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By Daryn G. Form
Third-party pension plans are not in the cards for most business owners and self-employed professionals. Some will have done some advance planning and diversified their wealth in sectors and businesses apart from their own, but for many the sale of their business – the goose that lays their golden eggs – will provide the funds for their retirement. Calculating an annual income from the invested proceeds of that sale is not quite as straightforward as the usual rules of thumb suggest. It can also be anxiety-ridden because there is considerable uncertainty about probable outcomes over an unforeseeable future. What follows are some suggestions about navigating that uncertainty.
Rules of thumb are useful, within certain parameters. To take a hypothetical example, John and Joan have recently sold the operating company and real estate assets of their family’s manufacturing business. They have invested the $2 million they netted after taxes and are trying to determine how much they can withdraw annually while ensuring that they do not outlast their money.
The rule of thumb is a useful starting point for you to have some idea of how much cash flow your portfolio can create.
The short answer comes from the rule of thumb commonly employed in this situation: starting from the age of 60, they can make annual withdrawals of roughly 4% of their portfolio value (at the time of the withdrawal) and be reasonably sure their money will last until they are 90 years old. Similarly, if they wait until age 65 to retire, they can make annual withdrawals of roughly 5% of the value of their portfolio until age 90. This guideline assumes that they, like most middle- to high-net-worth families, will have reduced travel and spending by their early 80s.
However, the most important words in this rule of thumb were the ones in parenthesis: rules of thumb are useful within certain parameters. A rule of thumb is meant, by its very nature, to simplify a complicated or detailed topic to aid understanding. Real-life scenarios demand an individualized plan for cash flow distribution based on a unique set of circumstances for each retiring couple. For example: are you taking your cash flow out of your company, shareholder loans, or dividends, or are you taking some of your cash flow out of RRSPs and will you be affected by RRIF minimums?
Your tax situation, your estate desires, and your personal risk tolerance all need to be addressed. The rule of thumb is helpful for planning purposes but your unique circumstances will drive an individualized cash flow plan for you.
Relying only on the rule of thumb is a recipe for disaster
The rule of thumb is a useful starting point for you to have some idea of how much cash flow your portfolio can create.
A well-constructed portfolio is designed to ride out periods of volatility in the market. This volatility will be reflected in snapshots of the value of your portfolio year over year. For the long-term preretirement investor, these snapshots are not particularly meaningful because historically, the stock market has continued to rise over time, albeit in a procession of temporary peaks and valleys. However, if you are making unadjusted withdrawals from your portfolio during the valleys in this progression, the original projections of how long your money will last will be adversely affected. It is important to adjust your spending patterns accordingly during down markets, particularly in the early years of your retirement when capital preservation is essential to the success of your plan. A protracted period of flat or negative returns would prematurely exhaust the principal of your portfolio – although the same volatility could work in your favour if you entered your retirement in a time of bull markets.
Rules of thumb are based on historical norms, but uncertainty is factored into how your portfolio is constructed. Speaking to your portfolio manager will give you a more detailed perspective on what you can expect over time. For example, projections about our hypothetical couple’s portfolio were made with the assumption that they have invested in a globally balanced portfolio of liquid financial assets with a rate of return of 6%, cost of living increases of 2% (reasonable, considering current and historical rates), and a portfolio risk/variability as measured by a standard deviation of 8.5%.
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Within that standard deviation of 8.5% there is a range of probable outcomes, as shown in the graph: Joan and John would have a 50% chance of having roughly $1.5 million remaining in their portfolio by age 90, a 75% chance of having greater than $600,000 in their portfolio by age 90, and a 5% chance of running out of money before age 90. If their portfolio withdrawal begins at the start of a prolonged bear market (or multiple bear markets) they will likely be in the lower outcome portion of the graph. If Joan and John begin their portfolio withdrawals at the beginning of a prolonged upward-moving bull market they are more likely to be in the higher financial outcome portion of the graph.
To deal with these uncertainties in planning cash flow over the span of their retirement, our clients have found it helpful to organize portfolios into several compartments for different uses; for example:
• A compartment for basic financial needs throughout retirement;
• Another intended to be spent down to zero over the first 15–20 years of retirement, when spending tends to be higher;
• An emergency account (e.g., for healthcare); and
• Estate provisions.
Rules of thumb are useful if you adjust your expectations by considering a range of probable outcomes and plan accordingly (and, I might add, favour a conservative assessment).
First published in the June 2018 edition of The Business Advisor.
