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Financial Strategies for Retirement

Most people approaching retirement are concerned about having enough income to maintain their lifestyle and sufficient savings to avoid running out of money before they die. The best way to address these concerns is to accumulate ample retirement savings during your working years. At retirement, most individuals are finished accumulating assets but still face some important decisions regarding their retirement savings, including: 1) asset allocation; 2) withdrawal rate; and 3) withdrawal flexibility. These can be thought of as levers with which you can exert some control over your finances in retirement.

Asset allocation involves a trade-off between investment risk and expected return. An aggressive asset allocation, one that is more heavily weighted in stocks than bonds, provides a higher expected return along with a higher degree of risk. A conservative asset allocation, with a greater emphasis on bonds, reduces both risk and expected return. Retirees have traditionally been advised to invest conservatively to reduce the likelihood of running out of money; however, with increasing life expectancies, most retirees should plan for about 30 years in retirement. For this reason, financial advisors generally recommend maintaining some equity exposure in your retirement portfolio for growth potential, although the precise weighting of stocks vs. bonds should be tailored to your risk preferences and unique financial circumstances.

A retirement withdrawal rate is typically expressed as a percentage of your initial retirement assets. The most commonly recommended annual withdrawal rate is 4%. To illustrate, if you accumulate $2 million by the time you retire, a 4% withdrawal rate implies that you will take out $80,000 per year for the rest of your life, typically adjusted for inflation to preserve your buying power. This is often referred to as a sustainable withdrawal rate because, in most scenarios, you can withdraw this amount without running out of money over a 30-year retirement period, assuming an asset allocation of 50% stocks and 50% bonds.

There are several problems with the standard 4% sustainable withdrawal rate. You may be at risk of depleting your savings if your portfolio is heavily exposed to stocks and you encounter a severe bear market, especially during the first few years of retirement. A fixed withdrawal rate assumes your consumption will be flat throughout retirement, when in reality most retirees spend more during the first few years and then considerably less on elective purchases as they reach their 80s and beyond. The biggest problem with a fixed annual withdrawal is that it does not allow you to react to fluctuations in market performance thereby increasing your risk of running out of money due to adverse market conditions.

By allowing withdrawal flexibility, you can significantly reduce your risk of running out of money in retirement. A variety of decision rules have been developed to guide a flexible withdrawal strategy. The simplest approach is an adjustable withdrawal rate based on your savings at the beginning of each year. For example, instead of taking 4% of your initial retirement savings every year, you could take 4% of your current savings balance at the beginning of each year. With this approach, the likelihood of depleting your assets is much lower, but withdrawal amounts are variable and there is no guarantee that you will be able to maintain your preferred lifestyle. Another flexible withdrawal strategy, referred to as an actuarial spending rule, adjusts your withdrawals annually based on your expected life span. A simple way to implement this strategy is to calculate your annual withdrawal by dividing your retirement savings at the beginning of each year by your life expectancy, as reported in the IRS life expectancy tables.

An important consideration in retirement planning is tax-efficient withdrawals. The tax rules covering distributions from IRAs, 401(k) plans, Roth accounts, and even taxable accounts are complex. An important part of our job is to help clients take distributions from the appropriate accounts in the proper sequence to optimize portfolio longevity and minimize taxes. This will be the topic of a subsequent newsletter.

Jeffrey J. Brown, MD CFA CFP®

Principal, Shearwater Capital

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