The Varieties of Decumulation Strategies
“Decumulation” (I don’t really like this word, but I suspect I lack sufficient influence to change things) is the spending down of assets that have been accumulated in preparation for retirement. It is the conversion of pension plans, RRSPs, TFSAs, and other financial assets into income.
The Default Strategy
A Defined Benefit (DB) Registered Pension Plan (RPP)
This is the scenario where a person retires upon reaching age 65, and begins receiving Canada Pension Plan (CPP), Old Age Security (OAS), and the monthly payments from their Defined Benefit Pension Plan. That’s it. The maximum a retiree can receive at age 65 in 2024 is $1,364.60 per month. If we assume that the retiree’s income averaged about 75% of any given Year’s Maximum Pensionable Earnings, that works out to $1,023.45 per month. If the retiree has 40 years of residency in Canada from age 18 to 65, then in the first quarter of 2024, a 65-year-old will be receiving $713.34 per month. It is hard to estimate how much a defined benefit pension plan might generate, but $2,500 per month is a good estimate. Put together, that works out to a little more than $4,200 per month. If there is a spouse or common-law partner, perhaps receiving the average CPP of $758.32 per month as of the latest available data, the same OAS figure, and a pension plan that pays about $1,850 per month, a total of a bit more than $3,300 per month, then the retired household is going to have monthly income of $7,500. Even if we consider that many defined benefit pension plans are not adjusted for inflation, about 43% of the total comes from CPP and OAS, which follow the Consumer Price Index (CPI). Given that retirees tend not to spend at the same pace as inflation as they age, this is not necessarily as significant a concern as one might think.
You could say that this is no strategy at all other than to seek out a job with good pension benefits and stick with it until retirement. The retirees in this case did not need to save anything for retirement. It was all taken care of through programs sponsored by the government and the employer.
An Annuity-Based Strategy
A Defined Contribution (DC) Registered Pension Plan (RPP), Group or Personal RRSP
Sadly, DB plans are not as frequent as they once were. If you are a public sector employee, a member of a union, or employed by one of the “old guard” large companies, you may have such a pension plan, but the more likely scenario is that, if your employer sponsors anything at all, you will have a defined contribution pension plan or group RRSP. This situation will require you to make some decisions. The same can be said for the owner of a personal RRSP, although in this case, I am assuming the retiree will not have the benefit of an employer contributing a portion. That being said, someone employed in a company that does not offer a retirement benefit may pay more. This puts the onus on the employee to save for retirement.
Someone with an RPP or RRSP can still elect the equivalent of the default strategy we saw with the DB pension plan above. The solution is to buy an annuity with the assets in your plan. It is not impossible to imagine someone with 40 years of employer-employee contributions to such a plan to have accumulated an account worth $500,000 or more. I will use the following assumptions:
- Premium from Defined Contribution Pension Plan: $500,000
- Age of Male Annuitant: 65 (March 2024)
- Age of Female Joint Annuitant: 63 (February 2024)
- Income Starts: April 2024
- Guarantee Period: 0
- Payout: $2,692.15 per month
- Payout After Death of Either Annuitant: $1,794.8 per month (66.67% of original)
Combined with CPP and OAS, this is not that different from The Default Strategy above. Both of these first two strategies offer stability, but this is the classic “senior on a fixed income” situation. There is not a lot of flexibility. In this annuity-based strategy, I have elected not to provide a guarantee period. This means that after the death of the second annuitant, the money is gone. None will be left for any heirs, even if the annuitants live short lives following the start of the annuity. This is the price one pays for a higher monthly income.
For that reason, most experts argue that only a portion of a retiree’s assets should be used to buy an annuity. Leaving some assets in a Registered Retirement Income Fund (RRIF – sourced from an RRSP) or Life Income Fund (LIF – sourced from pension funds) allows the retiree to adjust spending as needed.
Non-Registered Investments
Not everyone will have the financial wherewithal to have maximized accounts like the RRSP and TFSA, but for those who have, another annuity-based strategy is to take a portion of your non-registered portfolio and buy an annuity with it as well. The benefit here is that, since the annuity is bought with after-tax assets, a significant portion of the annuity payments are not taxable. Specifically, the retiree will want to arrange for a prescribed annuity that provides for a level taxable amount throughout the life of the annuity. Assuming terms like those described above for an annuity using registered sources, we get the following:
- Payout: $2,628.10 per month
- Payout After Death of Either Annuitant: $1,752.15 per month (66.67% of original)
- Taxable amount for a prescribed annuity: $862.56 per month ($10,350.76 annually)
A retiree could also withdraw the funds held in a TFSA to buy an annuity. Unfortunately, current rules do not permit an annuity to be bought within a TFSA so as to make the payments completely tax-free.
The “Four Percent Rule”
William Bengen is a retired financial planner in the United States. In 1994, he published an article in the Journal of Financial Planning, entitled “Determining Withdrawal Rates Using Historical Data.”
In this journal article, which addresses investing in the United States, Bengen used a portfolio of 50% large-cap stocks and 50% intermediate-term U.S. Treasury bonds. He then assessed the performance of that portfolio over rolling 30-year periods, beginning with the period 1926 – 1955. He concluded that with this portfolio, a retiree could safely withdraw 4% of their initial retirement portfolio balance every year, annually adjusted for inflation, without the risk of running out of money over a 30-year period. The goal was to determine how much could safely be withdrawn even if one retired at the beginning of the worst three financial decades.
The 4% rule has some pros. To name three, it is easy to follow, it provides predictable steady income, and it sets a withdrawal level that protects against depleting the portfolio prematurely. On the other hand, there are some cons to consider. First, it assumes that the retiree strictly adheres to this rule; second, it is based on a worst-case scenario; and third, it is not dynamic. In other words, it doesn’t respond to changing market circumstances. Speaking from a Canadian perspective, I’ll add a fourth con. It uses U.S. historical data, which may mean it is less useful in Canada and other countries. Ben Felix of PWL Capital put out a YouTube video entitled, “The 2.7% Rule for Retirement Spending,” which assesses the usefulness of this data for retirees. I recall that Jason Pereira, a leading figure in financial planning in Canada, referred to it as a “4% observation.” In other words, while this “rule” (by the way, William Bengen never referred to it as a rule) may be a useful exercise, other variables should be taken into consideration.
Systematic Withdrawal Strategy
Registered Assets
When you transfer an RRSP into a RRIF or a pension/Locked-In Retirement Account (LIRA) into a LIF, you become obligated to receive an Annual Minimum Payment. You can set this up to be paid out at different frequencies, from monthly to annually. In the case of a LIF, there is also a maximum amount to pay out, as pension assets are supposed to last a lifetime. Each year, your financial institution will advise you of the minimum payment. If you choose a monthly payment, you will get the same amount every month. However, you may be required to periodically sell off a portion of your investments to free up the necessary cash for the payment.
Alternatively, if your account consists only of mutual funds, you can set up a pre-arranged amount to be sold from your mutual funds and distributed to you every month.
Non-Registered Assets: Income Only
Some financial institutions allow investors to arrange for an accumulation of dividend and interest payments in a non-registered account to be paid out on a semi-monthly (twice a month) basis. Given that your investments will likely have a variety of payment dates, the payments could be quite “lumpy,” with one period producing nothing while another produces a couple of thousand dollars, but if you can spread out the spending of this income, you may find it helpful.
Bucket Strategy
In this approach, retirees divide their investment assets into three categories. First is the short-term bucket that covers up to five years of spending. The second is the medium-term bucket that would cover the period up to 10 – 15 years, while the third bucket would hold the balance of the assets.
Let’s assume a 65-year-old retiree couple with $1 million in investment assets. They need $25,000 per year from their assets to top up their income from CPP and OAS. Let’s further assume that they live to age 100. Therefore, they have 35 years to cover. They are on the more conservative side, so they set aside 5 years of spending in the short-term bucket, and 10 years of spending in the medium-term bucket, with the remaining 20 years set aside in the long-term bucket. The short-term bucket holds cash or cash equivalents, that is, a high-interest savings account and GICs. The medium-term bucket holds fixed-income ETFs. The remaining assets that belong in the long-term bucket are invested in a global equity ETF.
As they age, they spend more than $25,000 per year, but because they have always been better at saving than spending, even as their RRIF and LIF accounts get spent down, their TFSAs and non-registered accounts take up the slack and never drop below $1,000,000. However, they continue to adjust their allocation to short, medium, and long-term based on their ages, spending from the short-term bucket and then reallocating each year to replenish the short-term bucket to 5 years’ worth of spending, adjusting the medium-term bucket to equal the equivalent of 10 years, and then leaving the remainder in the long-term bucket.
I’m tempted to say that, in real life, most retirees would spend down their retirement assets over time, but many retirees die with more money than they started with. In any case, by keeping the total value of the assets steady at $1,000,000, you can see that the percentage allocated to the short- and medium-term buckets increases. In other words, using this strategy may force a retiree into an overly conservative portfolio. The reason is that 5 years out of a 35-year remaining lifespan (2024) only requires one-seventh of the portfolio, while 5 years out of a projected 20 years left to live requires one-quarter of the portfolio. A similar situation applies to the medium-term assets. This slowly but steadily squeezes what’s left to be allocated to the long-term bucket.
Dynamic Withdrawal Strategy
This strategy represents a variety of approaches to generating income from retirement.
Percentage of Remaining Portfolio
This is not that dissimilar to the Annual Minimum Payment approach that holders of RRIF accounts are obligated to take part in. The percentage slowly climbs over time. If you expect to live to 100 and you are 65 at the moment, you have 35 years remaining. You would withdraw 1/35th of the portfolio, or 2.86 percent that year. The following year, with an assumed 34 years remaining, you would withdraw 2.94%. On a $1 million portfolio, that works out to $29,400. If the portfolio went up to $1.1 million when 34 years were left, then $32,340 could be withdrawn. If it dropped down to $850,000, then only $24,990 could be withdrawn. And here lies the challenge. It might be a challenge to make substantial changes in spending year after year, especially downward changes.
Floor and Ceiling Strategy
This strategy can be used in combination with the strategy above or any other kind of dynamic withdrawal strategy. According to Wade Pfau, William Bengen proposed its use in combination with what has become known as the 4% Rule. This strategy allows the retiree to boost their spending by up to 20% in an up year while dropping it by 15% in a down year. If the market goes up dramatically or down dramatically in any given year, you don’t need to make as huge a shift as you would if you follow the percentage rule more strictly.
Guardrails Strategy
Developed by Jonathan Guyton and William Klinger, the goal is to allow for some flexibility while still maintaining a degree of income stability during retirement. You establish an initial withdrawal rate. For our purposes, let’s assume 5% or $50,000 on a $1 million portfolio (ignoring inflation). The guardrails are set at a certain percentage above and below the target rate of 5%. Let’s assume the guardrails are set at 20% above and 20% below the target. That works out to 4% and 6% respectively. If the market does well, and the portfolio rises to $1.3 million, then a $50,000 withdrawal would mean you would only be withdrawing 3.85% of the portfolio. Congratulations, you get to bump your withdrawal up to $52,000 so that you reach the lower threshold of 4%. The next year, the market retreats a little, but $52,000 is still between 4% and 6% so no change is made to your withdrawal. The following year, however, a bad market sends your portfolio down to $830,000. $52,000 is 6.27%. That’s too high since it exceeds the upper guardrail. Therefore, you need to withdraw no more than $49,800, which is 6% of $830,000. This adjustment is made annually, and while it does involve some fluctuation in withdrawals, it balances the sustainability of the portfolio with a reasonably steady income stream.
There are other strategies with nuances to those mentioned above, but you might wish to consider these approaches as you think about how you will generate income in your retirement.
This is the 237th blog post for Russ Writes, first published on 2024-02-26
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.