As we prepare to retire, most of us share three common goals. The first is to have sufficient income at retirement to enjoy the lifestyle that we have long anticipated. A second goal related to this is to protect our retirement nest egg and our income from the effects of inflation. Finally, we would all like to protect our assets and to pass them on to our desired beneficiaries.
Rate of Withdrawal vs. Rate of Return
It is important to understand upfront that there is a delicate balance between withdrawing funds to support your quality of life during retirement and the returns that your portfolio generates.
On page 76, two different retirement scenarios are illustrated in the chart noted “The Sequence of Returns Can Significantly Affect Your Retirement.” On the left side, the chart shows that over a 20-year period beginning in 1973, with $500,000 invested in the beginning, along with a 5% inflation-adjusted withdrawal rate, the portfolio is depleted. On the right side, the graph shows that with the same amount of money invested, the same inflation-adjusted withdrawal rate, over the same amount of time, but with the rate of return reversed, the portfolio is solid. Clearly, the rate of return has a tremendous impact on your retirement plans.
The allocation of your portfolio, its performance versus the rate of withdrawal, and the assumed period of time for retirement are all factors that must be discussed and planned for with a financial advisor. Your assumptions for expected rate of return and how you plan around this, will be the most important part of your retirement plan. Below are some of the things you can do as well to prepare yourself for retirement.
Step One: Have an emergency fund.
Whether you are preparing for retirement or not, you need an emergency fund. When was the last time you predicted a roof leak or car repair? The general guideline is to have three to six months of income in this emergency fund in very liquid assets, such as money market funds or cash.
Step Two: Be honest
about what you spend.
Most people underestimate what they spend. Before retirement, you need to take a good look at your budget to establish a realistic goal for what income you will need in retirement. Every retiree needs a different amount of income; however, with our entertainment-driven culture and increasing health care costs, most people wind up needing more money than they realize. While Social Security provides some income, it almost never meets 100 percent of a retiree’s income needs. Based on this fact, personal savings is required in pre-retirement years to achieve higher spending capabilities in retirement.
Step Three: Eliminate credit card or high-interest debt.
When retiring, debt obligations with high interest rates requiring monthly payments can greatly impact your standard of living. If possible, pay off credit cards and auto loans before retiring. You can do this by having a financial planner assist you in calculating the impact of increased payment amounts. A little extra each month can go a long way toward achieving this goal.
Step Four: Learn about investments.
You don’t need to be an expert, but you do need to work with your financial advisor to gain understanding about investments and your risk tolerance. This knowledge should help calm your fears during down markets as you will better comprehend your personal investment plan. Estimates are that 90 percent of your investment return is determined by the asset allocation that is selected. It is, therefore, critical that you and your advisor match your risk tolerance and needs with your investment choices. This process should also minimize the tendency of chasing the best performing asset class or investment over the past year. Rarely is the best performer from one year the best place to be invested the following year.
Step Five: Understand sustainable withdrawal rates.
The term “sustainable withdrawal rate” is used to define the amount of money that can be drawn from your portfolio while minimizing the probability that you might run out of money in your old age. A commonly used sustainable withdrawal rate is about 4 percent of a person’s portfolio value during retirement. As life expectancies and deviations in the market have been increasing, this rate of withdrawal minimizes the chances of running out of income.
Combining a sustainable withdrawal rate along with your portfolio’s expected return is a delicate balance. While essentially all portfolios have declined during this recession, you need to be realistic about what is sustainable based on your asset allocation. If the amount of income that can be drawn from your portfolio is not enough, you may have to delay retirement or cut current expenses to save more in order to achieve your goal(s). Those who are still employed should continue funding their 401(k) and IRA accounts, even during the latter years of employment. The tendency is to stop doing this in down markets, and this is normally a mistake. The purchase of new shares in these plans each month is like dollar cost averaging, and the shares bought at the lowest prices could represent great value going forward.
If you are already in retirement, it is important to re-evaluate your portfolio on a regular basis, such as an annual meeting with your financial advisor. As part of that review during market declines, you may find that a reduced withdrawal is necessary to lessen the long-term impact on your portfolio. It is better to be realistic and have reduced income for a brief period in your life than to ignore the situation and increase the risk of running out of money in latter years. If you are one of the fortunate investors who have an investment with a guaranteed withdrawal or income benefit, your retirement income may not need to be reduced. However, you won’t know if you don’t have the conversation with your advisor.
Regardless of your individual situation, everyone wants to be able to enjoy their retirement years and leave a legacy. Contact a financial advisor to assist you in planning for and maintaining a successful
retirement.