Having an effective strategy for managing your retirement income is critical. Successful retirement planning should reflect an understanding of the risks you face, how to balance your income and expenses, how and when to make withdrawal choices, and appropriate allocation and diversification of your investment portfolio.
- Step 1: Understand the Risks
- Step 2: Balancing Expenses With Available Retirement Income
- Step 3: Making Withdrawal Decisions
- Step 4: Allocate Your Assets
Even retirement income being drawn down from a sizable retirement nest egg can be impacted by the following risks:
Retirees are living longer. Today there is a 23% chance that at least one member of a 65-year-old couple will live to age 95. And with improving health care, even more people will live to 95 and beyond in the future, according to the Society of Actuaries.
Market volatility. This refers to how much the capital markets and the value of your investment can fluctuate. You may need to invest with short- and long-term goals in mind.
To address short-term income needs, invest a portion of your portfolio in more stable securities, such as bonds and cash equivalents, that carry less volatility over shorter time periods.
Inflation. Inflation has averaged approximately 3% annually over the past 80 years. As a result, the future cost of goods and services that retirees will purchase will continue to increase, eroding the purchasing power of assets set aside to meet these expenses. For example, a lunch that costs about $8 today could set you back more than $14 in 20 years, as you see in the table below.
To help ensure that assets continue to grow at a rate sufficient to last throughout retirement, you should consider investing a significant part of your portfolio in stocks.
Creating a detailed inventory of your sources of retirement income, along with an assessment of expected expenses, is a critical step for effective retirement planning. In a Social Security Administration survey of people age 65 and older, people in the top quintile cited income earned from investments and work as the greatest source of retirement income.
Future income. Since lifestyle is more appropriately adjusted to income rather than the reverse, first inventory your expected sources of retirement income, which may include pension benefits and other employer-sponsored retirement accounts, Social Security income, personal savings such as IRAs, and taxable accounts.
Essential expenses. Make sure your income is sufficient to cover the costs of essential goods and services, such as food, clothing, housing, health care, and any debt repayment that may be incurred before or during retirement.
Discretionary expenses. This is where your choice of lifestyle comes into play. Travel, entertainment, hobbies, and gifts (for example, the education expenses of grandchildren) generally are considered to be the "extras" of retirement spending and can be adjusted depending on how much income you have available.
Rule of thumb. Financial experts recommend that retirees plan on replacing between 60% and 80% of preretirement salary in order to enjoy a standard of living similar to that experienced before retiring.
Once you have a basic understanding of the risks, your sources of retirement income, and expected expenses, you can consider how and when to withdraw your assets.
Determine a realistic withdrawal amount. Withdrawing from retirement assets each year can be influenced by a number of factors, including:
- Life expectancy
- Health concerns
- Desire to leave money to beneficiaries
That's why many financial experts recommend an initial withdrawal amount of 4% of portfolio assets during the first year of retirement, with this dollar amount increasing by 3% annually to adjust for inflation.
Decide when to draw down your assets. You may choose to redeem securities monthly or annually. Either way, you may want to set up a money market account and "pay" yourself monthly.
Which assets to withdraw first. Some rules of thumb to follow for establishing a drawdown strategy to address taxes related to your retirement income.
- Investment selection. When deciding which investments to sell to generate income, first consider securities that have performed best since the last time the portfolio was rebalanced. This will help keep the overall asset allocation of your portfolio in balance and reduce overexposure to one or more asset classes. Of course, the tax ramifications of such a sale should be factored into any decision.
- Taxable accounts. You should almost always sell off taxable securities first because they represent assets that are not sheltered from taxes.
- Tax-deferred accounts. Next, tap tax-deferred retirement accounts funded with pretax contributions, such as Traditional IRAs and employer-sponsored defined contribution plans. Although these assets may grow on a tax-deferred basis, the withdrawals may be fully taxable at your ordinary income tax rate. If you are over age 70½, you may have to start withdrawing assets from these accounts because of the required minimum distribution rules.
- Tax-free accounts. Assets accumulated in tax-deferred accounts funded with after-tax contributions, such as Roth IRAs and Roth 401(k)s, generally should be taken last. Not only is any growth of the underlying assets tax-deferred, but any earnings are distributed tax-free if the accounts have been held for at least five years and you are at least age 59½.
A smart asset allocation strategy is still important. More than ever, it's important to maintain a diversified portfolio. Portfolio allocation is essential to balance the impact of market volatility and inflation on retirement savings. Allocating your portfolio among asset classes such as stocks, bonds, and short-term investments can help you manage short-term market volatility while still providing your investments with growth potential. Of course, no asset allocation can assure a profit or protect against loss in a declining market.
Although shorter-term investments, such as bonds and cash equivalents, offer some protection against market risk, there is also less potential for growth. As a result, stocks should continue to play a key role in your portfolio, with the potential for greater returns helping to insulate the portfolio from inflation and longevity risks, as illustrated in the chart below.