Cash Flow Projections and the Viability of Outcomes in Divorce
The more detailed and thorough the analysis of potential outcomes, the better the understanding and predictability of scenario-specific post-divorce cash flow. Cash inflows come in the form of support payments from the ex-spouse, income from employment, loans and withdrawals from savings and investments, and from other sources.
The discussion below focuses on using assets for cash flow. Because of such issues as income needs, limitations on liquidity, taxes, risk management and risk tolerance, this is a complex area in which mistakes are frequently made. Furthermore, the matter of cash flow is often not taken into serious consideration until after an agreement has been finalized and the various elements of the settlement have been set in stone. Ignoring cash flow during negotiations and advising the client to invest solely in money market accounts, certificates of deposit or government bonds — because they are “safe” — will limit inflows and also be subject to inflation risk. Competent and experienced divorce financial planners should be consulted for analyzing and making recommendations about issues such as these.
Determining an Appropriate Withdrawal Rate
Prior to contemplating taking distributions from an investment account, it is imperative that an appropriate rate of withdrawal be estimated. Numerous assumptions and factors play into the determination of what might be an appropriate withdrawal rate. This rate must be customized to the client’s unique circumstances and regularly reexamined in the context of changing market conditions and changes in personal financial position in order to ensure that the client does not outlive the underlying assets.
A common misperception and one that can lead to serious financial consequences is that an appropriate rate of withdrawal is synonymous with an investment’s average total return. Simply put, total return is a combination of income generated and changes in value of the asset. Contrary to popular belief, total return may have little to do with how much income an investment is generating. As an illustration, the stock market has historically grown at an average rate of return of about 9%. While there may be an income component to this rate of return, actual income associated with any particular investment may be anywhere from 0% to 100% of its total return. Total return can also vary greatly, even within certain investments. This is especially true over short periods of time. An investment with an average annual return of 9% may have a very high total return over some time periods and suffer high losses or high volatility during others.
Sequence of Returns
If money is being periodically withdrawn from an account, the sequence of returns is also important. Suppose a client’s post-divorce portfolio has an average rate of return of 9% over a four-year period, the returns broken down as follows: -13 in year 1; 7 in year 2; 11 in year 3; and 23 in year 4. If the client begins withdrawing assets in year 1, the negative effects of the poor returns that year will negatively impact future withdrawals and thus be magnified. If the client continued to make such withdrawals, it would be very difficult for the investment to recover, and the underlying assets could be depleted long before the client had expected.
On the other hand, if the sequence of returns was: 23% in year 1; 11% in year 2; 7% in year 3; and -13% in year 4 — still a four-year average of 9% — the client’s early withdrawals would have a much smaller negative impact on the final account value, and the assets would last significantly longer. Because markets are unpredictable, potential effects of the sequence of returns makes it crucial for the client to regularly monitor a withdrawal strategy. Mid-course corrections may be required, and the amounts withdrawn may need to be adjusted, thereby affecting the client’s overall cash flow.
What Is an Appropriate Rate of Withdrawal?
Numerous assumptions and factors play a role in determining an appropriate withdrawal rate, and each individual has unique goals, sources of income, savings, assets, lifestyle choices, health issues, investment risk tolerances and life expectancies. If assets are going to need to be used to support post-divorce cash flow, the required withdrawal rate and any associated risks need to be carefully considered before the client agrees to a settlement.
In a seminal study 20 years ago, based on a long-term analysis of market performance over overlapping 30-year periods, Certified Financial Planner William Bengen argued that an annual withdrawal rate of 4%, with an annual inflation adjustment, was a safe across-the-board strategy to help ensure assets in a balanced portfolio would last approximately 30 years. This 4% rule has been widely followed for many years and appears to be a good, ut not absolute, rule of thumb. For several reasons — primary among them today’s markedly lower interest rate environment — financial professionals have recently been cautioning that a 4% withdrawal rate might potentially be too high. To avoid an unsustainable withdrawal rate, it is best to be cautious about withdrawals and to monitor both the portfolio and the markets carefully. Also, because today’s life expectancies are substantially higher at the time Bengen conducted his study, the client’s assets may need to last even longer than he had originally considered.
A Word of Caution About Early Withdrawals from Retirement Assets
Although this article focuses on post-divorce cash flow, it does not discuss specific assets and their unique financial properties. For example, although the marital residence is considered to be an illiquid asset with unique tax and financial properties, this does not take into consideration reverse mortgages, which in some situations might be a good source of post-divorce cash flow.
Penalty-free 72(t) distributions can also be taken from retirement assets. This can sometimes be helpful, but because the client will be drawing on assets that might be needed later for support and because the client is sacrificing tax-deferred growth on the money withdrawn, the long-term consequences of such withdrawals needs to be carefully considered.
Importantly, to avoid mistakes, all potential sources of post-divorce cash flow need to be carefully considered during the pre-divorce process, not after the division of marital assets has already been settled.