RMD Strategy: Asset Allocation of RMDs
Even if you have oversaved for retirement, once RMDs begin, you must withdrawal funds every year. What should your asset allocation be given RMDs, and how much “Safe Money” do you need because of RMDs?
Do you want to avoid selling equities when they are down? If the market has crashed an you have to take your RMD, it might be nice to have some “Safe Money” you can withdrawal instead of selling stocks.
How much Safe Money do you need in your pre-tax retirement accounts (henceforward called IRAs) in order to prevent RMDs from forcing you to sell low?
We know the market can be down for a long duration before it recovers. Since you are forced to take distributions, what percentage of your pre-tax retirement accounts do you need in “Safe Money” (cash and bonds) in order to not to sell equities when they are down?
How Do you Calculate RMDs?
The RMD calculation changes in 2022. Have a look:
Above, you can see “old” and “new” RMD calculations starting at age 72. This is the uniform life table which is updated for 2022; most folks use it to calculate their yearly RMD percentage.
You can see the “old” RMD factor at age 72 is 25.6, and the “new” one is 27.4. This means you used to be forced to take 3.91% of your pre-tax money at age 72, and now it is 3.65%. Not a big difference, but it is a 6.65% decrease.
The new uniform life table takes into account the fact that folks are living longer, and thus “need” to withdrawal at a slower pace to account for longevity. Of course, most folks take out more than their RMD every year… but those folks are not my typical audience.
Now that we know the new RMDs in 2022, let’s next discuss sequence risk and how much safe money you might want in your pre-tax retirement accounts.
Sequence Risk and RMDs
If you have oversaved for retirement, you may aggressively invest in your IRA.
While you should de-risk prior to retirement, if you don’t “need” the money, then you can invest aggressively in your 70’s and 80’s for your kids or charity. As I say, at that point, asset allocation concerns the trade offs of sleeping well at night vs making the kids rich…
That said, since you are forced to take out RMDs every year (whether you want to or not), there are unique sequence risk considerations.
Normally when we talk about Sequence of Returns Risk, we are talking about the 5 years before and 10 years after you start portfolio withdrawals in retirement.
Here, we are talking about forced pre-tax distribution due to RMDs. These are fully taxable.
If you are forced to sell equities when they are down (because you have no “Safe Money” in your IRA—after all you are aggressively invested since you don’t need the money), then a couple of bad years might impede the overall returns.
So, if you must take out 30% of your IRA in the next couple of years, should you have at least that amount in “Safe Money,” or is it ok to be 100% stocks? How much safe money do you need as a result of the forced RMDs, and what should your asset allocation be due to RMDs?
Let’s answer that question in a second, but first, is RMD sequence risk an issue of fungibility or of taxes?
Consider the fungibility of your IRA and brokerage accounts for a second.
Wait, What About the Fungibility of Money in my IRA and Brokerage Account?
I might lose some people here, but that’s ok. Skip this section if you aren’t a nerd.
When RMDs force you to sell pre-tax equities when they are down, you cannot “just” adjust your overall asset allocation to make up for it.
Yes, money is fungible, and, actually, the inverse of the above is true. But while your brokerage account is fungible with your IRA, your IRA is not fungible with your brokerage account because of taxation.
First off: If you are forced to sell equities from your brokerage account when the market is down, you can just adjust your overall asset allocation and be just fine. Fungible.
As an example, think about this for a second:
You need cash from your brokerage account, but it is 100% equities (as you might see if you have a good asset location strategy). If the market is down, and you sell stocks low, aren’t you committing the cardinal sin of investing by selling low and locking in losses?
No, not really. Say you have bonds in your IRA. You can exchange some of those bonds into stocks at the same time you sell the stocks in your brokerage account. So you have sold stocks, and then sold bonds and bought stocks. That is [(-) stocks plus (-) bonds plus (+) stocks] which works out to just selling bonds!
[The dark underbelly of fungibility is that you actually must calculate the after-tax equivalence to get your asset allocation exactly the same as before, but that is complicated and most don’t bother… If you want to bother, you might decrease your brokerage account by your capital gains rate and decrease your IRA by your effective tax rate, and then adjust your asset allocation accordingly, but then your head might explode.]
But it is not the same if you are FORCED to take RMDs instead of choosing to take money from your brokerage account.
With RMDs, if you sell stocks low but yet you don’t need the money, you can just turn around and buy those same equities in your brokerage account with the liberated money.
The amount invested, however, actually is decreased by your marginal tax bracket (rather than effective) as, since you don’t need the money for expenses, they are the last dollars out of your IRA. Moreover, since you are practicing good asset location hygiene, you don’t have bonds just sitting around in your brokerage account that are fungible.
If I haven’t lost you by now, then you are smarter than me for sure.
But the long and the short of it: Since RMD’s increase over time, even if you don’t need the money, you should have more Safe Money in your IRA as you get older. This is as a result of the fact that when you are forced to sell equities low (and then pay marginal taxes on them) only to re-invest the money in a taxable brokerage account, you will never catch up because of the taxes. Not fungible, even if we use after-tax equivalence.
If you are still with me, I would love to hear what you think about this section. Are unneeded RMDs fungible? What say you?
Regardless, I hope you agree that Safe Money is needed in an IRA once RMDs commence.
The question is next: How Much?
Asset Allocation in Your IRA as a result of RMDs
This is simple math. How much safe money do you need in your IRA because you must take RMDs? Well, we know the amount you have to withdrawal every year (it is above), but the question is: how many years might the market be down?
To answer this question, we need to know the duration of the average drawdown. How long do drawdowns last?
How Many Months is the Average Time to Recovery from a Drawdown?
Let’s start simple. Above, you can see the performance and length of Corrections and Bear markets.
Recovery from a drawdown takes 22 months—call it two years—on average.
Let’s dig in a little more.
How Long do Bear Markets Last?
Above, you can see some bear markets are extremely short (3 months in ’87, ’90, and even shorter than that in March 2020).
We remember well the 2000 and 2008 wrecks; they lasted 31 and 17 months respectively.
This number (duration) is from the top to the bottom. After that, we still need to get back to breakeven!
What we are interested in: how long does it take for the market to recover?
How Long does Recovery Take?
Instead of the duration, see the recovery period, above.
Remember the bear market lasted just 3 months in ’87 and ’90? Well, how long did it take to get back to zero? That is, how long did it take for the stock market to recover the lost value during the bear market?
You can see 19 months and 5 months for ’87 and ’90, respectively.
And for 2000? The bear market lasted 31 months but took 55 months (4.5 years) to recover. And in 2007, even though the bear market was shorter (17 months), it took 65 months to recover (5.4 years). The longest recovery is in ’73 at 5.75 years.
So, in summary, on average it takes about 2 years to recover, but it may take up to 5ish years.
And this is, remember, historical data rather than predictions about the future.
So, How Much Safe Money do You Need in Your IRA?
So, in summary, you need 1, 3, or 5 years of RMDs kept as safe money to prevent you from selling equities when they are down.
One year if you are extremely aggressive and don’t want a lot of cash and bonds in your IRA. One year of safe money is, of course, easy to calculate. If equities are up when you take your RMD, just sell enough to meet your RMD and a little extra to account for the increase in RMD next year. Have one year of cash or bonds (or even long-term bonds) that slowly increases over time as your RMD increases.
If you are more moderate (and understand that this is, in toto, a super aggressive strategy to begin with), you might have 3 years of RMDs in Safe Money.
If you are conservative, consider 5 years of Safe Money.
Here is what you need: (at stated age, 3 year or 5 years of RMDs require this percentage in safe money)
- 3y 11.36%
- 5y 19.65%
- 3y 15.53%
- 5y 27.14%
- 3y 26.16%
- 5y 46.60%
In summary, even if you can tolerate a high equity allocation in retirement because you don’t need the money, you might want to decrease your asset allocation over time to prevent you from selling equities low.
This is the “Safe Money” in your IRA. Since you are forced to take the money out, it has a unique sequence risk as you get older. As stated with incredible perspicacity above, this is due to tax issues rather than fungibility concerns. (I’m happy to be proven incorrect on the topic.)
But beyond a point, there is a theoretical risk that you could wind up with less money if you are too aggressive in your IRA and don’t account for RMDs during a bear market.