Comparing savings and retirement to a life story, several years ago, I was flying to Houston from Washington, D.C. (we were living in Annapolis, MD at the time). Right after the crew finished the drink service, I was settling in with an audiobook. The pilot came over the intercom, telling us we were about to experience some turbulence. I didn’t think anything of it and focused on my book. I wasn’t expecting what happened next.
Within a minute of his announcement, we were free-falling.
I’m sure it wasn’t a pure free-fall, but it was markedly worse than any turbulence I had ever experienced. My heart was pounding. I was breathing heavily. I could feel the sweat on my hands and feet. Every child under the age of 10 was screaming in fear.
It only lasted about 5-7 seconds. The pilot came on again. “Please return to your seats immediately; we’re expecting more turbulence ahead.” Thirty seconds later, it happened again — the exact same experience. A two-second free-fall, shaking back and forth, followed by a couple of additional short free-falls. Any child that had somehow suppressed their emotions the first time was now wailing. Call me a pansy. I don’t care. My palms were soaked, and the seatbelt buckle felt like it was freezing.
It didn’t stop. It happened again. This time, some of the adults were screaming. We were all looking at each other. I had flown plenty and was never scared of it, but this was different. It felt like the pilots had lost control of the plane. The remaining 45 minutes were miserable. The turbulence died down, but you could feel it. The entire mood of the airplane was palpable. We didn’t trust this plane anymore. And we certainly didn’t trust whatever tornado we were apparently flying through.
I’ve helped hundreds of families make the transition from full-time work to retirement. For many, this is how it can feel when you experience your first market crash in retirement.
We are hard-wired to receive a paycheck every two weeks. We build our lives around it. We know it’s coming and we have already planned out how we’re going to use it. Retirement means the paychecks are no more. Even more weighty, retirement typically means you now have more assets than you ever have before.
Nick Murray spoke to the sacredness of this dynamic. For most Americans and most of the retirees I work with, they didn’t inherit millions of dollars*. They worked for four or five decades and invested diligently throughout their lives. So not only have they now reached more money than they’ve ever had. It’s possible they now have more money than their grandfather even knew an individual could have when he started his life almost a century earlier. Whether you’re retiring with $500,000 or $5,000,000, that last sentence might be true. That’s why I love that thought from Murray. It is a big deal when a family trusts me to advise them on their life savings, and I don’t take it lightly.
Want to know what’s interesting? The flight attendants and pilots never freaked out. Not once. It’s because they knew the plane. They knew the storm, and they knew the process to get us on the ground.
That’s my job. It’s certainly my job when I work with families nearing (or in) retirement. And to a much lesser degree, with this article. I know the plane. I know the storm. And I also know the process to get us on the ground. Some of you may be thinking, “I know the storm already. I’ve lived through market crashes.” This is a different storm. When you’re working and the market crashes, it’s a good thing for you. Keep pumping money into the market every two weeks with your 401k contributions, and a market downturn can be an opportunity. When you face market turbulence in retirement, it’s different. The paycheck is gone. No contribution and company match is going into the market. You’re watching your future paychecks go down in value right before your eyes.
But that should not be your experience. You do not need to spend your life in constant fear. Another idea from Nick Murray: wealth is not a certain amount of money or net worth. Wealth is freedom. In many ways, it’s freedom from worry about you or your children’s financial well-being. If you’re still worried, you’re not wealthy.
How do you remove the fear and begin to plan for retirement income that works? Let’s tackle that question.
Organization: Where are your Assets now?
Social Security: One critical component of retirement income planning is when to take Social Security (and if you’re married-for both of you.)
Pension: Your pension likely comes with options to either take it as a lump sum (combine it with below) or take it as an annuity.
–For many of you, this is the end of your fixed income. Not to mention, a large portion of you will likely want to rollover your pension, so Social Security is it. In this hypothetical scenario, let’s pretend that you want to spend $8,000/month in retirement and your Social Security provides a portion of your needs. That leaves the rest of your assets with a question as to how to wisely invest and use as income sources.–
401k (and any other old 401k/IRAs+pension if you choose lump sum): For many of you, you will likely roll your 401k and pension to an IRA. This will be your single largest source of wealth, and it’s all subject to income tax.
Roth IRA: Most retirees today don’t have significant Roth assets. The popularity of the Roth is relatively recent, and Roth 401k plans are even more recent. Still, this is a critical bucket for you if you can carefully and wisely convert some of your pre-tax assets into Roth before your 70’s.
Stock Plan: Any company stock you own, NUA distribution you play to do, and I’ll throw in any other brokerage account holdings you’ve accumulated over the years
Cash: Not cash in your IRA, but simply cash you’re holding in a checking/savings account
Other: Have a rental property (or several)? Have any oil/gas/mineral assets that produce income? We’ll include that here.
Ultimately, the question becomes this: What do you do with the investment/cash portion of your financial life? Once the Social Security decision has been made, you have to decide how your other assets are going to fill in the gap every month–for potentially the next 30-40 years.
^Quick note: Lots of research has come out recently in the financial planning world that we could see a lot more people living until age 100. Some even say 110 is within reach for many. Who knows. But part of my job is asking, “What’s the worst-case scenario, and how do we plan for it?” That’s why estate planning and insurance are a part of my planning process. That’s also why we have to build an income plan for the possibility that you might live a lot longer than you think. One other caveat-your expenses in life are not static. It’s likely that inflation will make everything more expensive for the first 10-20 years of retirement. Then, you might slow down a little and spend less. So, your retirement income picture looks more like this.
So, what are your choices?
Overview: All of Your Retirement Income Options
Pure Interest-The basic idea is you put your money in an investment and live off of the exact return it gives you each year. This made more sense 35 years ago when you could earn double-digit returns in a CD. Interest rates are low, so this is difficult now. And it doesn’t make sense to adopt this approach with a stock portfolio-what do you live off of during the negative years?
Annuity-I realize annuities have started to become a cuss word. Academically, there are situations where it can be in the best interests for someone to use. If there’s a gap in your income, you have a low tolerance for risk, and you don’t have millions of dollars saved, an income annuity can be a reasonable choice. The case for an annuity? It’s an effective way to give you a safe source of income. The case against an annuity? Historically, you’ve ended up better with a smart withdraw strategy (see below). It’s a similar conversation to your pension decision. You could take the annuity option-for many retirees, this may prove to be just fine. But, if you can stomach the risk, you might see the lump sum give you more income and more of a legacy to pass down to your heirs. The risk is critical, though. Mismanaging a lump sum can put your future income, and legacy, at risk.
Note: I run a wealth management firm specifically built for families coming from major O&G companies. So, while there are times that annuities can make sense, they rarely make sense for the typical client I work with.
Dividend Focus-This is extremely popular. There are money managers that have become very wealthy through this approach. It sounds really good in theory-“we’re going to just focus on the healthy blue chip companies that have been around forever. It’s safer and gives you a reasonable income.” The problem is, safe blue chips companies can be very reliable…until they’re not. I can assure you that most GE investors didn’t expect the steep decline they saw. Plus, it can leave you overexposed in certain industries. As mentioned, I work almost exclusively with Oil & Gas and Petrochemical retirees. I think the industry has a lot of potential in the coming decades. Still, I would never encourage anyone to base their retirement income off of a batch of 30-40 O&G stocks because they pay a healthy dividend. Same with utility companies. Even if your dividend portfolio is spread across several industries, plenty of research shows that you will likely underperform the market if you hold significantly less stocks than the market (and the market=1,000’s of stocks). My main point is this: dividend investing sounds safe and effective. But it can expose you to risk that you are not compensated for. I’m great with risk in your retirement portfolio–but there has to be a historically reasonable expectation of return for that risk. One last ringer: There is no evidence that high dividend payers perform better. There is some evidence to the contrary. I have no idea why you would want to under diversify and not reap a return for it. Dividend stock portfolios tell a compelling story that people pay fees for. That’s why they exist-to make money for Wall Street-not because they’re the best way to fund your retirement.
Disclaimer: If you are sufficiently diversified, having a tilt towards dividend payers will likely not hurt you. You still have an excellent chance at a successful retirement. I come strong with this point because, for many, dividend stocks are a sacred cow they need to bury. There are better ways to invest, but still, dividend stocks are far from the worst thing you could do with your money.
“4% Rule”-The 4% rule has become very popular. I believe Bill Bengen first came up with the idea. General thought: Invest your nest egg in a diversified 60% stock/40% bond portfolio. Take 4% out in year one. So, if you have $1M-take $40,000 in year one, then, give yourself a raise for inflation every year-so that $40,000 might grow by 2.5-3% every year. Over the past 100 years or so, this has successfully allowed you retire, give yourself an income for 30 years, and usually leave a healthy portion to your heirs.
One of the most helpful parts of this principle is that it gives you a baseline for understanding how much you need to retire. Simply figure out how much you need to live off of each year, add your estimated taxes, and divide it by .04.
The 4% rule certainly has some drawbacks. First of all, we don’t know if a 60/40 portfolio will continue to perform as it has in the past. We just finished a 40-year bull market in bonds. Interest rates are now very low. So, the 40% bonds in that portfolio will no longer give us 6-7%/year.
For the typical client I work with, the basic idea of the 4% rule makes a lot of sense. Specifically, their situation (their savings and the tax structure of those savings) often means that a version of the 4% rule (see smart withdraw strategy below) works very well.
Smart Withdraw Strategy
The framework for the smart withdraw strategy is the 4% rule with some minor tweaks. Ultimately, we don’t have any guarantee that the next 30 years will look like the last 100 years. So, we need to do everything we can to give you the best possible chance at a successful retirement. What are the tweaks that help? Let’s walk through them.
Starting withdraw percentage. I mentioned a 30-year retirement earlier. Well, if you retire early or if you have serious longevity in your genes, we might need to plan for more than 30 years and adjust accordingly.
Guardrails for future uncertainty. Want to know the worst-case scenario for your retirement income? It isn’t the 2008 crash. A market crash followed by a massive bull market isn’t a significant threat to your retirement income. But, a prolonged decade of low returns is. The most challenging period that almost broke the 4% rule was retiring in the late 1960s. Your first decade of retirement would have been a bunch of withdraws and stagnant returns. How can we combat this? Put some guardrails on it. If the market crashes, maybe we don’t take the inflation increase this year. Maybe we cut spending slightly. This increases your odds of successfully making your income last throughout retirement.
Taking income from the stock or cash/bond portion. One other enhancement is utilizing the stock portion** in a good year and not touching it during a bad year. More specifically, only take from the cash/bond positions during bad years in the markets. This might feel counter-intuitive. After all, if you’re 65 and, during your first bad market in retirement, you start taking from your cash/bond positions, this will inevitably give you a higher % of stocks in your portfolio. Yes, that goes against all of the things you’ve heard about owning more bonds as you get older. But, we can adjust the portfolio to restore your cash and bonds. And this strategy can significantly enhance your ability to meet your income goals for the rest of your life. This is a great example of a strategy that has significant academic research behind it-see Timeline App. How does it compare to paying some wealth management firm 1-2% every year to pick 40-60 high dividend stocks? Well, the high fee dividend idea doesn’t have academic rigor behind it, but I guess you’re contributing to your advisor’s country club dues!
We can’t stop the storms from coming. Historically, the market falls by about 14% almost every year. And every six years, the fall is closer to 30%. Personalize that-if you’re 60, either you or your wife might live through 35 more market corrections and six more crashes. But when we use the weight of history and academic research to build the best portfolio and income plan possible, we’re just like the flight crew in my opening story. We know the plane. We know the storms. And we will get through it.
This picture combines the smart withdraw strategy with a small glimpse into the tax-efficient section below. Your income might come from after-tax savings for the first few years to allow for Roth conversions. Then, we have a flexible income approach that allows us to take from your portfolio in whatever manner maximizes your income and future legacy.
How do I do all of this in the most tax-efficient way possible?
I hesitate to include this because it’s an entirely separate dimension. How to ensure your nest egg provides income for a 30-year retirement has become its own field of study. The stakes are high. Adding the layer of doing it in the most tax-efficient way is another field of study. Don’t get me wrong; it is critical. It can often save O&G retirees millions over the next few decades-especially now that Congress passed The Secure Act.
Practically, that means your nest egg goes to your children rather than the government through taxes. It also means you will likely be able to enjoy more income in retirement. Plus, it gives you an even higher chance of successfully retiring.
Your tax decisions in retirement are a matter of key decisions early on, organizing your assets appropriately, and then sticking to your plan long-term.
Early tax decisions start with your NUA distribution opportunity. This won’t apply to all of you, but if you retire with company stock inside of your 401k, you can remove it during your rollover. If you purchased the shares decades earlier and have a significant gain, this is a big advantage. Your 401k/IRA is subject to income tax. If you can remove highly appreciated stock from that bucket and instead pay the lower capital gains tax, this is a big win. I have some pieces related to the Exxon NUA coming out later this month. I’ll walk through how to analyze what’s in your best interests and how to organize it with the rest of your retirement and tax plan. I’ll also release an article on Chevron’s NUA as well. Each 401k typically has small intricacies within the NUA opportunity that make it important to understand your specific plan. I’ve studied most of them extensively-let me know if you’d like me to make a blog or video on your company’s specific NUA structure.
The next big tax decision is Roth conversions. If you’re retiring form any O&G/petrochemical company, you likely have the heavy bulk of your assets in pre-tax vehicles. Your 401k and pension are subject to income tax when you take distributions. At age 72, the IRS will force you to take distributions and pay tax on them. This is a big deal. If you retire at 62 with $3-4Million in your 401k and pension, this could easily eclipse $5Million by the time you’re 72. You will then see the IRS slowly take a hefty chunk of this away each year. But you’re not without hope-proper planning can lower your future tax bill by a tremendously large amount.
Lastly, organizing your assets and estate plan can be a big tax win. As long as the tax code gives different treatment to different accounts, you must pay close attention to your portfolio in each of your accounts. Let’s pretend that you have a Traditional or Rollover IRA, a Roth IRA, and after-tax investments (like a brokerage account). If you determine that you should have a 60% stocks and 40% bonds portfolio, a lot of retirees make one big mistake with implementing it. The mistake is mimicking the same 60/40 portfolio in each of your different accounts. A significantly better way would be to put the higher risk/higher growth assets in the Roth and the lowest risk/lowest growth assets in the pre-tax IRA. The result is the same 60/40 portfolio, but you now get to enjoy tax-free growth on the part of your portfolio that will likely yield better returns. Or, as long as the IRS allows a step-up in cost basis and lower capital gains tax rates, it can make sense to put higher growth assets in your after-tax account compared to your pre-tax IRA.
The above picture is a VERY simplified way to illustrate this idea. If you’re 64 and just retired, your after-tax might be all cash/bonds because that’s where your income for the next 4-5 years is coming from to facilitate Roth conversions. If you’re 75 and the tax code continues as is, after-tax and Roth might both be 100% stock. I structure this in a custom manner for each client I work with so that it gives them the maximum possible long-term benefit. But the basic idea-have your higher growth assets in buckets where they won’t be taxed. Have your lower growth assets in buckets that will face steep taxes-and for the Oil & Gas and Petrochemical retiree-your pre-tax IRA is your ticking tax bomb.
Lastly, check on your estate plan. The SECURE Act changes the way retirement plans are taxed when they are inherited. A mistake in your estate plan can be extremely costly now that stretch IRA’s are no longer allowed for most Americans.
That’s it, folks. As my disclosure states, this is educational content and not intended to be advice. I repeat that here because, as you can tell, your retirement income plan is very specific to your situation and customizable. Whether it’s another advisor or me, I strongly recommend getting advice from a fee-only CFP professional to review it.
As always, email me at email@example.com if you have an idea for a future blog or video. I mean it-some of our best content comes from questions you ask. And sign up for our free newsletter!
*Almost 4/5 American millionaires didn’t inherit anything. Only ~3% inherited more than $1M. Source: Chris Hogan
**Note: When I say stocks in a retirement portfolio, I’m likely referring to a globally diversified set of low-cost funds–Unless I’m specifically addressing individual stocks (as I was in the dividend stock section).