Retirement, often called “the golden years,” can be a truly rewarding phase of life. However, retiring not only involves radically adjusting how you spend your time but also triggers tremendous psychological and financial changes.
In this article, we focus on one aspect of the financial adjustments that happen when you retire: How do you receive income now that you are no longer working? There are practical and emotional issues to consider, so let’s dive in.
Emotional/Psychological Issues About Replacing Your Paycheck
Shifting from decades of saving for retirement to spending that money is a significant change. It can be unsettling if you have accumulated a decent nest egg, but possibly not enough to erase all concerns about spending without outliving your funds. Getting accustomed to living off your savings typically takes one to three years. Moving from growing your net worth for many years to gradually depleting it is mentally challenging for most people.
First, it’s essential to know it is normal to feel this way. Feeling a lack of control plays a big role in your anxiety, so the best way to deal with it is to feel more in control by having a financial plan that accurately models how much money you can safely withdraw from your savings without running out of money.
The unsettled feelings also reflect that you accumulated this nest egg by doing the right thing for many years. You kept saving so that you would be able to generate enough income in retirement, and now that saving has stopped. You’re “giving up” a great habit, but that was the plan. Reflecting on that point can help.
How much, and what about the “4% Rule”?
How much can you safely withdraw from your nest egg each year? We are often asked about the “4% Rule”. It says you can safely withdraw 4% of your retirement savings each year, adjusting the dollar amount for inflation each year, but does that still work?
The 4% Rule is a back-of-the-envelope way to get a quick-and-dirty estimate based on retiring at age 65 and living another 25 to 30 years. Assume you withdraw 4% of your savings each year for 25 years, increasing the dollar amount you withdraw each year to cover inflation. Without getting into the math, in theory, you would not use more than 100% of your nest egg.
While not worthless, the 4% rule should only serve as a very rough guideline. A couple of things can make that estimate far from accurate:
You might live longer than the 4% Rule covers. Men who reach age 85 and women who reach age 82 are actuarially likely to live beyond their 90th birthday.
Inflation could be higher than the return the investments in your portfolio earn, so the dollar amount you withdraw each year could be more than 4% of the total.
You or your spouse may have extensive ongoing healthcare needs later in life.
A Better Way To Determine How To Spend Your Retirement Savings
To get a more accurate estimate of how much you can spend and how best to withdraw money from your savings, start with what you want to do when you retire and how much that will cost. People typically spend more in the earlier years of retirement because they are still physically and mentally able to do more expensive things, such as traveling, renovating part of the house, or pursuing active hobbies.
Even when people have saved much more than they think they will need, some may “tighten their purse strings” (a quaint phrase that seems past its retirement age) so much that they don’t enjoy life in retirement as much as they could and should. For example, you may be able to easily afford to fly Business Class instead of Coach when you travel, but you decide not to spend the extra money “just in case.” Working with a financial advisor can convince you that you can fly Business Class (or maybe even First Class!) and still have enough to achieve your other aspirations, such as passing on a certain amount to your children or charities. That peace of mind is precious as it can enable you to enjoy your retirement much more than you otherwise would.
Including Social Security or Pensions in Your Retirement Income
How do Social Security or pension payouts figure into this planning? Given that those payments are “guaranteed,” setting aside the concern that the Social Security system will become insolvent, planning how best to withdraw your retirement savings should focus on making up the balance of what you have decided you need beyond those income sources.
Typically, the best strategy is to withdraw money from your taxable accounts first, take distributions from pre-tax accounts - traditional 401(k)s and traditional IRAs – second, and lastly, draw down your tax-free accounts — Roth IRAs and Roth 401(k)s). However, it’s important to keep tax brackets in mind and consider the totality of your situation on a year-by-year basis. Are you more likely to pay less in taxes now or later? Perhaps the best example of this logic is considering Roth conversions each year– another critical issue to discuss with your financial advisor.
If your retirement accounts will be inherited by anyone other than your spouse, you accelerate the tax burden associated with the withdrawals onto those heirs. The transfer of your wealth to your beneficiaries ought to be considered when designing the optimum withdrawal strategy. Comprehensive strategies estimate taxes throughout and after your lifetime(s) to pay the least amount legally required.
Liquidity, Investment Risk, and Near-Term Expenses
We typically recommend keeping 9 to 18 months of expenses in a high-yield cash account. This liquidity/emergency fund enables our clients to avoid being forced into selling investments in a bad market environment, which will inevitably occur and often without warning. The more investment risk your portfolio has, and the earlier you are into retirement, the more you should insulate yourself from having to make withdrawals during a market downturn.
While some favor buying individual bonds with “laddered” maturities (i.e., some that mature in six months, some in one year, and some in 18 months), this approach adds unnecessary complexity and has inferior credit risk diversification. Short-maturity bond funds are easy to buy and sell, experience little volatility when interest rates rise, and offer broad diversification.
Suppose you expect to fund a major expense in the next 12 months, perhaps to remodel your kitchen or build a new deck, and the market has recently taken a tumble. You could significantly improve your financial situation by deferring big expenditures until the market rebounds within the rough ballpark of previous market highs.
We don’t see this as trying to “time the market” so much as banking on the fact that we very rarely see two consecutive down years in the market (exceptions: the 1973-1974 oil embargo and the 2001-2003 “dotcom” bust). Selling stocks to do that kitchen remodel in April 2020, when the market had taken a big tumble because of the COVID-19 pandemic, would have been extraordinarily costly, especially given that stocks recovered just a few months later.
Should you try to live off your income?
When considering the emotional/psychological aspects of living on your retirement savings, many people are consciously or unconsciously determined to live on the interest and dividends their investments generate instead of looking at their overall portfolio’s total return (which includes capital gains). This desire to rely solely on investment income is often deeply rooted in a conviction customary in the 1900s. Modern investment science shows that a total return approach is superior while allowing for more control with tax management. Times have changed.
Once the prevailing sentiment is established, the income investment approach can have negative consequences. It can lead people to load up on high-yield but risky bonds (long-term or low quality) or high dividend-paying stocks that may not offer the best overall outcomes. Growth stocks often pay no dividends; instead, they return capital to shareholders through stock repurchases, but that doesn’t look like “income” to the average investor.
Perhaps more importantly, there is nothing wrong with spending down your principal – that’s why you saved for all those years in a disciplined way! Many people entering retirement see themselves as caretakers of their money, preserving as much as possible for their children. That’s a legitimate choice for some, but be sure to see it as a choice, not an obligation.
This retirement income period is the stage of life where people who have not previously worked with a financial advisor are most likely to seek an advisor’s help. How best to generate income in retirement is the hottest topic among all the things people come to us to discuss, especially in the years between when you stop working and when you start taking Social Security. Contact us to discuss how you can maximize the enjoyment your retirement savings can bring to your life.
Disclosure: Advisory Services are offered through Gold Medal Waters, a Registered Investment Advisor. This post and material presented are for informational and illustrative purposes only, and do not constitute investment advice and is not intended as an endorsement of any specific investment. As such, this material is not client-specific, we make adjustments in individual portfolios based on each client's financial plan, income needs, risk tolerance and total asset allocation. Interactive checklists are made available to you as self-help tools for your independent use and are not intended to provide investment advice. While Gold Medal Waters believes information derived from third-party sources to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability in regard to your individual circumstances. Investors should carefully consider the investment objectives, risks, charges, and expenses associated with any investment. The information discussed is not intended to render tax or legal advice. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Investing involves risk including the potential loss of principal, and unless otherwise stated, are not guaranteed. Past performance does not guarantee future results. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Consult your financial professional before making any investment decision.
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