Ask The CFP® Practitioner
“Constant dripping hollows out a stone.”
– Lucretius, Roman Philosopher, 99-55 BC
Question: What is the best way to start spending funds during retirement?
Answer: There’s no one-size-fits-all approach, exact scientific formula or precise system to use when it’s time to start taking withdrawals from your retirement funds. It’s more of a subjective and ongoing process that depends on a number of variables. A few of these factors include how much you’re starting with, life expectancy, health status, family financial needs, market performance, inflation, and an understanding that income requirements may change during different phases of life.
Early retirement, or the Go-Go years will often require more income than expected to pay for things like travel, hobbies, home improvements, and maybe even a little spoiling of the grandkids. Mid-retirement, or the Go Slow years tend to be more routine and may require for less money. Finally, the later or sometimes called Oh No years, could involve increased spending to cover rising health care costs and assisted living expenses.
There are three basic withdrawal strategies that can be used separately or in combination with one another to provide income for each of life’s stages. For simplicity’s sake, let’s use the example of Pete who has been an excellent saver and investor. He’s retiring at age 65 with a total of $2 million in his 401(k) and IRA accounts. Let’s run through the three methods and see how they work.
The first technique is based on a conservative percentage-based withdrawal rate. As a rule of thumb, 4 percent is the starting point and would produce $80,000 a year. Pete and his financial advisor began planning years before his retirement so he knows that this amount, plus his other income sources, such as Social Security and pensions, will cover anticipated expenses. This method makes the most sense for someone comfortable with fluctuating income levels. Depending on market behavior each year this could present a risk or a windfall.
For instance, if the portfolio value dropped by 15% after the first year of withdrawals, based on a 4% withdrawal, Pete’s income could drop to $65,280. Reducing Pete’s expenses to match lower income might not always be an option. During times of rocky market performance, this approach requires that Pete consider tapping into principal or be willing to reduce spending.
The second strategy is called constant dollar withdrawal. This plan is favored by those who prefer certainty, predictability and consistent annual income. The risk arises when expenses increase, inflation kicks in, or when portfolio performance doesn’t support the fixed withdrawal amounts. The obvious risk here is that the specific constant dollar amount won’t be enough to support proverbial Pete’s lifestyle during his lifetime.
The third method is called bucketing and it is a blend of the first two techniques. The concept requires holding in reserve a set amount of your portfolio in relatively safe and liquid investments (think cash and cash alternatives) so you’ll feel confident that your needs will be covered for the short-term, for instance six or twelve months. This way you won’t need to disturb your portfolio if the market is in flux. The cash-stash approach may provide a safety-net, yet it could limit overall returns as these assets are idle. The remainder of the portfolio would be dedicated to fixed-income and growth investments to presumably provide for longer term goal funding. Depending on personal preferences, each of these three methods can be designed to deplete principal over one’s own life expectancy or to leave a legacy for heirs and beneficiaries.
According to the Social Security Administration (SSA), a man reaching age 65 can expect to live on average until age 84.3, while his female counterpart can expect to live until age 86.6. Other interesting statistics from the SSA are that approximately one out of every four 65-year olds will live past 90 and one out of ten will live past age 95. Hopefully Pete will need to provide for an additional thirty years of living. This is why a retirement decumulation plan is as important as your retirement accumulation plan.
All three withdrawal scenarios require an educated guess on life-expectancy and health care expenses. Key elements to the success and sustainability of any plan include starting early and make saving and investing a priority.
Tapping into funds you’ve diligently saved can be emotional and anxiety provoking. We find that systematic withdrawal strategies, mimicking a regular paycheck or salary, help people adjust to a new phase of life in a familiar way.
It’s all about trade-offs and making the best decisions you can at the time. Even with a carefully planned withdrawal strategy we can’t anticipate everything. There will be disruptions to any plan, such as the itch to travel or unexpected health issues. Family needs are another wild card that can put a dent in any plan.
Most importantly, set realistic expectations of what you can comfortably spend during the best years of your life while working closely with your trusted financial planner for guidance along the way. Stay focused and plan accordingly.
There is no assurance that any investment strategy will be successful. Information received from outside sources is believed to be credible. The opinions expressed are those of the writer, but not necessarily those of Raymond James and Associates, and subject to change at any time.
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This article provided by Darcie Guerin, CFP®, Vice President, Investments & Branch Manager of Raymond James & Associates, Inc. Member New York Stock Exchange/SIPC 606 Bald Eagle Dr. Suite 401, Marco Island, FL 34145. She may be reached by calling 239-389-1041, or email email@example.com. Website: www.raymondjames.com/Darcie.