By Gary Brooks, CFP®
From the shores of Puget Sound we occasionally get a sea level-to-summit view of the Cascade Mountain foothills and Mount Rainier. Hold this sight in your mind as we work through how this image is a good representation of your financial life.
You start working, living below your means and accumulating savings (right?). Your savings and investments start to grow, at first moderately but potentially faster over time as more dollars experience compounding growth. Your investment balances and net worth may climb upward at a sharper angle now, just as the slopes of Mount Rainier steepen as you climb up above the surrounding foothills.
Now you can see the summit. In terms of your financial life, this is your retirement. If you’ve saved and invested well, you may be relieved to have reached the point where you feel secure about funding your preferred lifestyle after your working years.
But this summit, alpine or financial, is no finish line. Your ascent may be complete but now your goal changes quite a bit. It’s a different approach to get down the mountain safely just as it’s a different strategy for withdrawing assets once you stop saving.
There are new risks that weren’t applicable on the way up.
ORDER OF RETURNS MATTERS
When you’re saving, the sequence of returns isn’t important. It doesn’t matter what order fluctuations of annual returns come in, you’ll get to the same place. But when withdrawing assets amid fluctuating returns, the sequence can be very influential. If you are forced to withdraw assets during a significant market decline, those assets no longer have the ability to recover the way they did when you were saving. Poor returns early in retirement can change the trajectory of your retirement income substantially.
Withdrawn assets, used to fund your retirement spending, also reduce the power of compounding that is so helpful on the way up the mountain.
Another important difference in retirement is that your definition of risk may change. While building savings, volatility of markets is often defined as risk. Once you’re retired, risk is best considered to be potential shortfall of funding your income needs. You likely have limited options for going back to work to react to potential shortfall. Therefore, it become critical to manage your financial plan to avoid shortfall – usually due to either longevity, spending, or lower than expected investment returns. To understand the impact of each of these factors, it helps to model a retirement income plan that can help you understand the probability of meeting your future liabilities or spending preferences.
THINK TOTAL RETURN
In an ideal world – one that many investors think exists – you would be able to live off of dividends and investment income without touching your principal. However, even if you shift to a portfolio heavy on income producing assets (which has its own risks), this strategy is not likely to work at all times or persistently over a multi-decade retirement. Rather than thinking about income yield, think in terms of total return. It’s appropriate to spend from principal if the remaining principal is positioned for longer-term growth. Whether you spend from dividends or sell a few shares of stock that has gone up in value, the effect on your budget can be the same.
It’s OK to invest in stocks, likely more so than you assume. Abundant retirement income research suggests that if you withdraw 4 percent of your retirement assets, adjusted for inflation each year, you likely will not run out of money. You’ll alleviate longevity risk. Following this rule (which is hard to do consistently) means you wouldn’t touch 60 percent of your initial retirement balance after 10 years. You probably wouldn’t touch 20 percent of your money for 20 years, certainly a very long horizon that may benefit from stock market returns.
TIPS FOR SMOOTH DESCENT
Think about your retirement finances in terms of a multiple-bucket strategy. To supplement Social Security and any other non-investment income, you’ll want your first bucket to hold cash set aside for perhaps two years of expected withdrawals. That way, you’re not forced to sell something that you would rather not while it is temporarily in decline or out of favor with the market. Replenish the cash bucket as needed as part of a rebalancing strategy. When certain types of assets grow to be larger than their target weight in your portfolio, reduce them and use the captured gain to pour cash into the short-term bucket for upcoming expenses.
Understand how to be tax efficient. Money withdrawn from tax-deferred retirement accounts is taxed at ordinary income rates. This creates a larger reduction than assets removed from a Roth IRA (tax free) or from a brokerage account that is subject to capital gains taxes rather than ordinary income.
Large IRA withdrawals can also impact your Medicare costs and bump you into the next highest tax bracket if you unintentionally stray into higher income.
Plan for the phases of your retirement and how to manage income, including when to start Social Security or pension income, how to accommodate for likely more expensive early years of retirement due to more activity, or expensive later years of retirement due to growing health care costs.
Make sure to maintain a margin of safety. Money left over in case you live longer than you expect, expenses are higher, or investment returns lower than you plan for.
These strategies will help you come down from the summit in a way that improves the likelihood that your money will last as long as you do.
Gary Brooks is a certified financial planner and president of Brooks, Hughes & Jones, a registered investment adviser in Gig Harbor.
A version of this article was first published in May 2015 in The News Tribune.