Three Tips for Evidence-Based Retirement Plans


I recently participated in a fun exercise.

My friend Phil Huber, CFA, asked a group of us to define “Evidence Based Investing in 10 Words or Less.” My favorite definition came from Bob Seawright, who said, “A relentless focus on what works, what doesn’t, and why.”

On his blog, Above the Market, Seawright wrote that evidence-based investing is “the idea that no investment advice should be given unless and until it is adequately supported by good evidence.”

Who wouldn’t want that?

This growing movement has fueled Vanguard’s rapid growth, to over $4 trillion in AUM. It has also generated numerous articles, a magazine cover, an infographic, and some entertaining alternatives for those advisers who want to try another variation. It even spawned its own conference.

While these are welcome changes, much of the conversation has focused on the investing side of things: What funds to own; how to set an investment allocation; which factors work and which don’t; and how to minimize expenses, taxes, and trading costs, for example. However, the evidence as it relates to retirement planning — specifically the distribution phase of an investing lifecycle — is often left out of the discussion.

Both the accumulation and distribution phases are critically important. And with retirement, as with any vintage of wine, your clients have only one chance to get it right.

To extend the metaphor, think of the accumulation phase of an investing life as the planting of a vineyard. A vineyard, like a portfolio, can survive many different seasons and weather patterns, and like a well-designed portfolio, a vineyard is resilient. Though the vineyard is tended over time, the care should kick into hyperdrive each fall when the grapes are harvested.

As the weather over each growing season and at harvest makes each vintage of wine unique, the year the client retires and the portfolio distributions begin has a big influence on the overall retirement experience. When it comes to distributing a portfolio, there are specific factors to pay attention to. Here are a few suggestions to put a little evidence-based thinking into your clients’ retirement plans.

1. Get the withdrawal order right.

In “Tax-Efficient Retirement Withdrawal Planning Using a Comprehensive Tax Model,” Alan R. Sumutka, Andrew M. Sumutka, and Lewis W. Coopersmith, studied the most efficient order to withdraw funds from different types of accounts — taxable, tax-deferred, and tax-free — and then quantified the benefits of getting it right.

They looked at 12 different combinations for ordering withdrawals.

I’ll spare you the details and highlight two of the strategies: First is the “Common Rule” method, which is the default rule of thumb. For most, it involves spending down a taxable account first, followed by tax-deferred funds, then tax-free funds. The second method, the best withdrawal order strategy identified, was the Informed TDD strategy. It takes tax-deferred withdrawals up to the level of tax deductions, then taxable funds, then tax-free, and finally tax-deferred again, if needed.

What is the advantage of applying a little evidence to the process? Assume a $2-million portfolio split 70% in a traditional IRA, 20% in a taxable account, and 10% in a Roth IRA. There is an initial $50,000 withdrawal rate. The evidence suggests that an additional $400,000 of wealth is gained and $225,000 less in taxes are paid over a 30-year retirement period by switching from the “Common Rule” method to the evidence-based Informed TDD strategy.

Minor change. Major payoff.

2. Avoid the “variable risk preference bias.”

Because of the strong bull market over the last eight years, current retirees are facing something known as the “variable risk preference bias” — the inclination to take on more or less risk based on recent market performance. The stronger the recent performance, the more willing investors are to increase the level of risk in their portfolios — a pattern that runs counter to the buy low, sell high mentality central to investing.

What’s more, this bias affects older investors more than younger ones, according to researchers Michael Finke, David Blanchett, CFA, and Michael Guillemette. They found:

[O]lder workers are more likely than younger investors to experience what we call variable risk preference bias. That is, their willingness to take investment risk varies depending on recent stock-market performance.”

“When risk tolerance was measured in a bull market, . . . older workers tend to appear relatively risk tolerant (they prefer a riskier portfolio). But when they took the same risk-tolerance test in the spring of 2009 after a steep fall in stock prices, older workers were much more risk-averse (they preferred a safer portfolio).”

Today’s lingering bull market is persuading many to take more risk. This urge, coupled with “retirement date risk,” can encourage perilous behavior in those close to retirement. Research by Wade Pfau, CFA, suggests that a retiree’s safe withdrawal rate is highly dependent on portfolio returns near their retirement date. For example, returns in the retirement year are over three times more influential in securing a safe withdrawal rate than the returns 10 years prior.

Being unprepared for a bear market is similarly hazardous. The time for recovery will be limited and a planned retirement could be jeopardized.

After a long bull market, the likelihood of clients taking more risk increases. But as the evidence shows, taking these risks near retirement is the most dangerous time to do so.

3. Stay engaged for a better life.

Older workers benefit from several current trends: the growth in service industry jobs as opposed to more physically demanding occupations, and increasing life expectancy and improved health care. Marc Freedman of the Wall Street Journal says the top reasons people continue working in later life are “to stay active and involved” and because they “enjoy working.”

The research is mixed as to whether working into the traditional retirement years is healthy. However, Christopher Farrell of The New York Times believes “it tends to tilt toward ‘yes.’”

In the same vein, Nicole Maestas, an associate professor of health care policy at Harvard Medical School, stated that the benefit of work — the “Activation of the brain and activation of social networks” — may be critical.

From a financial standpoint, earning income in retirement has a huge effect on financial plans.

We found that a retiree who spent $60,000 annually in retirement but worked an additional 10 years earning $30,000 until Social Security kicked in reduced the required portfolio balance to sustain a 30-year retirement by 30%. This could allow for an earlier transition to semi-retirement, or simply increase their confidence that they had a safe cushion of money when needed.

These ideas are just a start. What did I leave out? What are some of your favorite evidence-based strategies for the distribution phase of retirement? Let me know in the comments section below.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Images credit: ©Getty Images/A-Digit

Isaac Presley, CFA

Isaac Presley, CFA, is Director of Investments for Cordant Wealth Partners, a wealth management firm focused on serving current and former Intel employees. He leads the firm’s investment committee and directs the company’s investment strategy and research. In addition, he heads the firm’s blogging efforts on the Cordant Blog.

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