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 vision 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. 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.
CHANGING DEFINITION OF RISK
When you’re saving, the sequence of returns isn’t important. It doesn’t matter what order fluctuating annual returns come in, you’ll get to the same place. But when withdrawing assets, the sequence can be very influential. Poor returns early in retirement can change the trajectory of your retirement income substantially. 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.
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 becomes critical to manage your financial plan to avoid shortfall – usually due to 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 identifies the probability of meeting your future spending obligations.
THINK TOTAL RETURN
In an ideal world 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 persistently over a multi-decade retirement. Rather than focus on income, 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 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 means you wouldn’t touch 60 percent of your initial retirement balance for 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
Keep cash set aside for perhaps two years of expected withdrawals. That way, you won’t be forced to sell something that you would rather not while it is temporarily in decline or out of favor with the market. Replenish cash as needed to rebalance your investments. When stocks or bonds grow larger than their target weight in your portfolio, capture the gain and use it to fund upcoming expenses.
Mind your tax consequences. 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. Large IRA withdrawals can also unintentionally increase your Medicare premiums.
Know how to optimize Social Security income. According to the Center for Retirement Research at Boston College, Americans leave over $10 billion per year unclaimed by not understanding options such as spousal and survivor Social Security benefits. It’s a complex system but appropriately utilized, it can reduce your reliance on investment returns.
Collectively, these strategies may help you down from the summit with improved likelihood that your money will last as long as you do.
Gary Brooks is a certified financial planner and the president of Brooks, Hughes & Jones, a registered investment adviser in Old Town Tacoma. Reach him at bhjadvisors.com.