Imagine you are headed out on a hike. If it’s going to be a long hike, you’ll likely wear a Camelback and maybe even fill up a few extra bottles to take with you. This process of filling up your bottles represents the savings, or accumulation phase, of your financial life.
Once retired, the process changes. Now you need to determine how much you can drink from each bottle, and over what time frame, to make sure you have enough to last throughout the adventure. This is the decumulation phase.
This is the point in time where you need a withdrawal plan. It’s no longer about filling up the bottles as fast as you can – now it’s about using the water at an appropriate pace, without over or under-consuming as you go. At this point in time you need a different way of measuring success.
A few upcoming retirees recognize that their needs will change and they outline the new criteria they should use to measure against. I met with a man recently who came to his appointment with typed notes that outlined what he expected a retirement withdrawal plan to include. His notes included these five points he expected us to cover in our planning process:
- The income goals to be met via withdrawals (core vs. discretionary).
- The assets to which the withdrawal strategy applies that will fund those income goals.
- The initial withdrawal rate taking into account the tax implications of distributions from the qualified accounts and the pending required minimum distributions.
- The method for determining the source of each year’s withdrawal income from the portfolio.
- The method for determining the withdrawal amount in subsequent years, including both the trigger points for adjustments (other than an inflation based-increase) and the magnitude of the adjustment itself.
I was impressed! He said he had compiled his list from various articles he had read about retirement income planning. I am going to expand up on each of his five items, and describe how we incorporate each into our process.
1. The Income Goals
It all starts with what you want to spend. We have to identify the amount of money you need to maintain a comfortable lifestyle in order to see if that goal is achievable. We use budget forms, bank statements, and conversations with you to determine this. First we need to identify essentials, like a roof over your head, health care, food, etc. Once essentials are covered, we can see if there is room for you to spend extra on things like more travel, hobbies, or gifting to children and grandchildren.
2. Assets to Be Used
A smart retirement plan should not require you to use every available asset you have. There are some assets that should be carved out as reserves. We like to set aside an emergency fund that we do not include in your plan as an asset that is available to produce retirement income. We also think it makes sense to set aside home equity as “Plan B”. Life happens and it makes sense to set aside assets for things that may come up that could not have been anticipated. We show you which assets are and are not included in your plan.
3. Withdrawal Rate and Taxes
Your withdrawal rate is a measuring device. It can be used as a rule of thumb (as in the 4% retirement rule), but it should not be the final factor in determining your withdrawal amount each year. It needs to be put in perspective of your entire plan – your expected withdrawals over retirement – not just your starting withdrawal rate.
Taxes also have to be factored into this analysis. Some retirees pay almost no taxes so they keep every dollar of IRA withdrawals. Other retirees will pay 35% or more in income taxes in retirement, so they only keep .65 cents of every dollar of IRA withdrawal. Simply taking your account balance multiplied by a withdrawal rate of 4% doesn’t tell you how much after-tax money you’ll have available to spend. Your plan must factor in taxes. We do this by projecting an annual tax return for each year of your retirement – something we call a multi-year tax projection.
4. Source of Each Year’s Withdrawal
There are numerous methods for managing retirement income portfolios. A few common ones are:
- interest only, where you only spend the interest and dividends generated by the portfolio,
- systematic withdrawals, where you follow a withdrawal rate process
- time segmentation, where you use a short term investment ‘bucket’ for money you’ll need in the first 5 years of retirement, and mid and long term buckets for money you won’t need to touch any time soon.
The important thing is that you understand the methodology and stick with it. Jumping between methodologies is not an effective strategy.
Our approach is most closely aligned with time segmentation. In partnership with an investment firm, Asset Dedication, we build an income ladder that secures your near-term withdrawal needs, so you need not worry about what that markets are doing this month, or even this year. With this process for the first 5 to 10 years of retirement we have each account’s withdrawal sourced to a bond, CD, or other safe investment that is maturing. The remainder of the portfolio can then be invested in long-term growth choices.
Then there is a monitoring process to measure your accounts against your plan. This monitoring process tells us when to harvest the growth portfolio and add on to your income ladder. This process helps manage both sequence risk and interest rate risk. It is not a process designed to get every extra bit of return – that is not the goal in retirement. It is a process designed to secure a desired level of spending for life.
5. Method for Determining Withdrawals in Subsequent Years
Planning is not a one-time event. Each year we update the analysis we do for our clients. We use a few things to determine subsequent withdrawals. The first thing we look at is an annual tax projection. This helps us figure out what account withdrawals should come from, and if we can realize capital gains at a zero percent tax rate. This must be done each year, and when employed consistently can save a retiree thousands in taxes over the years.
The second measuring device we use is your plan. Did you spend more or less than our projections? Did accounts exceed your target rate of return or not? If you spent more, we discuss this. If accounts exceeded the target rate of return, we might take profits. If we go through a prolonged period of time where accounts underperform (like 2008-2009) then we may ask you to forego inflation raises, and take out no more than you withdrew the year before. If your spending was greater than we projected and the markets are poor, we may suggest a pay cut.
This dynamic monitoring process allows us to identify potential problems fifteen years in advance, and take action now to prevent those problems from materializing.
All of the above components are part of a well-constructed withdrawal plan. Does every retiree need each component? No, probably not. But every upcoming retiree can reduce stress, and increase their peace of mind by engaging in the planning process.
-Written by Dana Anspach