As the old saying goes, “Failure to plan is a plan for failure.” Nowhere is that statement more true than where it comes to retirement income planning. It is a fact that people are living longer today, which means many will be spending decades in retirement.
Faced with as many as thirty to forty years in retirement, besides the risk of not saving enough, the prospect of running out of retirement money too soon is perhaps the greatest risk that retirees will confront. To manage that risk, careful planning and financial management of retirement savings is critical. Wise decisions about how to best start and continue the process of drawing down those savings is important both in making retirement savings last and in providing adequate retirement income.
Considerations for Tapping a Retirement Nest Egg
Many people retiring today will have several different retirement savings resources to combine as effectively as possible to provide them with a monthly retirement income stream. These resources may include 401(k) plans, deferred compensation plans, IRA accounts, taxable account savings and eventually social security for those retiring before age 62. In addition, a few fortunate souls may even have one of those rare company pensions to add to the mix. Identifying all the resources available to provide retirement income is a good first step in the planning process.
After identification of all income sources, the next step is preparing a projected retirement budget to determine expected retirement expenses. Often experts mention 70% of pre-retirement income as the amount that will provide for a comfortable retirement. Rather than rely on an average figure that may not fit an individual’s specific circumstances, it is always better to do a personalized budget to obtain the most accurate projections.
From the calculation of total expenses, subtract fixed monthly incomes from sources like pensions, social security (if applicable), and any fixed monthly annuity payments if expected. The difference or shortfall is the amount to fund from personal retirement savings like those mentioned, 401(k) accounts, IRA accounts, etc. What must be determined is how much to withdraw from those sources each year without exhausting the assets too early.
Retirement Savings Withdrawal Rates
Most everyone these days nearing retirement has likely heard of the “4% rule.” For those who have not, this oft quoted rule of thumb suggests that with respect to retirement savings rates of withdrawal, a good approach is to withdraw 4% the first year and then adjust that each year thereafter by the a percent equal to the current inflation rate to maintain purchasing power. It is a conservative approach aimed at preventing most people from outliving their retirement savings.
In practice, however it may be possible to withdraw more than the 4% rule suggests. Striking a balance between how much retirement income is needed and the average rates of return received on retirement investments is the key, again with the aim of not burning through retirement assets too quickly. Whatever percentage is selected, the major portion of amounts withdrawn should represent earnings and the lesser portion principal.
Retirement Nest Egg Portfolio
Diversification never goes out of style when it comes to investing. It remains an important aspect even in retirement. Instead of putting all retirement money in one kind of investment, several types should be used. Without some portion of retirement savings being invested in stock or equity mutual funds, growth and earnings are going to be meager at best. The mix is an individual matter and depends on individual tolerance of risk. One person might be comfortable keeping 60% of their retirement money in stocks. Another might not be able to sleep at night with that high a percentage. Nevertheless, some portion should be in stocks or equity funds.
Another portion should be kept in long-term income producing investments like a diversified portfolio of bonds or bond funds. Diversification here refers to a mixture of domestic and international bonds.
Finally, one portion should be kept in cash-type accounts like money market funds, certificates of deposit, treasury bills, etc. Rather than a percentage, here the aim is to keep an amount equal to about three years of projected retirement expenses. To do so will prevent the forced sale of equity investments during a down market. Historically Bear markets last for three years or less. A three-year cash cushion will help smooth out the normal cycles of the stock markets. As the cash pool is depleted, it can be replenished via the sale of longer-term investments from the other two portions.
Sequence of Tapping Retirement Money
With regard to 401(k) accounts, deferred compensation accounts, IRA accounts and taxable investment accounts, a definite order should be followed when making withdrawals. Taxable accounts should be drawn from first and then taxable deferred accounts like 401(k) accounts, deferred compensation accounts and traditional IRA accounts. Tax-free accounts like Roth IRAs should be the last type of investments tapped.
The reasoning behind this hierarchy is simple. Tax deferred and tax-free retirement accounts typically grow fastest absent the drag of taxation and so these accounts should be left to grow as long as possible before they are drawn from.
Taking the time to plan and following a few time-tested principles with regard to wise retirement savings organization and retirement nest egg withdrawals should put retirees in a position to enjoy their golden years without the risk of running out of money too soon.
Source: Ruffenach, Glenn and Kelly Greene. The Wall Street Journal Complete Retirement Guidebook: How to Plan I, Live It and Enjoy It. New York: Three River Press, 2007. Print.
Larry Darter - Larry Darter is a freelance writer and published author with three books to his credit. He is a graduate of the Univ. of Central ...
