A few weeks ago, I gave you six ways to make your nest egg last.  It’s an important topic, so here’s a seventh: Dynamic Spending.  There’s a growing body of research that shows it can significantly extend the life of your portfolio.  What is it and how does it work?

In retirement, like in your working years, your budget will include both fixed and discretionary expenses.  Fixed expenses are things like food and your mortgage.  Discretionary expenses include things like travel.  In retirement, many of your fixed expenses are gone.  Your house and cars are likely paid off.  The kids are out of college.  You’re no longer saving.  Fixed expenses make up a smaller portion of your budget than ever.  Your discretionary expenses are another story.  Most retirees have a long list of travel, hobbies and other things they want to do.

That type of budget—low fixed, high discretionary—is ideal for dynamic spending rules.  As the name implies, dynamic spending is simply adjusting your spending each year based on how your portfolio is doing.  You establish rules that give you a raise when times are good and cut back a little when times are tough.  The adjustments don’t need to be large to be effective and, as we saw earlier, spending adjustments are easier in retirement because a larger portion of your budget is discretionary.

How it works.

Vanguard did some research in this area and found evidence that dynamic spending rules can greatly improve success.  What they tested was a hybrid distribution strategy that was basically a percentage withdrawal of the previous year’s portfolio value with adjustments based on certain rules.  They would allow the spending to adjust each year based on year-end value, but would limit it to a ceiling and a floor.  This allows your spending to rise as high as the ceiling when times are good and adjust downward as far as the floor when times are bad.

Let’s look at a quick example.  Assume a $1 million portfolio and a 4% withdrawal rate, so the first-year distribution is $40,000.  Now for next year, they would calculate a ceiling and a floor 5% above and 2.5% below that $40,000.  So the ceiling is $42,000 and the floor is $39,000.  Now let’s assume we have a big up market and the portfolio value is $1.1 million.  4% of that would now be $44,000.  That’s above the ceiling, so you limit your withdrawals to $42,000.  What if instead the portfolio had a bad year and it dropped to $900,000.  4% of that is $36,000.  That’s below the floor, so you take the floor amount of $39,000.  Basically, you’re giving yourself a raise during good times or taking a pay cut during bad times, but you are limiting each by predetermined amounts.  This strategy had a 92% success rate vs. the 78% success rate of just taking a dollar amount grown by inflation. That’s a huge jump, all because you set a few simple rules that help ensure you don’t overspend (and risk running out of money) or underspend (and risk not living to the full).

~ Joe

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“Will my money last?”  That’s the biggest concern for most retirees.   What can you do to stretch your retirement dollars for as long as possible?  A recent article in the Journal of Financial Planning (JFP) analyzed six factors and the role each played in portfolio longevity.  (Determinants of Retirement Portfolio Sustainability and Their Relative Impacts, by Jack C. DeJong Jr., Ph.D., CFA; and John H. Robinson).  Let’s take a look at each:

Initial withdrawal rate

The less money you take from your portfolio each year, the longer it will last. No surprise there.  What is somewhat unexpected, however, is that the withdrawal rate that is considered “safe” is shrinking.  Thanks to lower assumed bond rates, the long held 4% rule should probably be renamed the 3% rule for those who need their portfolio to last 30 years.  That’s one conclusion reached by the JFP article and it is backed up by other studies from respected researchers like Michael Kitces and Wade Pfau.  So if you anticipate a long retirement, and you think bond rates will stay near their historic lows, it’s probably a good idea to dial back your initial withdrawal rate.  If, however, you saved more than needed, retire later or have health issues that shorten your retirement (e.g. 20 years instead of 30) the 4% rule will likely hold.

Interest rates

The Fed’s decade long experiment with low interest rates has been great for borrowers, but terrible for retirees. Generating income is harder than ever.  When the initial research was done for the 4% rule, mean bond rates were around 5-6%.  Now they are much lower.  Lower returns mean your portfolio won’t last as long.  It looks like rates will stay low for the foreseeable future.  Plan accordingly.

Asset Allocation

Retirees typically invest in both stocks and bonds so they can balance out the need for growth with the need for stability. What’s the right mix?  Several recent studies seem to suggest that dialing up stock exposure a bit (say from 60/40 to 70/30) might help improve portfolio longevity.  Before taking that advice, however, I think there are three important considerations.  First, what is the likely future return of stocks?  The studies assume a lower return for bonds, but assume future stock returns will be similar to past stock returns.  When stocks are as richly valued as they are now, however, future returns are generally lackluster.  Second, how will you respond in the face of increased volatility?  The studies assume that retirees will calmly ride out any increased volatility from the higher stock allocation.  That flies in the face of what we know from both behavioral finance studies as well as the long running Dalbar study on investor behavior.  Volatility often causes people to do the wrong thing at the wrong time.  Third, how much return do you need?  If you haven’t saved enough, it can be tempting to swing for the fences and heavily overweight stocks.  If you nest egg is adequate, however, it might make more sense to swing for singles and doubles rather than risk striking out.  The takeaway from all this?  Don’t take the added risk unless necessary.  And if you decide to increase your stock allocation, wait for a good opportunity, such as after a market correction.  Stocks will be cheaper and bonds will likely have rallied.

Inflation

Inflation mutes your investment returns and diminishes your purchasing power. For retirees, low inflation is better and will help portfolios last longer.  You can’t control the inflation rate, but it’s helpful to know what it is.  We’re currently in a prolonged period of low inflation around 1-2%.  That can help improve portfolio longevity and offset the lower expected returns discussed earlier.

Investment Expenses

Investment expenses act as a headwind against returns, so it’s important to a) keep them as low as possible and b) make sure the people you hire are adding value. In a large study on the value of advisors, Vanguard concluded: “Left alone, investors often make choices that impair their returns and jeopardize their ability to fund their long-term objectives.”  This type of behavior often leads to “wealth destruction rather than creation.”  Vanguard suggests that advisors can help add value if they “act as wealth managers and behavioral coaches, providing discipline and experience to investors who need it.”  Specifically, they say to look for an advisor who can help with things like asset allocation, security selection, behavioral coaching and distribution strategies.  According to Vanguard, those things are worth about 3% per year in net returns.  In other words, a good adviser creates value, but has reasonable fees.  The JFP article found that portfolio longevity is greatly improved when expenses are limited to around 1%, but diminish significantly when expenses rise beyond 2 or 3%.

Withdrawal Strategy

Distribution strategies come in lots of different flavors, but the goal is usually the same: turn your assets into an income. The JFP article tested 4 different withdrawal strategies: a) spend stocks first, b) constant allocation, c) simple guardrail and d) spend bonds first.  Most of those are self-explanatory except the guardrail strategy.  With that strategy, withdrawals are taken proportionally from stocks and bonds with one exception.  No withdrawals are made from stocks following a down year.  Most retirees use the constant allocation strategy (draw from asset classes proportionally and rebalance each year), but the study found that the two strategies with the highest success rate were spend bonds first and the guardrail.  Both strategies reduce the likelihood that you’ll have to sell assets for a loss during the early years of retirement which, not surprisingly, will help your money last longer.

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When planning for retirement, you need to make a lot of assumptions.  How long will you live?  What will your investment returns be?  How much income will you need?  When it comes to that last one, most people just estimate their first year of retirement expenses and then adjust that amount higher each year to account for inflation.  This seems like a logical strategy.  It’s predictable.  It provides a steady income.  It gives you a raise each year to account for rising costs.  There’s just one potential problem.  New research shows it’s not how the typical person spends money in retirement.

New spending research

David Blanchett, Michael Finke and other academics have studied how spending changes throughout retirement and what they found might surprise you.  Rather than starting at a certain amount and then moving higher with inflation, people spend more in their early years and then gradually decrease spending as they get older.  This trend typically continues until later in life at which point healthcare costs cause spending to rise again.

Why is this important?  First, your retirement plan is driven by assumptions and perhaps the most important assumption of all is how much you need to spend each year in retirement.  If you have that number wrong, your plan won’t be as accurate as it could be.

Second, most people, planners and software assume a static rate of spending in retirement that needs to increase every year with inflation.  If that’s not correct—and real spending gradually decreases instead—then we’re overstating the cost of retirement.  That means you might be able to retire sooner, retire with less or take a higher distribution rate.  Here’s an example to show you what I mean.

In his research, Blanchett found that a household that needed $50,000 in income at age 65 would decrease real spending by about 15% by age 80 and 20% by age 85.  Let’s assume you retire needing $50,000 in income and you plan on getting half of that from Social Security and half from portfolio withdrawals.  Even if your spending goes down, your Social Security won’t, so any spending reductions can be used to reduce portfolio withdrawals.  So if you want to decrease total spending by 20%, then you can decrease your withdrawals by 40%.  That means less strain on your portfolio which, as mentioned earlier, means you might be able to retire sooner than expected, retire with less, or spend a bit more early in retirement when you’re healthy and active, knowing that you’ll decrease spending later.

Applications

There are some important ways that you can incorporate this new spending research into your planning.

Make a Core/Discretionary budget: Not all spending changes equally during retirement.  Certain core spending on things like food and housing will be with you throughout retirement and are more likely to increase with inflation.  It is your discretionary spending—such as travel and entertainment—that will likely decrease as you move through retirement.  To better predict how your spending will change, make a budget that itemizes core spending (e.g. grocery money) and discretionary spending (e.g. travel or a new car).

Shrink core expenses:  Once you know how your spending breaks down, get rid of as much core spending as possible before entering retirement.  Housing is the largest retiree expense and more and more people are retiring with mortgage debt.  This is especially easy to justify in a low rate environment.  But the downside of servicing a mortgage in retirement is that you’re not servicing it from your paycheck, you’re servicing it from your investment portfolio.  If your portfolio drops, you still need to pay your mortgage.  That means selling into weakness and increasing your odds of running out of money.  Core spending is riskier because there’s little flexibility.  Discretionary spending, however, tends to decrease as you move through retirement and you can adjust it if necessary (e.g. postpone your vacation if the market drops).

Rethink your distribution rate:  In Blanchett’s research, he found that a 4% initial withdrawal rate over 30 years under the constant spending model has the same approximate probability of success as a 5% initial withdrawal rate if spending changes as discussed earlier (assuming $50,000 in initial spending).  If you can take 5% instead of 4%, then you would need 20% fewer assets when you retire.  For example, a 4% withdrawal from a $1,000,000 portfolio gives you the same dollar amount as a 5% withdrawal from an $800,000 portfolio.

Stay healthy:  Obviously you can’t prevent all illness, but do everything you can to be healthy.  This will improve your odds of a long, active retirement and can delay or even eliminate some of the health costs that cause spending to rise later in retirement.

Insure against rising costs:  You might be asking, “Why do health costs rise later in retirement?  Doesn’t Medicare cover those expenses?”  Medicare covers a lot of things, but with very few exceptions, long-term care—where you need help caring for yourself—is not one of them.

What are the chances you’ll need this type of care?  Seventy percent of the people who reach age 65 eventually require some form of long-term care.  Those are good odds.  It reminds me of the time I picked up a rental car in Dublin.  I found out the car was a stick, the steering wheel was on the right, you drive on the left, and the place we were going only had single lane roads.  The guy behind the counter asked <insert Irish accent> “Are ya gonna be wantin’ the insurance today then?”  “Yeah,” I said.  “Better give me everything you got.  There’s a good chance you won’t be seeing that car again.”  The lesson?  Insure against bad things that are likely to happen.

Enjoy life:  There’s a good reminder embedded in the research we’ve been discussing.  If spending decreases as you move through retirement, then for whatever reason, the typical retiree is doing less—either by choice or necessity—at 75 than at 65 or at 85 than at 75.  If you retire at 65 and stay healthy and active until 75, then you’ve got 10 years to do everything you’ve been putting off for the last 40.  That’s not much time.  Be ready to hit the ground running when you retire.  Yes, that means the early part of your retirement will be a little more expensive, but if incorporate this new spending research into your plan with the help of a competent adviser and the results hold up, then you should be in good shape.

~ Joe

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Not long ago, most people worked as long as they were able and eventually either “died in harness” or relied on younger family members to care for them in their old age.  And then along came this idea of retirement where through hard work, shrewd investing and some help from a pension (if you’re lucky) and Uncle Sam, you could hang up your work boots a little early and spend your golden years enjoying a bit of leisure and fun.  But for most people, the math of retirement only works if they’re able to earn some interest on their savings.  That is a challenging task in a world where Central Banks the world over seem to have declared war on savers.  What does this mean for the long term viability of your retirement?  In other words, are low interest rates ruining retirement?  More importantly, what can you do to keep your plans on track?

The 4% Rule

Back in the early 1990s, a financial adviser by the name of William Bengen did research on sustainable portfolio withdrawal rates.  Assuming an asset mix of half stocks and half bonds, he back tested withdrawal rates against historical 30 year periods in the market.  His conclusion was that if you wanted your portfolio to last 30 years, the maximum withdrawal that you should take each year is 4%.  That rate has worked well for millions and many assume it will continue to work great unless future returns are significantly worse than past returns.  Enter the Central Banks.

ZIRP and NIRP

The global economy has been stuck in slow growth mode since recovering from the near death experience of the 2008 financial crisis.  To stimulate growth, Central Banks around the world lowered rates to pretty much zero and engaged in endless rounds of quantitative easing.  When that didn’t work some of them started adopting negative interest rates.  That’s right, zero apparently wasn’t low enough.  Now they’re moving to negative.  ZIRP (zero interest rate policy) has given way to NIRP (negative interest rate policy) in countries such as Denmark, Sweden, Switzerland and Japan.  The logic is to force banks to lend, weaken currencies to help exports and stimulate economies.  Not surprisingly, there are a lot of people who think these policies could come with some pretty significant unintended consequences, not the least of which being that it will be pretty tough for savers, pension funds and governments to meet those future withdrawal needs if large portions of their bond portfolios are earning zero instead of the 4%-5% that history has taught us to expect.

The $64,000 question (more like $64 trillion) is whether or not these low interest rates will derail retirees and the portfolios, pensions and Social Security program that they rely on to fund retirement.   I can say with certainty that…it depends.  If these low rates are an anomaly and they eventually return to normal, then the 4% rule of thumb that retirees rely on and the return assumptions that pensions rely on can continue to work.  But if they stay this low for a long time, then retirement as we have come to know it is at significant risk.  Which will it be?  My gut tells me that rates will eventually rise and the 4% rule will continue to work, but it makes sense to plan for the worst even while hoping for the best.

What to do

There are several levers you can pull in order to improve your odds of success.  Some are better than others.  One side effect of ZIRP has been to force people into riskier investments in search of returns.  That works great until it doesn’t as we saw recently when markets rang in the New Year by plummeting.  Another side effect of ZIRP has been to encourage individuals, companies and countries to take on more debt.  That can also work for a while, but debts eventually needs to be repaid.  Are there better options?

Draw less.  If a 4% withdrawal rate is too high, the most obvious way to protect yourself is to take less than 4%.  I have some clients that are taking 2%-3%.  Some are even taking 0% because their pension and Social Security cover their expenses.  There is an extremely high probability that those taking less than 4% will be fine even if rates stay low for a long time.  Of course drawing less only works if the amount you’re taking is enough to cover your expenses.  That might mean you need to…

Cut retirement expenses.  Examine your retirement budget for items you can reduce or eliminate.  Housing and transportation are often major expenses. Consider downsizing to a smaller home or sharing a car with your spouse. Staying active and healthy can save on health care co-pays and prescription costs. Substituting planned hobbies or activities with less expensive alternatives also can trim costs without significantly changing the quality of your retirement.  Taken cumulatively, these adjustments to your retirement budget can help reduce the strain on your nest egg and still provide a meaningful retirement.

Save more.  Spending less is one option, but you could also improve your chances if you save more (assuming you’re not already retired).  Recent research by Aon Hewitt and others shows that a person will need Social Security plus savings worth about 11-12 times their annual income in order to fund their retirement.  If interest rates stay low, that multiple will be higher.  If you are still working, make saving a high priority. Both 401(k)s and IRAs have higher contribution limits for people over 50. Take advantage of those limits by putting away as much as possible. The maximum 401(k) contribution for 2016 is $18,000 plus an additional $6,000 if you’re over 50. IRA contribution limits are $5,500 plus an additional $1,000 if you’re over 50.  Extra additions to your portfolio could significantly improve your financial position in retirement.

Pay off debt.  As I mentioned earlier, one of the unfortunate side effects of low interest rates is that the Fed is punishing savers and encouraging debtors.  Debt can make sense if it’s used to purchase an asset that generates income such as a new computer for the office or a college education.  Last I checked, however, a $60,000 SUV or a gourmet kitchen aren’t income producing asset for most people.  When used unwisely, debt adds risk and reduces cash flow. Those things are especially troublesome to someone in retirement.  By retiring debt free, you can greatly reduce the amount of savings necessary to fund your retirement.

Work longer.  Working longer may not sound fun, but neither is running out of money. If low rates reduce the viability of your retirement plan, one option is to keep working and earning a paycheck. This strategy has multiple benefits: it allows you to save more, it gives your portfolio more years to grow, it could help boost your potential Social Security benefits and it decreases the overall amount of income you need to draw over the years. Of course this assumes that working longer is an option.  Don’t put all your eggs in that basket in case your health doesn’t cooperate or your job skills don’t translate well in a changing world.

Delay Social Security.  If you delay collecting Social Security until after your full retirement age, you will get a permanent increase in your benefits. The increase is based on the year you were born. For example, those born after 1943 will get an 8% credit for each year they wait. The increase caps out at age 70, but waiting until then will increase your benefits significantly.

Obviously, we have to deal with the world as it is, not how we want it to be.  When I started my career, you could buy a 1 year CD yielding 7%.  That made retirement planning much easier.  Now you’re lucky if you can get 1% on that same CD.  That’s just the world we live in and there’s a chance that it could persist for some time.  Plan accordingly and you’ll greatly improve your odds of retirement success.

~ Joe

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Some people have the time, temperament, knowledge and discipline to handle their own finances, while others could use a little help.  Regardless of which category you fall into, you should seriously consider hiring an adviser to help you when it comes to retirement.  Why?  Because the financial issues facing a retiree are very different than the financial issues facing a pre-retiree.

Whether we do it or not, most of us are at least familiar with the concept of saving.  Saving is a pre-retirement issue.  We’re usually less familiar with concepts like cash flow management, determining how much we need to retire, pension payout options, retirement plan distributions, estate planning, maximizing Social Security, researching and obtaining health insurance and the tax consequences of certain distribution strategies.  Those are post-retirement issues.  Those are issues that most of us don’t deal with very often, so getting a little help is probably a wise move.

Retirement Quiz

To help people evaluate their retirement knowledge, The American College of Financial Services recently developed a retirement literacy quiz.  They gave the quiz to 1,019 Americans ages 60 to 75 who had at least $100,000 in assets.  How did they do?  Eighty percent of the people failed.  Ouch!  Fourteen percent got a Gentleman’s D.  Less than one percent got an A.  Those results reaffirm the point I was making earlier.  Most people aren’t familiar with the types of financial issues that they will be dealing with in retirement and could benefit from some help.

I’d encourage you to take the retirement quiz and see how you do (Full Disclosure: I got 100%, but hey, this is what I do for a living!).  Hopefully long time readers will do better than most since I’ve written on many of the topics before, but if you miss your fair share, consider reaching out for some help.  Maybe that means hiring an adviser.  Maybe it just means browsing past articles in our Archives or picking up a resource from our Store like The Ideal Retirement Design Guide.  Bottom line: get some help if you need it.  Don’t let mistakes derail your retirement.

~ Joe

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Will retirement be cheaper than you think?  Maybe.  A lot depends on your income replacement ratio.  What’s that you ask?  It’s the percentage of your current income that you will need during retirement to maintain your standard of living.

Some people will need 100% of their current income.  Others will be able to get by on less.  Ironically, the more money you make now, the lower your income replacement ratio will likely be.  That’s because you probably aren’t using all of your current income for expenses that will still exist during your retirement years.

Here are three major expenses that will likely disappear from your retirement budget:

Savings:  Retirement is a shift from the accumulation phase to the distribution phase.  That means no more 401(k), IRA or savings account contributions.  How much are you saving now?  Five Percent?  Ten?  Fifteen?  Once you’re no longer saving, you won’t need that income.

Payroll taxes: Looking at the glass half-empty, retirement means no more paycheck.  Looking at the glass half-full, that also means no more Social Security and Medicare taxes on your earned income.  Right now you’re paying a 6.2% Social Security tax on your first $114,000 in income and a 1.45% Medicare tax on all your income (7.65% total or twice that if self-employed).  And if you’re a high-wage earner ($200,000 for singles, $250,000 for couples) you’re paying an additional 0.9% Medicare surtax.  Those taxes go away when your earned income goes away.

Work expenses: Think of all the expenses you have that relate to your job: commuting, dress clothes, expensive lunches, a second car.  Most of those expenses can be reduced or eliminated in retirement, which is probably the equivalent of hundreds of dollars each month that you can cut from your budget.

If I apply those three items to my own budget, I could eliminate more than a quarter of my expenses.  How about you?  How much could you get rid of?  I’m guessing the amount is significant.  If you’re able to pay off your house and retire debt free, you could eliminate even more.  To be fair, you’ll also have some expenses that get added to your budget during retirement (e.g. travel, hobbies, etc.), but those likely won’t outweigh the cuts.

A common rule of thumb for your income replacement ratio is 85%.  David Blanchett, head of retirement research at Morningstar, thinks that most people will be able to get by on less.  Whatever the number, it is the primary driver of how big your nest egg needs to be.  Shave 20% from your income replacement ratio and you’ll be able to shave 20% from your nest egg, which means you could save less and retire sooner.

Start Today

One of the benefits of the exercise above is that it shows the direct link between expenses and retirement.  The less you need, the sooner you can retire. Remember that your ideal retirement is not about age or work status.  It’s about control.  It’s a gradual shift from doing what you have to do to doing what you want to do.  One way to speed that shift is to save more, but equally effective (and often overlooked) is to need less.

~ Joe

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If you spend a good portion of your day in a building like an office or a school, chances are good that you’ve participated in a fire drill.  Those faux escapes give everyone a chance to practice evacuating the building and give those in charge an opportunity to identify and fix any potential problems.

If retirement is on your horizon, it would probably make sense to do something similar.  Call it your “Retirement Fire Drill.”  After all, sometimes you get to choose when you retire, sometimes (through illness or layoffs) you don’t.  It’s good to be prepared.

So let’s sound the alarm and pretend that today is the day that you’re transitioning into the next phase of life.  How will the planning you’ve done so far hold up in the real world?  Below are 5 areas to test.

Is your budget going to work?

You have made a retirement budget haven’t you?  If not, download our free retirement budget worksheet.  What will your sources of income be once your paycheck stops?  Do you have a realistic estimate of how much that income will be?  How about expenses?  Some people say you can live on about 70 percent of your preretirement income, but is that realistic for you?  There’s only one way to find out.  Practice living for a few months on the income and expenses that you’ve projected.  Then reexamine your budget and see if anything needs to change.  If it didn’t work for a 2 month trial, it probably won’t work for a 20 year retirement.  Take what you learned and make adjustments as necessary.

Is your asset allocation going to work?

If you retired today, how would your investments fare if we had another downturn like 2008?  Are you invested too aggressively?  Or how about if we got into a period like the late 1970s and early 1980s when inflation increased by double digits each year.  Are you invested too conservatively for your retirement income to keep pace?  Shocks to your portfolio early in retirement greatly increase your chances of running out of money.  You can minimize that risk by having your asset allocation correct and by setting aside a year or so of retirement income in cash so you can draw from that, rather than your investments, in the event of a downturn.

Is your health care going to work?

You won’t be eligible for Medicare until 65.  Are you planning on retiring before that?  If so, how are you planning to bridge the gap?  Even if you wait until 65, do you have enough set aside to pay for the premiums and co-pays required under Medicare?  Have you budgeted in the cost of a Medicare supplement policy?  Are there any health care issues (e.g. dental work, operations) that you should take care of now, before transitioning into retirement?  And what about long term care?  What if you or your spouse became disabled or needed ongoing professional care?  Do you have a plan to pay for that care that doesn’t include spending down all of your assets and leaving the healthy person in a financial bind?

Is your income strategy going to work?

If you and your spouse are 65, there’s a 72 percent chance that one of you will live to age 85.  There’s a 45 percent chance that one of you will live to age 90.  Will your income last that long?  Are you taking a sustainable amount from your investments each year or are you in danger of running out of money because you’re taking too much?  Will part or your income (such as a pension or Social Security) disappear when you or your spouse dies?  Can the surviving spouse live on the remainder?  Rework your budget to factor in one or more of those income shocks and then think about how you would respond.

Is your estate plan going to work?

If you plan on moving to a different state, have you checked with your attorney to see if your will and estate plan documents will be valid in the new state?  What if you became disabled or incapacitated?  Do you have powers of attorney that specify who takes charge?  If that person is your spouse, what happens if he or she dies before you?  Does your will reflect your current wishes?  Do you have the correct beneficiaries listed on accounts and insurance policies?  Are your documents organized and easily accessible?  Do everything you can to have your affairs in order.

How did you do?  If you encountered a few problems, don’t worry.  One of the great things about a drill is that it’s just practice.  Take the information you learned from the fire drill and tweak your plans to give yourself a better outcome.  That way you’ll be ready when the real alarm bell sounds.

~ Joe

I originally published this article at www.fpanet.org.

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Your 401(k) is a great tool for accumulation, but it’s probably not the best place to leave your money once your goals shift to distribution.  After retiring, it usually makes sense to roll your money out of your 401(k) and into your IRA.  Here’s why:

Simplification.  The average person changes jobs several times over the years.  That could mean multiple retirement plans at former employers in addition to your IRAs and other investment accounts.  During retirement, you will need to begin drawing money from those accounts.  The more accounts you have, the more complicated that becomes.  If you have multiple 401(k)s, roll them into an IRA.  If you have multiple IRAs, consolidate them into a single account.  Doing so will cut down on paperwork and expense and will make your distribution strategy easier to manage.

More choices.  Your 401(k) likely has a limited number of investment options.  That’s not the case in your IRA, where you can invest in pretty much any stock, bond, mutual fund or ETF.  More choices typically means more money, because you can choose funds with better performance and lower expenses.

More control.  When it comes to accessing your money, your IRA has fewer limitations and rules than your 401(k).  For example, you can take penalty free early withdrawals from your IRA for things like higher education or certain medical bills.  In addition, your 401(k) may have restrictions on how often you can make changes to your investment allocation. Finally, most people prefer to call the shots on their account rather than having to deal with their former employer every time they need to make a change or take a distribution.

Better beneficiary options.  Your 401(k) will typically require you to list your spouse as the primary beneficiary unless he or she consents to you naming someone else.  That can complicate planning for those in their second marriage who want to keep certain assets separate.  Also, if your spouse dies first and you haven’t named someone else, the 401(k) will typically default to your estate when you die.  That can result in unwelcome tax consequences.

With an IRA, you can name anyone as your beneficiary and that beneficiary has more distribution options than they would if they were inheriting from your 401(k).  With the IRA, they can choose to distribute the money over their lifetime, rather than being forced to take it all at once as with the 401(k).  That can spread the taxes out over many years.

Easier Required Minimum Distribution (RMD) calculations.  When you turn 70 ½, you are required to begin taking minimum amounts from your IRA and 401(k) accounts.  The fewer accounts you have, the easier it will be to calculate the correct amount and take the proper distribution.  Make a mistake and you will owe a big penalty to the IRS.

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I met with a prospective new client this week and he asked me the question I get asked by most people during introductory meetings:

“When can I afford to retire?”

We spent about an hour working through some numbers and coming up with the answer.  I thought seeing a real world example would be helpful to some of you, so I asked him if I could share the details as long as I kept his name confidential.  Here are the basic facts:

• He and his wife are 61 years old
• He has worked for his current employer for 41 years
• His 401(k) is worth around $700,000
• They have another $600,000 in savings and investments
• His estimated Social Security benefits are $1,900 per month if he retires early at 62 and $2,500 per month if he waits until full retirement age at 66.
• His wife does not work outside the home and has not qualified for Social Security
• Their house is paid for and they have no other debt
• They need an income of $60,000 per year in retirement

Step 1 in deciding when to retire is answering the question “How much income do I need?”  As George Foreman said, “The question isn’t at what age I want to retire, it’s at what income.”  In this case, the client (Let’s call him Jim) wants to have about $60,000 per year gross (i.e. Before taking out taxes).

Step 2 is figuring out where that money is going to come from.  If Jim retires at 62, he will get $1,900 per month from Social Security.  That’s $22,800 per year.  He wasn’t expecting his wife to receive any Social Security because she hadn’t worked the 40 quarters required to qualify.  Needless to say, he was happy when I told him that she qualifies for a spousal benefit.  Spouses are entitled to receive the higher of their benefit (in this case $0) or half their spouses benefit (in this case $950 per month).  That adds another $11,400 in income per year.

So they need a total of $60,000 and $34,200 of that is coming from Social Security.  That means their personal investments will need to generate the remaining $25,800.  Is their nest egg up to the task?

They have a total of $1,300,000.  As we have discussed here many times before, research shows that a safe withdrawal rate from a portfolio is around 4 percent.  Taking a 4 percent withdrawal from their portfolio would get them about $52,000 per year, which more than covers the $25,800 they need.  So looking at the numbers, Jim and his wife could afford to retire at 62.  But should they?  I advised him to seriously consider waiting a few years.  Here’s why:

• They will almost certainly need more income than they are expecting.  Jim told me that his $60,000 estimate is the absolute minimum they’d need to maintain their lifestyle.  If anything unexpected happens and they need to draw more, they could run out of money sooner than expected.
• They are both in good health and have parents that are alive and in their nineties.  Given their health and family history, there’s a good chance that they will live for a long time.  If that’s the case, their money needs to last.  Working for a few more years not only gives them a chance to save more, but also means that they won’t be drawing income from their savings yet, which will help it last longer.
• The breakeven point on their Social Security (where it makes sense to wait until full retirement age to claim benefits) is about 12 years.  That means if they plan on living past age 74, it probably makes sense to wait to begin collecting benefits until full retirement age rather than taking a reduced benefit at 62.
• Another potential reason to wait is health care.  Right now, Jim’s employer pays the cost of his health care, but that would stop if he retires.  Since he and his wife won’t be eligible for Medicare until age 65, retiring now would mean either going without health care or paying out of pocket for coverage.  To continue his current coverage using COBRA would be about $900 per month.  Waiting to retire until they are eligible for Medicare would eliminate that expense.
• Finally, we’re living in an uncertain time.  Inflation is tame now, but could easily get much worse.  The markets are volatile.  Interest rates are low.  All of these things can damage a portfolio’s ability to generate enough income.

Conclusion: Jim and his wife can afford to retire now, but as long as they’re in good health and Jim is relatively happy at his job, waiting could greatly increase their security during retirement.  I hope that example helps shed some light on the process of deciding when you can afford to retire.  Touch base if you have any questions or if there’s ever anything I can do for you.

Joe

The post Case study: When can I retire? appeared first on intentionalretirement.com.

(Note: This is Part 3 in a 3 part series that I did for the Omaha World Herald on retirement planning for different life stages.)

To state the obvious, farming and cooking are two different things.  One is about creating.  The other is about consuming.  A similar relationship exists between preparing for retirement and being retired.  One is about filling the barn—your 401(k), IRA, pension, Social Security credits, etc.—and the other is about emptying it by using what you created to provide for your needs.

That transition—from accumulation to distribution—has a lot of moving parts.  Any missteps can impact your retirement for years to come.  Taking too much too soon from the wrong accounts or in the wrong markets can be the difference between retirement bliss and retirement blunder.  So what can you do to improve your odds of success and get your retirement off on the right foot?  Begin by asking yourself the following four questions.

How much do I need?

Before you can begin drawing income, you need to figure out how much you’re going to need.  Your costs will largely depend on the lifestyle you choose to live, so start by thinking about what you have planned for retirement.  Do you want to travel?  Are you planning on moving?  Is there a particular hobby you want to focus on?  Once those decisions come into focus, it will be easier to craft a detailed retirement budget.  To help with this process, you can download a free Retirement Budget Worksheet at www.intentionalretirement.com/resources/.

Where is it going to come from?

Once you have a good handle on your expenses, determine what percentage of them will be your responsibility.  Start by making a list of all of your potential income sources.  Social Security and Medicare will likely do some of the heavy lifting.    If you are lucky enough to have a pension, it will cover another portion of your expenses.  If you plan on working part-time or have some other source of income, list that as well.  Using this information, fill in the blanks to the equation below.  The difference between your total need and the income provided by things like Social Security and your pension is the amount that you will need to draw from your nest egg each year to fund your retirement.

Is my nest egg up to the task?

Now that you know how much you need and where it’s going to come from, you can determine if your nest egg is up to the task.  When you retire, your portfolio takes over the job that the payroll department handled during your working years.  If you retire at 65 and live until you’re 85, it needs to cut you 240 monthly paychecks.  There is no foolproof answer for how much you can safely draw from your portfolio each year, but much of the research points to around 4 percent.

With that in mind, grab a calculator and divide the number you came up with in the previous question by your total retirement assets.  If the result is less than or equal to .04 (4 percent), you’re in pretty good shape.  If it is greater than .04, it should raise a red flag.  All is not lost, but some changes are likely in order.  To avoid running out of money, you may need to save more, work longer, work part-time, or cut retirement expenses.

What is my withdrawal strategy?

The last piece of the puzzle is to decide on a withdrawal strategy that is right for you.  There are a number of ways to draw from your accounts.  You can take dividends only, convert all or a portion of your accounts to guaranteed payments by purchasing an annuity, or structure the accounts to self-liquidate over your lifetime, to name a few.

The strategy that I prefer is often referred to as the bucket strategy.  Done correctly, it gives you the most flexibility and greatly increases your chances of outliving your money.  It involves structuring your investments into different “buckets” that you can pull from at different times or under different conditions.

For example, you would have one bucket that contained several years of needed distributions in a very safe investment like a money market or certificate of deposit.  In another bucket you would have riskier investments like your stocks and bonds.  In still another bucket, you would have your tax advantaged investments like your IRA or an annuity.

The idea is to pull your distribution each year from the most appropriate bucket.  If you retire just prior to a bull market, you can pull income from your growing investments.  If you retire on the cusp of a bear market, you can take withdrawals from your cash.  The safe bucket keeps you from being forced to sell your riskier assets in a declining market.  The risk bucket increases your odds of outpacing inflation.  The tax-advantaged bucket allows you greater control over your tax bill.

The primary advantage of this strategy is that it gives you options.  If you, your spouse, and your advisers are able to evaluate those options and make distribution decisions each year that accrue maximum benefit to you, you are likely to see a significant increase in the amount of money you can draw from your portfolio over the years without a commensurate increase in your risk of running out of money.

Monitor and adjust

No matter which distribution strategy you choose, you should never “set it and forget it.”  Take time each year to meet with a trusted adviser for a periodic portfolio check-up.  This is especially critical during the early years of retirement when your sequence risk (the risk that you will retire and begin withdrawing money during a period of low or negative investment returns) is highest.  Some questions you should consider during your annual review:

• Is your withdrawal rate sustainable?
• Is your income still sufficient and keeping pace with inflation?
• Is your asset allocation still appropriate?
• Is the amount of risk you’re taking still suitable?
• Has the value of your assets changed significantly?
• Has your life expectancy changed?

Your answers will help determine if you can keep your withdrawals the same or if a change is in order.

Keep in mind that anyone can retire.  Staying retired is the challenge.  By crafting a well thought out distribution strategy you can help ensure that your resources will see you through your retirement years.

The post How to turn your savings into an income stream appeared first on intentionalretirement.com.