPAs at industry seminars.
Steve, thanks so much for joining us today to share your insights and wisdom on how to draw down a retirement portfolio as tax-efficiently as possible!
Steve Parrish 02:07
My pleasure, Andrew. Thank you.
Andrew Chen 02:09
I’d love to start just by learning a little bit more about your background. How did you get into retirement and estate planning advisory work in the first place, and ultimately what you’re doing now in terms of academic research?
Steve Parrish 02:19
Sure, I’ll be glad to talk about that. If we go way back in history, after I passed the bar exam, I decided, “I don’t really want to practice law.” So I went out and got something that was new back then called a chartered financial consultant designation, and started this whole new thing of financial planning back then, and became a financial planner for several years.
That ultimately led me into an executive position with a financial service company. And that was what I did a lot of my career, where I had a team of accountants and attorneys and MBAs who provided advanced services and support for retail advisers working with their clients.
And then, about six years ago, since the topic is retirement, I retired (if you want to use that term) from my financial service company and went into academe as my third encore career.
As you indicated, I’m Co-Director of the Retirement Income Center at the American College with somebody who is pretty well-known, Dr. Wade Pfau. And what we do is we’re essentially thought leaders. We provide a designation on retirement income, the RICP.
We do a lot of writing. You’re aware of my work with Forbes. Wade just came out with a great new retirement book which is doing very well on Google.
Also, we do a lot of interviewing with publications and that kind of thing, so we get the word out about retirement income planning.
Andrew Chen 03:59
Perfect. That’s great context. Just to set the stage for our discussion today, I want to preamble that.
In some sense, optimizing retirement withdrawals is straightforward in that what you’re solving for is to generate sufficient monthly cash to live on, enjoy in retirement, while simultaneously minimizing your overall tax liability, and ideally avoiding adverse consequences to things like parts of Medicare, Social Security taxes, even benefits like health exchange subsidies, if that’s part of the picture. All of which are impacted by your income level in retirement.
And also, although meanwhile continuing to try to get the best risk-appropriate return on the rest of your portfolio that hasn’t been drawn down yet, but many factors impact what that right withdrawal strategy is going to be for your specific situation…
Like your asset allocation and location, the taxable status of your accounts, your tax bracket, your RMD timeline, the timing and account of your other income sources, like pension and Social Security, and obviously, how the market itself is performing for your investments.
Given the complexity of accurately analyzing all these drivers to determine the best withdrawal strategy to your own specific situation, what are the most important principles or guidelines that retirees should know about when it comes to determining what assets to draw down in retirement, and in what sequence?
Steve Parrish 05:14
It’s a good way to frame the question because, several times, you use the term “risk” and then “return.” One of the most important principles to keep in mind for retirement planning is the way you look at risk and return changes when you go into retirement.
Think about it this way: When you are investing for retirement, what’s your return is whatever you get on your portfolio. What’s your risk is that it might go down. It might have default on particular securities.
But once you’re in full-blown retirement, really risk and return are two different things. They’re two new things.
Return is whatever you draw down. In other words, it’s not what you’ve got in your portfolio. It’s “What am I taking out each year?” because that’s the return.
What’s my risk is that you run out of money before you run out of oxygen. In other words, it doesn’t maintain itself.
So, that’s probably the key thing: You really have to look and say, “I’m going to decumulate my portfolio once I get to retirement. So I have to think about the return as being what I pull down versus what I make in my money.”
Two others to think through is it’s a process, not an event. It’s not like, “Okay, I hit 50 or 65 or 70, and now I’m going to withdraw 4.5%, and that’s it,” because really retirement is dynamic.
You go from those go-go years where you go out and see the kids or the grandkids or go to Disneyworld or whatever, to the slower-going years where you’re maybe relegated to the rocking chair, to the no-go years, where you might be frail.
Because of that, you really have to look at that withdrawal strategy as a dynamic thing, not as just a flat “I’m going to take 4.5% and let it accumulate with inflation.”
The one other I would bring up is retirement. How you’re going to define retirement for financial purposes is going to be different than for personal purposes.
On one spectrum, I’m on Medicare, I’m on Social Security, but I’m not retired in any shape or form of that, just because of what I do. On the flipside, if somebody is going to retire early, if you look at them, they might be leaving the industry, they might be now doing volunteer work, so retired personally, but from a financial standpoint, they are not retired because they have not hit Medicare age. They shouldn’t be taking down Social Security.
So, you have to define what you mean by retirement, and that depends on what you’re looking at for your personal or for your financial.
Andrew Chen 07:59
Those are good insights. I like that frame that you mentioned. You call it the go-go, slow-go, and no-go years.
When you look at broad sets of people, do you tend to see that people should be preparing a bigger financial cushion, like they should ramp up their expected drawdowns as they advance through those years, or do expenses actually tend to come down because maybe you’re not traveling anymore? I’m just wondering how health and travel offset each other.
Steve Parrish 08:35
Research tells us that goods and services tend to inflate in the early years for true retirees. I don’t know if it’s because they have somebody mowing their lawn or what, but their spending levels (and this is at the macro level; everybody is going to vary) does not keep up with inflation.
And it makes sense. As they get older, they’re not going out to the movies and to dinner and vacations and that kind of thing as much, so they don’t spend as much as inflation might be doing.
And you have to take each person individually. In some cases, particularly affluent people, they may actually be taking down more in the early years of retirement than they were taking in their working years because they have the time and the ability to do it. I have friends who retired, and they spend all their time, it seems, going into Amazon and buying things.
But the reality is normally it will go down, and appreciably so, with the one thing that is hard to guess, and that’s health. The fact is, near death, you will normally see a spike in expenses, but that’s because of the way things work, where suddenly you have x days in the hospital before you die. But generally, your expenses would normally go down.
Andrew Chen 10:06
You’re like the exceptional case where you’re in financial retirement, but not in actual retirement because you’re still doing all this great academic research. For a normal retiree who coincides actual and financial retirement together, that’s Case A, and Case B is an early retiree who actually retires before financial retirement, a bunch of those entitlements kick in.
I wonder if there are any additional insights or principles or guidelines that you would urge each of these two groups to bear in mind as they think about how to ensure that they don’t outlive their portfolios.
Steve Parrish 10:51
For the classic person that’s retiring, and truly retiring at that same time, by the way, more and more research tells us that’s not the norm. More and more people are doing phase retirements because they can.
But to address that one, the important thing for them is to realize that it’s going to feel like retirement is an event because you do Social Security, you do Medicare, you stop working, so you make all your decisions, you take your 4.5%, and you’re done. That’s not a good way of looking at it because, just like you’re growing when you’re working, you’re also going to have a whole different path.
It may be 30 years, or it may be 40 years if you retire early, in retirement, so you can’t look at retirement planning as that magic day when you get the gold watch and they have the party for you.
For the ones that really want to retire before the government benefits like Medicare and all those kick in, I think very much in that, you’ve got two things. One very obvious is you have health insurance.
You’ve really got to address that. “What am I going to do? How am I going to cover that?”
The other gets into how do you deal with your portfolio? Because you’re potentially looking at 30-40 years, so you’re going to have to have more things built in to deal with black swan events, inflation, that kind of thing, than I will when I someday get around to retiring in my 70s.
So, it’s very important with the younger retirees that they really are looking at things like inflation, having some kind of a buffer. It just makes sense because it’s such a long period of time they’ll be retired, hopefully.
Andrew Chen 12:47
For retirees who have some reasonably stable alternate income, like a passive income source, such as real estate rental income that maybe they have a mortgage on now, but in retirement will become free and clear and suddenly spike up…
How should a retiree, or a would-be retiree who anticipates this happening, think about the planning of their portfolio drawdown, so that not only do they not outlive their portfolio, but their portfolio doesn’t drastically outlive them with tons left over?
For sure, they could pass it down as legacy to their kids and family. But if they wanted to make sure they didn’t die with tons and tons in the bank, are there any principles that you would advise this group of folks to think about?
Steve Parrish 13:52
First of all, look at those sources of income, because we’re talking about an early retiree, so we’re talking about a lot of years. And ask yourself, “How safe is it?”
An example is working with somebody a few years ago when he had to really look at his retirement in two different ways, because he had a very lucrative deferred compensation agreement. The deal with deferred comp is it’s only as good as the company is. It’s not guaranteed.
So he had to do his planning if the deferred comp continued or if the company didn’t make it. Guess what, fast forward about 12 years, the company didn’t make it. So he had done some planning so that he suddenly didn’t go from six-figure spending every year to Social Security.
That’s one thing: How safe is it? The other thing to look at is the assets you’re talking about (real estate is a good example), is it likely to stay up with inflation long term?
You would hope that stocks would. You would hope that real estate would.
You can’t expect an annuity or something like that because it’s contractual. So, you first look at what is the source of that.
The other is if you know you have those sources of income coming in, here’s one way to look at it. With whatever else you have, a portfolio of equities, that kind of thing, maybe get more aggressive because you’ve got a floor, you’re eventually going to get Social Security (let’s assume that), and you’re going to have the sources of income that should continue (rents or real estate, that type of thing).
So, maybe with your portfolio, if your stomach is up for it, you could get a little more aggressive because the downside of that is maybe you have to put off that European vacation versus eating cat food and living in your car.
Andrew Chen 15:49
That’s a good point. If I’m hearing correctly, it’s potentially thinking about real estate rental income or some alternate income that you have in that regard (maybe it’s a pension or whatever) as a bond-like instrument, so that that gives you the stability that normally fixed income would, so you can go a little bit more aggressive on your liquid portfolio.
Steve Parrish 16:08
Correct. And this is a good point to bring up, one other point. Depending on how early you retire, the other most important asset you have, which you can either let go away or preserve, is your human capital.
If you’re really going to FIRE, if you’re really going to retire early, you also ought to be figuring out, “Is it worth it?” Maybe the answer is no.
But is it worth it to maintain my human capital by keeping up my licenses, stay current on the industry and everything else, so that if things go crazy, a black swan event, hypothetically a recession of 2008, hypothetically a pandemic, you could at least tap into that asset, which is your ability to go back to work if you need to.
Andrew Chen 17:08
It sounds like a lot of work if you’re in medicine or law, because these industries, there’s new knowledge that always comes out. I work in the technology industry where things move at lightning speed.
If you’re not actually working in the job, first of all, it can be hard to stay sharp and stay abreast of all the current knowledge, and it takes time. And then psychologically, maybe it actually just isn’t retirement.
Do you find that people do this commonly out of the fear that human capital will atrophy, and what if they need to use that as a fallback?
Steve Parrish 17:44
Perhaps it’s just because of personal experience in what I do, but my answer is basically going to be yes. So many of my affluent friends are coming from some kind of professional background.
I know you have things like continuing education and all that, but right now in this labor market, there is a value to us gray hairs, so a lot of them do that. I think they’re worried “I don’t want to continue to pay my bar association fees or do continuing education.”
But my suggestion would be, at least in the early years, it’s a worthwhile investment in you because not only are we worried about a recession or a black swan event, but also, a lot of these people were hard chargers, they thought they were going to golf every day, and go, “No, this isn’t working.” And I could tell you a lot of friends who went back to work after a few years because they realized they like to work.
Andrew Chen 18:48
Some conventional advice suggests that you should withdraw RMDs first, since the tax penalty in those are highest, then your taxable accounts, then your tax-deferred accounts, finally your tax-free accounts.
First of all, I wonder if you could comment: Is conventional wisdom here sound advice? And if the answer is not always, then what are the kind of circumstances or situations when it might not be appropriate to sequence your withdrawals in this way?
Steve Parrish 19:11
A good way to handle that is so many of these are rules of thumb, and rules of thumb can really get you in trouble. There’s a great retirement planner named Dana Ansbach who came up with this great analogy.
She said, “If you know you’re going to go from New York to LA, a rule of thumb is go west. That’s pretty accurate. But once you start going, you probably better have a map or a GPS or whatever.”
That rule of thumb that says “Let’s be real efficient in how we pull these down” sounds great, but personally, I think the exceptions tend to swallow the rules sometimes when you get into it.
First of all, if you are holding off on things like IRAs because you’re not paying tax now, the trouble is that throws you someday into a higher tax bracket. And what people don’t get about taxes is, sure, when you pay taxes, you’re going to net less, and if your income goes up too much, you’re going to go into a higher bracket. They get that.
But what they don’t get is as soon as you start popping up your income, it’s going to affect a bunch of other things. The classic one for affluent people is Medicare Part B premiums.
I’ll just give you an example of last year in the pandemic because it happened to me as I was looking at my taxes and realized I was just a few hundred dollars at my modified adjusted gross income into the next bracket where I would have a 40% increase in the Part B premium I would have to pay for Medicare. All I had to do was put $1500 or something into an IRA, and I made that go away.
What I’m getting at is it’s fun, it’s easy to say, “This is going to be my strategy,” but really you need to work through that, because in most cases with affluent people, what you’re going to want to do, the main thing, is take out your after-tax money first, because you’ve already paid tax on it, let the other money accumulate, but you might as well start taking bits and pieces of that each year to the extent it doesn’t push you into another tax bracket.
Obviously, in Congress, they’re thinking about changing this. But right now, the bracket is between 22% and 24% for $90,000. So you could be taking down some of your IRA money, and it’s going to increase your tax, but it’s not going to increase your tax bracket.
That makes sense, so that your Roths and those kinds of things can continue to build up tax-free and you can access them later.
And then we can talk about it later, but when you talk about wealthy people, you completely flip the switch because the issue is a 40% estate tax versus a 37% income tax. So you flip it and you want to take out your taxables first.
It would be nice if I could give you just an easy answer, but those rules of thumb can get in the way because the exceptions are swallowed by the rule, and the rule is swallowed by the exceptions.
Andrew Chen 22:30
That’s an interesting way to think about it. I’m reminded, a while back, I read this article Michael Kitces has written before about the strategy of spending from taxable accounts first in retirement, but then topping up, all the way up to your marginal tax bracket, especially in the early retirement years, by doing partial Roth conversions.
If you expect that future, direct withdrawals from your IRAs and 401(k)s will ultimately face even higher effective tax rates compared to the marginal rate you would face now just by topping up with Roth conversions.
I think that’s directionally where you were indicating. You might want to just think about how to optimize in that way. I’m curious if you have any thoughts about that strategy overall, and advice on this front.
Steve Parrish 23:19
If you look at the big writers in retirement income, there’s a pretty good agreement. I don’t think you’re going to find people saying, “Yes, but…” to that point.
Michael has done things for the American College, and Wade Pfau, and Bill Reichenstein. All the people are basically saying the same thing. And you can model it out, either with your own calculator or with software, where you really take it as close as you can get to the marginal tax bracket.
Again, as you said, it doesn’t have to necessarily mean you’re taking the money out. It could be doing Roth conversions. So if you don’t need the money, “I don’t want it,” fine, but then use that as an opportunity to convert into a Roth.
Because the other thing that people don’t think about, I’ll just add one level to that thinking, you referenced it earlier: you may have a legacy to pass on to your kids. And as somebody who is my age versus yours, you become very aware, as you get into that age, of leaving a legacy, and you’d like to if you can.
The fact is, at some point, particularly if you’re affluent, and definitely if you’re wealthy, you need to start worrying about the taxes of the next generation. So if you can do some conversions to a Roth, that’s going to avoid having to take required minimum distributions.
That’s going to mean after you’ve passed on, they’re going to get this money, but they’re going to get it on a tax-free basis rather than taxable. That’s an additional gift coming from you.
My point is you shouldn’t just worry about whether the Democrats are going to increase taxes in the future. It’s more than that. It’s really the whole process of looking at the family in your planning rather than how much tax you’re going to pay next year.
Andrew Chen 25:13
You talked a little bit about the ability to model this. My intuition is that you actually have to project a bunch of things when you’re trying to optimize in this way.
You have to project when you think your taxable portfolio might run out, how much you would need to withdraw annually from your IRAs and 401(k)s after that point to fund your desired lifestyle, how much you’ll therefore have left over in those IRAs and 401(k)s once RMDs kick in, and what marginal tax bracket and effective tax rate you think that will put you in, both before and after RMDs.
It feels like a significant amount of tax modeling and portfolio growth and tax rate assumptions you’d have to make. That feels challenging for normal retirees to do this scientifically, so I’m wondering if you have any advice for how retirees can make these decisions or optimization in a quantitative way so they have confidence in this decision without basically becoming a professor at the American College.
Steve Parrish 26:13
A few things. First of all, close counts. We can get pretty precise with software and say, “This is what it says,” but we all know garbage in, garbage out.
The fact is if tax rates for an individual stay the same, it makes no difference whether you put it in an IRA or a Roth IRA, mathematically. So always give yourself some wiggle room as far as doing that.
Second, involve an adviser. I have to be straightforward on this. None of us are as smart as all of us, so this kind of stuff doesn’t work all that well for DIY modeling.
And I’m not against DIY. I do a lot of them myself. But still, it’s like you don’t go into WebMD and figure out how to do surgery either.
The other one is if you do some of this and you think, “This is more than I want to handle,” realize what happens with people when they retire is sometimes their interest in finance goes away because they enjoy the grandkids and golfing and all that, and they don’t want to be bothered. There are alternatives, but you only want to do the alternatives if you thought it through.
An example is now that the stretch IRA really has effectively gone away for most people, maybe you do an alternative. Maybe you’ve been building up your IRAs. An idea is you could, if you’re healthy enough, buy life insurance, make your kids (or whoever your heirs are) the beneficiary of that, and then each year, you peel off a little bit of your IRA.
Yes, you paid tax on it, but you’re spreading out your taxes. And now you’ve basically made a tax-free bequest to your kids.
Frankly, Andrew, that’s just easier. I’m not saying it’s the right thing for all people, but that would be an example of after you look at it, you go, “I don’t want to do all this modeling. Let’s keep it simple.”
So, those are some thoughts.
Andrew Chen 28:18
Sequence of returns risk is basically the risk that your portfolio gets low, or negative return soon after you retire, because of a recession of 2008, for example, gets hammered so badly that making retirement withdrawals on top of that mortally wounds the portfolio, so it can never really quite recover.
That’s probably the most significant risk that can jeopardize a retiree’s drawdown plan and their retirement security. What can retirees and soon-to-be retirees do to protect themselves from sequence risk?
No one has a crystal ball, and no one can tell how the markets will perform, where and how long peaks and troughs will be, so how can retirees or near-retirees strike the optimal balance between protecting against sequence risk as best they’re able, but also not being so risk-averse as to just hold cash equivalents and let inflation eat away their purchasing power?
Steve Parrish 29:05
Exactly. Right now, I think that’s the scariest issue out there for people that have enough money to worry about it. But mass affluent have to worry about sequence of return.
And let me emphasize something because prior generations didn’t have as big an issue because they might have had a defined benefit plan or something like that, so the sequence of return issue was more the employer than themselves. Now everybody is sitting on 401(k) accounts, so it is their issue, and it’s not someone else’s issue.
And I am really worried now because we’ve seen the “great resignation” that started with COVID-19, and now we’re hearing people say, at least at the time of this recording, the market is hot.
“I have enough in my 401(k). I can retire earlier than I expected.” That’s the very kind of language that says they don’t understand sequence of return.
So, we know what the issue is. It’s like the great recession. You retire in 2008, and the next thing that happens is you get a 30% drop, and suddenly you’re taking out too much money.
We sometimes refer to a “red zone” maybe five years before your planned retirement and five years after, where the sequence of return risk is. And the strategies that you can take. There are really practical things you can do that aren’t super complicated.
First of all, try to look for a portfolio that’s maybe a little more conservative during the “red zone.” And I don’t mean go on all the cash or anything even close to it, but if you were modeling out a 60/40 or something like that with equities to cash equivalents, you could tone it down a little, at least as you directly approach it. If somebody is going to retire this year, that’s a good thought because we are obviously sitting on a high market, and I’m not saying forever.
The other thing is you referenced Michael Kitces, and I referenced Wade Pfau. Both of them have done some interesting studies that prove out this point.
Maybe you look and some of these equities that I have that are doing very well but are sitting on high PE (price-to-earnings) ratios. Even if you’re convinced they’re the hottest things since canned beer, you back off on them simply because the research we’ve looked at is the safe withdrawal rate is going to be much more protected if you’re in markets that are seeing high PE ratios, and you back those off a little bit.
That’s just a fairly practical thing you can do during that period of time.
The one other thing I had mentioned is we always think about sequence of return as you’re going into it. But what happens when you’re in it?
You were going to pull down 4.5% of your portfolio, and suddenly it’s 2022 and the market goes down. What do I do now?
Remember, if you’ve done some good planning, you might tap into other sources. Examples would be maybe you have cash value in life insurance, or maybe you have a home equity where you could set up a reverse mortgage and tap into that.
If it happens to you, if you have some buffer assets, that’s the very time where you leave your equities alone, hopefully they’ll recover, and you tap into some of these other sources, so that you don’t have to sell low and buy high.
Andrew Chen 32:41
Yeah, you mentioned the five years leading up, but then also during, I read a bunch of thought leadership around creating a bond tent where you phase into fixed income heavy, but then you phase out as you enter retirement because, by definition, if you’re doing that, then you’re basically ramping back into equities exactly as your sequence risk is also toning down, because you’re making it through in those first few years.
Do you generally advise or believe that a tenting strategy in that way is prudent, or are there situations where it does not make sense?
Steve Parrish 33:26
I think it’s definitely one to look at. The issue there is bond laddering, where you figure out when those are going to hit. Makes a lot of sense.
It’s not particularly friendly from a tax standpoint. Realize if you buy deep discount bonds, you’re still going to have an annual tax event. But that way, at least you know what’s coming.
Another one could be, nowadays, with annuities, they’re getting so much better at being able to target exactly when an annuity might pay out. Using maybe a single premium immediate annuity that’s only for a period of years is another way of going at it. The challenge is people are going to look at that and say, “That’s pretty tricky,” but that is when you’re most exposed.
I know the third one I’d bring up, not a lot of people are going to do it, but with the right people, doing auctions callers. In other words, covering a put with a call just during the sequence of return period of time is not the worst idea because it’s cutting off the risk of it going down. And maybe it’s not going up that much because you have to sell that call, but it’s sandwiching it in so that you’re hanging in in those tough years.
Again, the thought is you are decumulating your portfolio, so when you’re going to get burned the most is just when you retire, when that portfolio is the biggest. So, any of those strategies could help.
Andrew Chen 35:03
I know there’s always exceptions, but absent a specific scenario, I guess we can only speak at some level in abstraction. But is there any rule of thumb that you would advise folks to think about when sequence risk greatly diminishes?
Is it 10 years into retirement, then you can let your guard down a little bit, or does it really depend on facts and circumstances, like how much portfolio you have, what’s your withdrawal rate, how old are you, what’s your life expectancy, etc.?
Steve Parrish 35:37
It’s all those things, but I think a way you can look at it is to ask yourself, “What’s my floor?” In other words, “How much safe retirement income do I have?” Social Security, reasonable rents coming off of real estate, a pension, those kind of things.
So that you can look and say, “What’s my downside?” Again, cat food and living in your car, or just not getting to go to Europe.
Once you’ve done that, then you have a lot more room on figuring out what you do with the sequence of return. Because sequence of return deals with one issue: it deals with taking capital and turning it into income.
So, if you’ve structured in a way that your capital, if something horrible happens, is still not going to cause a horrible situation, then the sequence of return issue goes away pretty quickly. If you are totally living off of capital, then you better keep sequence of return in there for a long time, and at least protect your “longevity tail.”
I’m not talking about a lot of money, but maybe buy a deferred income annuity that starts at 75 or something, so at least you’re not going to live longer than you expected because of medical technology or good habits, and suddenly not enjoy the tail part of your retirement.
Andrew Chen 37:03
By the way, are there any metric heuristics that folks can look at, or that you advise on looking at, in determining whether you’re directionally in a hot zone or a safer zone?
I think a lot of people talk about things like the CAPE (cyclically-adjusted price-to-earnings) ratio. Are there things like that that you encourage folks to look at, so that they can have some sense of where they might be in the cycle?
Because as you alluded to earlier, it’s obviously different if you felt you were ready to retire right before the financial crisis at 2008 versus if you felt you were ready to retire in the depth, the throes of recession in 2010, but you nevertheless still felt ready. Then you only had upside from there for many years.
Are there any metrics that folks can look at as a rule of thumb to get that directional sense?
Steve Parrish 38:02
Full confession that I started as a tax attorney more than as a PhD in finance, I’m going to disclaim and say what they tell me versus what I know. But again, people like Kitces and some of the others have very much pointed to the PE ratio being a big one, just because it’s almost like the canary in the coal mines, saying, “Look out.”
So, any kind of thing that’s futures-based will tell you. And then some of it is a little bit common sense of just looking at where you are historically in the market.
I’ve referred to the 4.5% rule because I assume most people know that, and that’s historically based. The whole challenge you have there is that was based on U.S. securities, and in a century that was pretty good, last century.
So, one of the things we have to look at is look at it on a global basis. Any work you do, you should be looking at…not heuristics, but at least any kind of measures that are global rather than just U.S. stocks.
Also, a lot of us would say to give it some kind of a haircut because it’s just not fair to assume that we’ll constantly have a situation where our recessions lasted for only short periods of time, and inflation was very low. That’s not a reasonable assumption, especially if you’re a young retiree going for a long period of time.
So, whatever you do in coming up with that, give it a haircut. And keep an eye out for whenever you get the tulips type effect, if you know what I’m talking about there, where everybody says it’s a sure thing. If you’re getting a 20:1 PE ratio, you better be worried as far as long-term viability.
Andrew Chen 39:56
I wanted to shift a little bit since you mentioned your background in law.
If you could comment a little bit about what are the most important legal, and maybe even tax tools or techniques, in terms of things like utilizing tax-free gifts or specialized trusts, donor-advised funds, things of that nature that, in your view, folks may want to consider using in the final years leading up to retirement, as well as maybe even in retirement, to help them maximize tax efficiency with their drawdowns.
Steve Parrish 40:26
One is to re-emphasize what I said before: Don’t look at taxes as just “I pay more taxes, I have less net.” You really have to think about thresholds, and you have to watch out for them.
A good way of going at this is to analyze where you’re going to be. Are you going to be a middle income person in retirement, are you going to be an affluent person, or wealthy? I really think if you use those three definitions or categories, it will help.
Because if you are going to be middle income from a tax standpoint, the things you have to watch out for. I assume you’re aware of the concept of tax torpedo, but as weird as it sounds, you could actually have your Social Security have an effective marginal tax bracket over 40%.
You go, “How can that be?” And I don’t want to go through the math of it, but it’s all in when you chose to take Social Security versus some of your IRAs.
You would do planning for that. It’s not hard, but it’s more than what we want to go in today.
If you’re affluent, that’s when you get into things that really we have talked about: figuring out your drawdowns, where you take it up to your next marginal tax bracket, converting off chunks of Roth.
By the way, when is a good time to do Roth is both do it so whatever the cost of it keeps you from going in your next tax bracket, but the other is…I don’t like the term “market timing,” but there is such a thing.
I did my Roth conversion last year in March. Why? Because we had the pandemic, stocks had collapsed, so that was a good time to convert because that’s the point at which the value for tax purposes came up with the Roth conversion.
With the wealthy, it’s almost opposite day because the issue becomes a “cliff tax” because it doesn’t marginal up to it. It’s 40%. And realize that’s going to apply to more people possibly because of what’s happening in Congress.
So there, you’re trying to avoid that 40% tax as much as anything because you have other sources of income. So, what you’re going to start doing is looking at things like taking your IRAs now and paying tax on it.
Again, at the time of this recording, we still don’t have a tax law, but for now, we can do things like grantor trust, which is the most counterintuitive concept in the world. In fact, they’re called intentionally defective trusts because what you do is you make it defective so that you have to pay tax on it.
But that’s a good thing because every time you pay tax on income, it’s the equivalent of a gift to your kids. Because if it’s $100,000 and you pay 30% tax on it, they get $100,000 rather than $70,000, but it’s not subject to gift tax. So, grantor trusts are a good example.
GRATs. You’ve heard that term. The reason we always hear about the Waltons in the news, and how many billions of dollars they have, is because Sam did some incredible planning way back when with GRATs.
I won’t go through the whole concept, but essentially, you can move out a lot of money to the next generation without paying any gift or estate tax. The estate tax is 40%.
So you’re trying to do your planning to avoid that tax, even if it means paying income tax. Because, remember, someone is going to pay income tax, so you might as well pay that, and it becomes a gift.
At this point, things like making gifts work pretty well for anybody that thinks they’re going to be in the federal state tax range. If instead they’re more affluent but not really worried about it, then it’s opposite day going the other way because they may want to hold on to assets, because then the basis of the asset steps up to date of death value, and that helps the beneficiaries.
So, you really want to look: Are you middle, are you affluent, or are you wealthy?
Andrew Chen 44:42
That’s a really good frame. You talked about GRATs (grantor retained annuity trusts). You also talked about intentionally defective trusts.
At what level of wealth does this start making sense to consider using those kind of tools? Is that really only at that wealthy bracket where you are going to bust the federal state tax exemption limit, which is $23.5 million at the time of this recording, or are there any scenarios where the affluent may want to consider?
Steve Parrish 45:05
Generally, the answer would be yes. Your bogey really is the exemption level for the federal state tax.
The one glaring exception I would make is an owner of a closely held business because their situation is their business is their retirement. And they may have kids in there, so you get into the issue of “Am I actually going to have a liquidity event where I’m going to have money?” It can pop up in value very quickly, and you can get into quite the battle with IRS over the value of it.
GRATs, intentionally defective trusts, irrevocable life insurance trusts, some of those things that you normally would associate only with hitting the exemption, you might move down a little bit for the business owner because they have this huge pop up of value, and they want to get the clock going with the IRS. If the IRS is going to challenge the value of that stock, let them do it now, not after your death.
Andrew Chen 46:07
Yeah, that’s a fair point. So it sounds like, outside of that exception, if you’re just an attorney that makes a lot of money, or you were an early engineer at a technology company that IPO-ed and you got a windfall of IPO stock but not enough to bust that federal state tax limit, and you don’t have a closely held business, then you’re probably not needing some of these advanced trust tools, is that right?
Steve Parrish 46:34
Yes, I agree with that. A lot of that work is just not worth doing.
And let me distinguish one other thing. Now, people, because of COVID-19, are thinking more about estate planning.
So I’m not saying that trusts and that kind of thing should be ignored. I’m talking about the trusts like the intentionally defective ones that have tax reasons. There’s still a lot of reasons to use trust for the affluent.
Andrew Chen 47:00
Everything we’ve been talking about relating to optimizing retirement drawdowns, how does the consideration set change or additional considerations crop up for early retirees, people who have FIREd or plan to fire, who therefore may effectively be planning for up to two back-to-back 30-year retirements, or up to 60 years total? Any additional considerations that groups at this younger age that are retiring this early should be thinking about?
Steve Parrish 47:33
As I’ve said before, but I’ll say it again: At least consider protecting your human capital, or at least make the decision. If you say, “No, I’m done with this,” you’re going to do something, maybe it’s going to be volunteer work, fine, but make that decision proactively. Know what you’re doing.
The other is if you’re going to have that long retirement, I think you have to be more thoughtful about inflation and cost of living. You really have to start early. Actually, you have the opportunity to start early because some of these ideas only work if you are around a while.
Ideas like TIPs, inflation-protected treasuries. Right now, they’re selling at this premium where you go, “Why would anybody do it? You’re cutting yourself out of the market.”
But it might be a great idea for someone that’s young enough because eventually they’ll catch up and be useful.
Be looking at the “longevity tail” again. If you’re sitting there in your mid-40s or approaching 50, and plan to do this, you could get what’s called a deferred income annuity which basically doesn’t kick in anything.
You don’t get your money back, you can’t commute it, the money is gone. But what it does is it starts paying out an income at 70, 75, or 80. That’s a pretty cheap buy when you’re young, and it covers that tail because that could be a long way down there.
So, those are the additional things you have, just because you’re looking at that. You really have to deal with inflation and the longevity tail.
And paying attention to health insurance because that’s a pretty big expensive issue, particularly because it’s a political football, so you don’t know where it’s going to go. So, have some kind of money set aside.
People don’t always realize that even when they hit Medicare, they’re going to have a lot of health expenses. So you have to have money put aside to cover the health risk.
Andrew Chen 49:41
All right. This has been a really enlightening conversation. I’ve really enjoyed it.
Where can listeners find out more about you and what you’re up to?
Steve Parrish 49:49
I’m at the American College of Financial Services. The nice thing with us is we are there simply to be thought leaders. You can do a few things.
One, you can just Google the “American College” and see some of the great things we’re doing. If you’re an adviser, consider retirement income certified professional. If you’re a consumer, the other thing is I write for Forbes, so that’s in the retirement channel, and there are a lot of great writers in the retirement channel for Forbes.
Really make it something fun. One of the things that people do when they retire, or I suggest to them, is find new things that are your job. One of them is to stay healthy.
Suddenly when you retire, eating right and working out, make it part of your job. Also staying up on these things, you have a little more time.
Get on the Forbes or retirement channel. I write for Kiplinger. There’s a lot of good sources, and it doesn’t have to cost anything.
Finally, it doesn’t have anything to do with me, but some aspects of retirement are DIY, others are get some help.
Andrew Chen 51:00
All right, we’ll be sure to link to this resource in the show notes, Steve. Thanks so much for chatting with us today. I really look forward to sharing this with our audience.
Steve Parrish 51:09
Thanks, Andrew. I’ve enjoyed it.
Andrew Chen 51:11
Cheers. Take care.