The big day has finally arrived. No more waking up early to battle your commute, keeping up with endless emails, fighting to make it to the top of the corporate ladder or leaving the office at 7 p.m. You finally made it to retirement with a sense of security that your assets will provide you enough income for the rest of your life.
The only barrier to cruises and endless tee times is figuring out which assets will be distributed first and setting reminders to distribute those assets annually. The following three questions will give you the answers to get the most from your retirement distributions.
1. How much do you spend? When I use the word “budget,” clients usually recall the days of ramen noodles and peanut butter and jelly sandwiches. Since then, many people haven’t had a strict budget to guide their spending because most of us have learned to live without one. Freedom from work may give us time to celebrate, but outlining a budget is crucial to success in retirement.
Of the thousands of clients that I have met with over my career, I would place the number that have had a budget and lived by it to less than 20. You may have been able to overcome income shortfalls during your career by postponing a purchase or opting for a cheaper version of the product. But when your retirement income is driven by investable assets, you better have a good understanding of what your expenses are and where they can be reduced, if necessary.
Before completing a financial plan, I recommend all of my clients give me an average of what they have spent per month for the past two years. They can do this by completing the “24-month checkbook drill,” or looking at their checking account statements and averaging all the monthly withdrawals. They can also use an application such as those on Mint.com.
Either way, your expenses are one of the biggest areas you control in retirement and if you don’t have a solid understanding of what they are, the value of a financial plan could be compromised. Without knowing how much income you need to withdraw, you can’t really know how much you need to make on your investments.
2. What is your required rate of return? Knowing how much your portfolio needs to make is extremely important. For instance, let’s say that you have a portfolio value of $1 million and you require distributions of $40,000 to live on. With inflation and taxes you would likely need 6 to 8 percent. Most often, however, I see clients take on excessive risk because the majority of their assets are invested in equities and their “conservative” assets are in bonds, which are in a bubble.
The result is that there is too much risk throughout all of their investments with little downside protection in the event of a market downturn or a prolonged recovery. Your investment allocation has to take into consideration many factors, such as time and risk tolerance, but knowing what your required rate of return is will also guide what your risk tolerance should be. More importantly, it can dictate what your investment allocation should be.
3. When do you need the money? Investments can be categorized into different time horizons based on when the money is needed and on economic conditions. For instance, my firm has several clients who like to have one year’s worth of income be as liquid as possible. Most often, it is held in cash or money market funds. This gives them the peace of mind they will be able to meet their needs independent of how the market performs.
I think that six months’ expenses held in cash is fine, but the point is you shouldn’t place money that will be needed in the next six months in a risky investment such as a small-cap tech company. Instead, your investments can be segregated into different asset classes based on different time horizons. This composition will be entirely based on your financial plan, but knowing that your investment strategy mirrors your retirement needs will bring you comfort.
Once you have married the time horizon with your investment strategy, you can determine which investment vehicle will best help you reach your goal. An easy example is to place more speculative or long-term investments within a Roth individual retirement account. Doing so helps give you incentive to take a long-term approach, because you will be required to take distributions from your Traditional IRA accounts and therefore may not need the assets within the Roth account.
It also can make a huge difference in the growth of the asset itself, since the principal and any gains will never be taxed after deposit. This exercise is something anyone can do with enough time, but a seasoned retirement planning specialist can easily assist you with structuring your investments.
Taxes, inflation and market returns are factors in retirement that you will have little control over, but will battle endlessly. Given that most people have a likelihood of living 20 plus years in retirement, you must have a withdrawal strategy for taking funds from your retirement accounts in order to have a fighting chance of making it to your last day with money to spare.
The same “rules” used during your working years to accumulate capital can’t be relied upon to help you ensure a perpetual income. Follow the rules listed above for a good starting point to building your withdrawal strategy. Also make sure to consult with a retirement planning specialist for questions about your options or the validity of your approach.
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