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An appropriate withdrawal rate is the single most important component of planning a successful decumulation strategy for retirees, and the second biggest factor is luck, a Toronto conference on investing for decumulation was told Monday.

The portfolio withdrawal rate trumps the importance of asset allocation, the size of the portfolio, and time horizon in avoiding “depletion risk” or ensuring that the retirement portfolio lives longer than the client, speaker Jim Otar, a certified financial planner, author and retirement income consultant told the conference, sponsored by the Investment Management Consultants Association.

“In retirement, people realize that steady income is important,” Otar said. “While many advisors see a sustainable withdrawal rate as the maximum amount that can be taken out of a portfolio with an acceptable risk of not depleting it prematurely, the reality is that you don’t want any risk of depletion.”

While 4% is often used as a benchmark for annual portfolio withdrawals to create an income in retirement, this amount must be calculated according to individual circumstances, evaluated along the way, and readjusted if necessary. Otar said decumulation is particularly challenging in the current low interest rate environment, and the outlook for achieving a healthy and sustainable income for ever-increasing life spans that could last 95 to 100 years is “depressing.”

Clients should be shown the impact of how one or two years of negative returns at the outset of retirement can permanently impair the health of their portfolio when combined with regular withdrawals. Whether clients experience positive or negative returns in the first few years of retirement is what he refers to as “luck.”

He suggests advisors devise strategies for clients in dealing with this “sequence of returns risk,” including accumulating a larger pool of assets before retirement, withdrawing less income in retirement or purchasing an income annuity to cover a portion of the desired income, as it’s virtually impossible to predict when market corrections will happen.

While he advocates a buy and hold strategy to withstand market corrections, he also said there may be extreme circumstances where technical analysis of the behavior of market averages or high price earnings ratios show that equity markets are extremely overvalued. These “hurricane signals” can be a warning to move at least temporarily to a more conservative stance in terms of the portfolio’s asset allocation, particularly for clients about to launch into the decumulation phase.

Sooner or later, overly expensive stock markets will correct, he said. Whether that happens six months or two years down the road, it will create a “bad sequence of returns” for the client at his early stage of retirement. Otar’s rule of thumb is that if the market P/E ratio is above 12 when the client moves to the decumulation stage of life, and the client’s portfolio withdrawal rate is more than 4%, achieving lifelong income is unlikely unless adjustments are made.

Otar also suggested what he calls the “four-year checkup.” In the fourth year of retirement, the idea is to check whether the client has more or less money than he or she started with. If it’s more, the probability of depletion during a lifetime that could last to 100 years is considerably lower. If the portfolio loses money in the first four years, there is a high likelihood it will evaporate in the client’s lifetime unless changes are made, Otar said.

Another recommended strategy is to divide the client’s expenses into three buckets. These buckets include the “essential” expenses that are necessary to live, the “basic” expenses that cover a more comfortable lifestyle, and the “discretionary” expenses, that cover the nice to have, bucket list items. If essential expenses can be covered by a combination of government and any corporate pensions, as well as the purchase of an insurance annuity, the client is more insulated from fluctuations or poor returns in their investment portfolio.

This strategy requires a detailed and accurate calculation of client spending patterns, and is not based merely on easy rule-of-thumb guidelines such as creating a retirement income equivalent to 70% of pre-retirement amounts, Otar said.

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