Retirement Income for Life: 4-Box Strategy
By Robert Powell | MarketWatch
Some financial advisers pride themselves on being able to think “outside the box.” But when strategizing about retirement income, Farrell Dolan, a principal at Farrell Dolan Associates, prefers to think inside four boxes.
The four-box strategy, as Dolan describes it, involves breaking down lifestyle expenses and retirement income sources into two sets of two boxes—and then matching up those boxes to maximize the odds that a retiree’s savings supports him or her for life.
Dolan, along with David Blanchett, the director of retirement research at Morningstar Investment Management, and John Olsen, the president Olsen Financial Group, spoke at a recent MarketWatch Retirement Adviser event in New York City. “This whole stage of living in retirement really is less about products about more about lifestyle,” Dolan told the audience. “You first really need to take a look at what your lifestyle is. You have to define it between yourself and your spouse.”
Dolan’s retirement-income approach, which he also wrote about for LIMRA’s MarketFacts Quarterly, starts with a look at lifestyle expenses, which can be broken down into two boxes: essential ‘must-have’ expenses and discretionary expenses.
“Essential expenses,” said Dolan, “are the things I really have to have in life to make life worthwhile for us. And yes, it includes food, shelter, and clothing, and taxes, and all those mundane things.” But, he added, “Every one of us has something that goes into this essential box that goes far beyond food, shelter, and clothing. “
Discretionary expenses, the second box, are more flexible, said Dolan. These are expenses such as travel, entertainment, and hobbies that might be important to you, but could be cut during highly volatile markets or scary times.
To be sure, as Dolan acknowledged, it’s difficult for people to determine their total expenses in retirement given that they don’t know how long they might live. “There’s so many unknowns that I think it’s important to start by thinking about what you have to have, and then what you want,” said Dolan. “If you’re planning for a 20- or 30-year time frame, you know, all bets could be off… It’s important to be dynamic in thinking about: What do I have to have and what do I want to have as I move through life?”
Adding to the challenge, it’s hard to envision your retirement years when they’re still part of the distant future. “The further you are from entering this stage of life, the further back you go… it becomes more difficult,” said Dolan. “The vision is less clear. As you move closer, you really have to work at getting it (clearer)… I find that it evolves and changes over time.” What’s more, Dolan said, “At different points in your life you need different plans.”
The income “boxes”
If expenses account for two of Dolan’s four boxes, the other two involve the two major sources of income in retirement: lifetime sources, such Social Security and defined benefit plans, and income from assets such as those found in 401(k), IRA and taxable accounts.
In practice, here’s how Dolan’s plan would work: You would fill in each of the four boxes with your lifestyle expenses and sources of retirement income, and then you would connect the boxes in a disciplined, specific order, according to Dolan.
Lifetime sources of income such as Social Security and defined benefit plans should be used to fund essential expenses such as housing, food, health care, even golf for some. And, income from assets such as those found in a 401(k), IRA or taxable accounts are should be used to fund discretionary expenses such as travel, entertainment, and hobbies.
By linking essential expenses with lifetime sources of income, you’re “making sure that these needs are covered regardless of any risks,” Dolan wrote in his LIMRA white paper. “The key tenet of the four-box strategy is that essential expenses must be covered first and be fully funded by sources of lifetime income.”
You’ll enjoy some big advantages if your lifetime sources of income are sufficient to fund essential lifestyle expenses. One, you’ll avoid market risk. You’ll get a steady income regardless of what happens in the market. Two, your income will be guaranteed for life. Three, having this sort of income reduces the odds of outliving your assets, or what’s called longevity risk. And four, knowing that your essential expenses are covered with guaranteed sources of income could give you the courage to manage your “income from assets” portfolio more effectively—“to establish an appropriate asset allocation and maintain it for the long term,” as Dolan wrote.
Now, if there’s a gap between essential expenses and lifetime sources of income, you’ll have to fill it using as few assets as possible, according to Dolan.
There are two viable solutions for filling the gap: One is a fixed income annuity, which provides income for life, and takes advantage of what are called mortality credits. The other is a separate investment portfolio where you would use a conservative systematic withdrawal plan (SWP) designed to provide the highest amount of income for 20 years, 30 years or longer. The early research on this subject suggested that you could withdraw 4% on an inflation-adjusted basis and have it last 30 or so years, but new research has revealed the shortcomings of that approach.
These two solutions are not necessarily the perfect solutions. A fixed income annuity provides income for life, but no inflation protection. The SWP plan might provide a hedge against inflation, but doesn’t provide guarantees for lifetime income, according to Dolan.
Splitting the difference on income
Dolan’s suggestion to deal with shortcomings of the respective approaches is this: Split the difference. Purchase a small income annuity every four or five years with money from the “income from assets” box. “This will increase the payout of the lifetime sources box to compensate for inflation,” Dolan wrote in his white paper.
Discretionary expenses, meanwhile, will be funded by the income-from-assets box. This box typically contains all sorts of investments and products, including individual securities, funds and ETFs, managed accounts, and variable annuities with guaranteed living benefits. And the goal is to create income for discretionary expenses – those things that you would like to do but can also be cut or postponed – while at the same time positioning the portfolio for future growth, Dolan wrote.
And so, it’s important that you not only establish and maintain the right asset allocation for this money, but cut discretionary expenses during highly volatile markets. In other words, you will want to have what some call a dynamic withdrawal rate for this money, a rate that could be high during strong markets and lower when markets are weak, according to Dolan.
There’s a secondary benefit of this dynamic withdrawal rate strategy. Instead of moving your money into conservative investments during bear markets, you would simply cut back on your spending. “The four-box strategy exploits investors’ need to ‘do something’ by redirecting them to do the right thing to relieve pressure on their portfolios: reduce discretionary spending,” Dolan wrote.
Another retirement-planning issue that can’t be ignored, according to Dolan, is this: “Before diving into products and solutions, investors really need to be educated about the financial risks that they face during retirement.”
Investors also need to understand what risks are being mitigated with this or that retirement-income strategy, and which risks are not. And that’s a hurdle not just for retirees and would-be retirees but advisers as well, said Dolan.
Dolan said the industry has been very product-oriented, but it’s now in a place where it has to define lifestyle, and that’s very different. “We have to come up with solutions that (don’t) look at one product or another, but organize them together to mitigate the risks and have it make sense for the consumer. And that is a long row to hoe for many advisers.”