Dec 12, 2017 -

Posted at 3:57 pm News/Resources

Co-written by Marie DeCaprio CFA®, CFP® and Jeremy Rhen, CFP®

It has been imparted on us from a young age the need to save for our later years, when we untether from the workforce and enter retirement. Most people spend the majority of their lives earning an income, sacrificing, saving and investing to build a comfortable nest egg for a leisurely retirement; except, how much thought goes into what happens when we actually get there? Flipping the switch from saving for retirement to spending that said retirement is ironically the culmination of our adult lives, yet not often considered. It takes much care and consideration to plan for and follow-through with a strategy to live the future lifestyle we envisioned while ensuring our savings isn’t depleted too early. This is called a spend-down strategy.

 

Retirement spend-down is the point in which we must replace our income with some combination of social security benefits, pensions or other sources to ensure the longevity of our nest egg. However, studies show that most people are confused about this transition and assume these supplemental income sources are enough to sustain them for the remainder of their days.

 

4% Rule Isn’t 100% Accurate

How much can I spend vs. How much should I spend? The 4% rule is often quoted as the “rule of thumb” when spending down a retirement portfolio. The concept being that so long as you only spend 4% of your retirement nest egg each year, your savings will remain intact. This is widely accepted and, in-theory, would provide a steady stream of income for a good number of years. However, this rule has very specific assumptions at its core.

Individuals have very different risk tolerances from one another and receive very different guidance regarding their asset allocation. The 4% rule is based on a “balanced portfolio” of 50% stocks and 50% bonds. However, most portfolio allocations will differ and you will have different levels of expected return, and in-turn different spend-down rates.

The 4% rule also does not consider what type of accounts your assets are in. All retirement assets may be in tax-deferred accounts (IRA, 401(k), 403(b), etc.) and are fully taxable as income should you decide to tap into those funds. Alternatively, the assets may be in taxable accounts that have a taxable basis (your original purchase price) and only taxable at lower capital gains rates to you. Or, you may have assets in tax-free (Roth) accounts which are generally not taxable at all. Most people have some mixture of these types of accounts, and then the question becomes what order should they be exhausted and what are the tax consequences for each account when taking distributions?

As you can see, the 4% rule of thumb is much more like a possible starting point, and even then perhaps not fitting at all when constructing a spend-down strategy.

 

Tackle the Unknown

A great start to planning for retirement years is reducing the uncertainty. How long will my nest egg last me? How much will my investments grow? These are critical questions to consider.

One way to create a long-term projection tailored to your individual retirement is use of Monte Carlo simulation analysis. This is a financial model that outlines a range of possible outcomes for your retirement portfolio given your starting balance, your annual spending and your portfolio allocation. When you alter the variables, such as possible life span and rates of return, you will get different results. The projected results give the investor a better sense of where they stand to ensure they do not out-live their investments.

Since there is no real concrete way to predict how the market will perform during your retirement years, or exactly how many retirement years you need to plan for, it is vital that you work with a financial advisor to back-in to an appropriate spend-down plan for a secure retirement. The job of a financial advisor is to help determine the appropriate amount of spending needed in retirement (it is a common thought that you will need 80% of your current gross income in retirement); and, determine other income sources that will offset the need to draw from your portfolio during retirement, such as Social Security, rent income, pensions/annuities, and part-time employment.

Here are some important items that a financial advisor can work through with you to construct a well-thought out retirement spend-down strategy:

  • Setting important dates like a retirement age and life expectancy
  • Forecasting lump sum cash inflows/outflows in retirement such as: inheritances, downsizing of home, sale of business, funding education, purchasing a vacation home, travel, etc.
  • Make qualified assumptions related to portfolio allocation and associated returns with regards to portfolio allocation, inflation, and historical returns/volatility
  • Project retirement success (% chance of achieving goals) which is defined as not running out of money or leaving a specific legacy to family/charity

Once a retirement spend-down strategy is created, it is important to revisit the strategy with your financial advisor periodically to evaluate and make adjustments as needed. This may entail spending less, retiring later, or changes needed to your investment allocation to be more or less aggressive to ensure you are always right on track to lead the retirement lifestyle you worked so hard for.