Retirement Portfolio Spending Strategy – Withdrawal Order Flowchart

According to research from the Vanguard Group, another area where a skilled financial advisor is supposed to able to add value is helping retirees manage withdrawals from their portfolios in order to minimize taxes. According to their paper:

Advisors who implement informed withdrawal-order strategies can minimize the total taxes paid over the course of their clients’ retirement, thereby increasing their clients’ wealth and the longevity of their portfolios. This process alone could represent the entire value proposition for the fee-based advisor.

The paper goes on to show how correct ordering can improve returns by up to 0.70% annually versus people with multiple different account types withdrawing in the wrong order. The thing is, ordering your withdrawals properly isn’t all that complicated. I would even say it just requires basic math and common sense. Most of it is summarized in this flowchart:

portspend

Details:

  • RMDs stand for required minimum distributions. In general, these are forced withdrawals from pre-tax “traditional” IRAs (including SEP and SIMPLE IRAs) and pre-tax workplace defined-contribution plans (including 401(k) and 403(b) plans) once you reach age 70.5.
  • Next, taxable flows include things like interest, dividends, and capital gains distributions that are already being “spun off” from your taxable portfolio. These are going to be taxed no matter what anyway.
  • Next, spend your taxable portfolio itself by selling shares and paying any capital gains taxes that may be due. Sell investments with the lowest gains first to minimize taxes.
  • What you have left are tax-deferred or tax-free (Roth) accounts. Do you want to pay taxes now, or later? If you think your marginal tax bracket will be higher in the future, then you should pay taxes now (withdraw first from tax-deferred account). If you think your marginal tax bracket will be lower in the future, then you should pay taxes later (withdraw first from Roth accounts). You could make your decision differently each year depending on your current situation.

How Good Portfolio Management Can Improve Real-World Returns

Vanguard has released a research paper called Putting a value on your value: Quantifying Vanguard Advisor’s Alpha, which provides the data and methodology behind its previous statement that a good financial advisor should be able to affect the performance of client’s portfolio by about three percentage points. The areas where good management can add value are summarized in the graphic below:

vgalpha

As a DIY investor, this chart also provides suggestions for areas to focus your energy. The biggest single “value-add” appears to be in the area of behavioral coaching. This basically boils down to convincing the client/investor not to abandon their previous plans during times of extreme greed (bull market) or fear (bear market). In other words, do nothing. In my previous post, I posed that a simple Vanguard Target Date Retirement fund would provide both low expense ratios and regular rebalancing – no advisor required. It turns out that if you can buy one of these Target funds and leave it alone for a long time, you’ll do even better…

Vanguard analyzed the performance of 58,168 self-directed Vanguard IRA investors from 1/1/2008 to 12/31/2012, a 5-year period which includes both the financial crisis and subsequent recovery. These self-directed investors were compared with an appropriate Target Date fund benchmark. The authors even state “For the purpose of our example, we are assuming that Vanguard target-date funds provide some of the structure and guidance that an advisor might have provided.”

An investor who made at least one buy/sell exchange between fund over the entire five-year period trailed the applicable Vanguard target-date fund benchmark by 1.5% annually on average. Investors who made no exchange lagged the benchmark by only 0.19%. The chart supplied is a little tricky to read, but illustrates the performance gap.

vgalpha2

(You want more “area under the curve” on the positive excess return side, and less “area under the curve” on the negative excess return side.)

I agree a good financial advisor can add value. Many people are doing none of the strategies listed above. However, a motivated DIY investor can implement most of not all of these strategies themselves. If you can buy a Vanguard Target Retirement fund and leave it alone (easier said than done), you can get much of the way there without an advisor. The problem is that you may have to go through an extreme market cycle to know if you can actually do it. Excerpted from the paper’s conclusion:

This 3% increase in potential net returns should not be viewed as an annual value-add, but is likely to be intermittent, as some of the most significant opportunities to add value occur during periods of market duress or euphoria when clients are tempted to abandon their well-thought-out investment plan.

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