Taking Back Control of Your Retirement Income
October 24, 2012One of the key issues debated this presidential election season has been Social Security. Regardless of who’s in the White House come January, Social Security is not enough to cover more than the most basic living needs. With the average monthly Social Security benefit of $1,230 only increasing by 1.7 percent next year, this fact isn’t going to change anytime soon. For some, a government or corporate pension may provide additional, regular income. The majority of Americans, however, will have to maximize what they themselves have set aside in their retirement plans to sustain their standard of living throughout retirement.
I spoke with a couple about to retire recently. They told me about all the things they anticipated doing in the next few years: travel, taking some classes at the local community college, becoming more tech-savvy to keep up with the grandkids. A shadow, however, passed over the wife’s face as she mentioned something she was NOT looking forward to in retirement. “I’m going to miss that green envelope,” she said. “Knowing I won’t be seeing it in our mailbox makes me really nervous.”
She was referring to her husband’s monthly pay receipt. For decades, his paycheck had been deposited as regularly as clockwork in their checking account and was the anchor and compass of their financial management. Without it, they felt like they were on their own trying to figure out how much they could withdraw from their retirement reserves – not to mention how to plan for taxes, deciding which accounts to draw from first, and how to invest.
In short, after a lifetime of receiving paychecks on a consistent basis, retirees must shift gears and start creating their own income. However, like my retiree couple, they find the prospect pretty challenging and at times, overwhelming.
To take back control of their financial future, retirees must learn to separate fact from fiction when it comes to generating the income needed for their sunset years. By focusing on actionable goals, retirees will able to maximize their retirement assets. Let’s first get the fallacies out of the way:
One magic withdrawal rate will ensure you will never run out of money.
It’s true that there has been considerable research done on “safe withdrawal rates” — defined as the highest yearly payout from an investment portfolio that will not deplete the portfolio over a given period. So much depends on the parameters used to identify this rate. In some cases, the rate is defined by using historical portfolio returns. In others, variability in investment returns is simulated from current risk data. Generally speaking, however, there is a consensus that a 4 percent annual withdrawal rate is a reasonable payout over the life expectancy of most retirees.
What retirees need to understand, however, is that this rate is not, and should not be, inflexible. There may be years that a higher rate is warranted or necessary – during times when the investment portfolio is doing well or when there are large expenses, perhaps for medical costs.
This is where an annual consultation with a financial advisor works better than a hard-and-fast rule. Each year, The advisor can reevaluate the need for greater or lesser withdrawals from the portfolio, while also considering the longevity of the portfolio in a way that fits the unique circumstances of a retiree’s life.
Safe, income-producing investments can be relied on to create income in retirement.
There are two problems with this assumption. First, it’s too simplistic to think that investments that pay interest or dividends are safe, whereas growth stocks are not. Retirees often confuse regularity with safety. While it is true that bonds, for example, provide predictable income – which to most retirees is the Holy Grail of retirement investing – this does not mean that this income is perfectly safe. Bond issuers do sometimes default, and companies that pay dividends do occasionally cut their payouts to shareholders. However, a far greater risk, associated with bonds in particular, is that inflation will reduce the purchasing power of those regular payments.
Second, in today’s low interest rate economy, it can be difficult to find yields on fixed income investments sufficient to maintain a retiree’s lifestyle. Unfortunately, this drives many retirees in search of higher yields, which carry unacceptable risk.
For most retirees, a healthy allocation to investments that will grow over time, rather than those that promise regular income, is warranted. Today’s growth is needed for higher payouts in the future.
Spending capital from the retirement portfolio is a bad idea.
This advice was handed down to Baby Boomers by their Depression era parents and is, in fact, related to the fallacy that retirees must depend on income-producing investments only. The advice is no longer relevant to today’s retirees, primarily because of tax law changes and the accounts used to save for retirement. Traditional IRAs, 401(k)s, 403(b)s, and self-employed plans are structured, under the tax laws, to be depleted over our lifetimes. In fact, retirees are penalized if they fail to take principal from these accounts at a certain age. Many retirees find the prospect of spending down these accounts very upsetting, when, in fact, doing so under the guidance of a qualified financial professional can result in a far more comfortable, secure retirement.
Now for the facts. Here’s what really matters to a retiree drawing out income from his or her retirement savings:
Taxes matter.
Where taxes really matter is in determining acceptable withdrawal rates. Suppose, for example, a retiree decides he needs approximately 4 percent from his retirement portfolio to cover his annual living expenses. As discussed above, a 4 percent payout is a reasonable (but not certain) rate to ensure portfolio longevity. When, however, this payout is made from a tax-deferred retirement account, the retiree will need to withdraw approximately 1 percent more from the portfolio to cover the tax liability on these withdrawals, making his payout increase to 5 percent. The sustainability of the portfolio over his lifetime may drop considerably at this rate.
What many individuals fail to appreciate in saving for retirement is the importance of using both taxable and tax-deferred accounts. Having the flexibility to choose between the two types of accounts when it’s time to make a withdrawal, and thereby controlling the amount of taxes owed in any given year, can be critical to sustaining the retirement portfolio.
Timing matters.
When a retiree starts taking income from his or her retirement accounts can make a huge difference. As individuals who retired in 2007 or 2008 are all too aware, a bad investment market combined with portfolio withdrawals may diminish the sustainability of those withdrawals by several years. In cases of bear markets, those able to delay retirement and continue earning income rather than consuming assets are in a much better position to avoid running out of money during their lifetimes.
Spending matters more than investments.
Many retirees believe that if they could just get the portfolio allocation and security selection “right,” they will have enough for their retirement. It may surprise them, however, to realize that in the studies done on sustainable withdrawal rates, the allocation of the portfolio providing the withdrawals was not very important to the results. In other words, the amount of fixed income in the portfolio could vary from approximately 35 to 65 percent without significantly changing sustainable withdrawal rates. This suggests the most effective way to ensure that retirees’ resources will last in retirement is for them to focus primarily on expense management.
Taxes, timing, and spending: what matters most in creating income in retirement are, in fact, pretty simple principles. What’s not so simple is coordinating the three. Finding a financial professional can make a big difference here: he or she is trained to take all these factors into account in designing an individual retirement income strategy that makes sense for you.