Clients who have saved for years and invested their capital carefully are often apprehensive when the money has to flow in the opposite direction. No matter what the approach, it always comes down to the same question: how much income can I expect each year?

Planners often estimate people need to replace 70% of their pre-retirement income. But some mavericks — such as Laurence J. Kotlikoff, a Boston University economics professor — believe the replacement ratio could be as low as 50% for certain individuals. He may be right. However, most clients prefer to have money left over rather than risk running out before they’re through.

The conventional approach is to get clients to set a base distribution rate that has a high probability of success, increasing subsequent withdrawals only when they have the money to do so. For instance, several studies analysing distribution rates in past markets over multi-year cycles have determined that a hypothetical 4% inflation-adjusted distribution from a balanced portfolio has a very high probability — but not a guarantee — of lasting at least 25 years.

Unfortunately, as most affluent retirees will want to spend more money in early retirement, this approach is out of sync with reality, reports Charles Robinson in a Journal of Financial Planning study entitled “A Phased-Income Approach to Retirement Withdrawals: A new paradigm for a more affluent retirement.”

More often than not, he says, it leaves retirees strapped for cash early in retirement — when they want to spend more. Also, it does not fully address their big fears:paying for health care and long-term care, outliving their assets and failing to leave a legacy.

Instead, he believes, retirees would be better off with a phased-income approach to withdrawals that focuses on issues such as health-care costs near the end of retirement and then works backward from there. This would allow for more flexibility and larger early-retirement withdrawals.

The phased-income approach first calculates potential costs for health care and LTC premiums, and designs legacy strategies for the later retirement years. This component is calculated separately from the estimates of assets needed for regular living expenses. The next step estimates income needed for essential living expenses under a “worst-case” economic scenario, assuming the retiree lives beyond age 95. Assets are set aside to fund this income target in real dollars.

Income needs are then estimated for ages 85 to 95 and money is set aside, with the idea of buying an immediate annuity at age 85. But by age 85, the annuity may not be needed because of possible excess investment returns or because the retiree has died. Deferral of the annuity purchase until age 85 means less money has to be spent for each dollar of annuity income, freeing up still more money for the early years of retirement, Robinson says.

The remaining assets are then used to fund twin 10-year income periods: ages 75 to 85, a stage when spending typically slows down; and ages 65 to 75, the most expensive and active time in retirement.

Focusing on couples who generate at least US$60,000 in annual retirement income, Robinson tested various scenarios using this approach and found that at no time did retirees run out of money. He suggests even conservative early-stage retirees were able to enjoy greater income by boosting their initial withdrawal rates to 5.6% and, among clients with greater risk tolerance, to more than twice the traditional 4% rate.

Of course, this approach means that clients are more likely to be vulnerable to market downturns as they enter what Dr. Moshe Milevsky, professor of finance at York University, has labelled the “retirement risk zone” — namely, the period just before or after they retire. This is because weak markets can erode retirement portfolios dramatically during this critical period, leaving them without sufficient time to recover.

Robinson discounts this possibility, acknowledging that less affluent retirees may have to curtail discretionary expenses. They may also have to rely more on alternative sources, such as reverse mortgages. Still, the principles of the phased-
income approach should allow even this group to boost their withdrawal rates in early retirement. IE