Capital Ideas^™ 
Investment insights from Capital Group

Of all the fears that keep retirees up at night, one of the biggest might be the fear of running out of money. Questions like “How long will I live?”, “Will my investments hold up?” and “Will unexpected costs or events erode my savings?” speak to this fear.

Answering these questions is a central challenge of the retirement industry today. At Capital Group, home of American Funds, we encourage retirees and financial professionals to think less about retirement assets as one lump sum that must cover all expenses, as many do, and instead to think more about a ‘building blocks’ approach. This approach means allocating assets to blocks aligned with personal retirement objectives. Four blocks frequently prioritized by retirees are basic living expenses, discretionary expenses, unplanned emergencies and leaving a legacy.

The building blocks of a confident retirement

We believe that thinking about asset allocation in terms of building blocks can help retirees adopt a mental accounting framework for their assets — making it easier to understand, quantify and prioritize their retirement spending and legacy objectives. Our approach has been informed by in-depth qualitative research conducted for Capital Group, including interviews with hundreds of retirees and near-retirees.¹

1. Living: Are the essentials covered?

Living expenses typically include day-to-day necessities such as food, housing, transportation and health care. While investors may have some flexibility with meeting these types of expenses over time, many may seek 100% confidence in meeting them at the outset.

2. Lifestyle: What are your optional expenses?

The lifestyle block includes discretionary spending — the spending you can live without if necessary, such as travel, spending on grandchildren, dining out and entertainment. What constitutes a lifestyle expense will vary from retiree to retiree, as will their comfort level with variations in income and spending as their lifestyle evolves over retirement.

3. Emergency: Do you have a cash cushion?

An emergency fund can provide retirees with more confidence in their ability to weather unexpected market, health or household expenses. Investors should plan for the unexpected and have ample cash and/or more readily liquid reserves on hand.

4. Legacy: Do you plan to pass on your wealth?

For some, leaving a legacy is a defining goal of a wealth planning strategy. Many others simply plan to leave behind “whatever is left” after also accounting for living and lifestyle expenses in a single portfolio of assets invested together to balance income, growth and capital preservation objectives.

Putting the building blocks into action

What is the optimal withdrawal rate for a couple’s retirement portfolio? In the above hypothetical example, Harry and June used the four-building-blocks framework when discussing their spending goals and available resources with their financial professional.
 

• Their annual basic living expenses are $40,800. They would like to set an objective to achieve 100% confidence in meeting these essential living expenses over their lives.
• They desire $27,200 annually for their lifestyle expenses in retirement. Since they have more flexibility in achieving this spending goal, they agree that 75% confidence in reaching it is appropriate, given that the portfolio needs to balance income, growth and asset preservation.
• They have cash savings of $45,000 in their emergency fund for any unforeseen expenses.
  
• They would like to leave a legacy for their children, which would include the family home valued at $500,000.

Their $1,000,000 portfolio would need to generate $40,000 ($68,000 less $28,000 from Social Security) to cover both their living expenses and desired lifestyle spending — a 4% withdrawal rate.

Testing the income plan against multiple outcomes

To stress-test this 4% withdrawal rate’s ability to confidently support both living and lifestyle expenses, their financial professional looked at a Monte Carlo simulation, which calculates probabilities based on a number of hypothetical return scenarios. Since Harry and June were most concerned with downside risks, the simulation focused on the lowest 10th percentile of possible outcomes.

According to the simulation, the standard 4% withdrawal rate may be too ambitious in this case. With the proposed split between living and lifestyle expenses, weighted for a combined success rate of 90%, the simulation shows a withdrawal rate of 3.55% or less would provide more confidence in sustaining their spending needs. The analysis suggests that Harry and June’s financial professional may need to discuss with them the trade-offs and implications of decreasing their spending objectives, delaying retirement and adjusting their portfolio, as well as exploring opportunities to increase their level of protected income to improve their overall confidence in retirement.

Building retirement confidence — one client at a time

Given the many unknowns of retirement, a building blocks framework may help investors better define their retirement income needs. With insights gleaned from this framework and the benefit of professional advice, investors should be able to invest in portfolios that align with their desired lifestyle and legacy goals and objectives as they navigate through retirement. For financial professionals, that means creating portfolios designed to help clients pursue overall income security, meet their essential living expenses no matter how long they live, and invest for a high degree of confidence.

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