For most people, retirement represents a shift away from the saving, investing, and accumulation phase of life to the spending and distribution phase. This can be a problem if you haven't planned well: Although money typically does not come in like it did before, often it goes out just as fast as it always did. What took you a lifetime to accumulate is now exposed to a series of risks and potential shortfalls.
How can you manage the distributions from your lifetime savings to last through your retirement -- perhaps with some left over for your beneficiaries? As average life expectancies increase, more pension plans transfer investment risk to employees, and inflation continues to cut into purchasing power, this question is becoming increasingly critical.
Sources of retirement income
Many people think that their Social Security benefits will cover their retirement expenses. Unfortunately, that is almost never the case. The Social Security Administration (SSA) estimates that, on average, only about 41 percent of a retiree's annual income will come from Social Security. Benefits will replace approximately 12 percent of income for retirees with pre-retirement incomes of $250,000 and 56 percent for retirees who had incomes of $30,000.
Where will the rest of the money come from? Above is the SSA's breakdown of other income sources.
Pension plans and employer sponsored retirement plans include 401(k), 403(b), 457(s), defined benefit and defined contribution plans, and other small business plans. IRAs include traditional, rollover, Roth, spousal, stretch, and IRA plans sponsored by employers.
Although the government may not regard personal taxable savings and investments as sources of retirement income, they are necessary to fill gaps left by retirement plans. Personal savings include investments in money markets, real estate, stocks, bonds, savings accounts, and other liquid investments.
Employment can also be an important income source. Even if they are well off, many retirees choose to continue working for the social contact and other satisfactions that a workplace can bring.
Other sources, such as deferred compensation, life insurance, bonus plans, and stock options, typically account for a small part of overall retirement income.
Managing expenses
To plan how you will manage your retirement income, start by defining your short-term and long-term goals. Do you want to spend most of your income? Gift some to charity? Leave some to beneficiaries?
Next, itemize your assets, liabilities, and risks to income. What are your sources of income? Do you expect any large future expenses? What is your family health history? This will help you pinpoint potential shortfalls, or gaps, from expenses that might exceed your planned income. Distinguish between essential expenses -- such as mortgage payments/rent and health care -- and discretionary expenses (see my Eons article: "How Can I Estimate My Retirement Lifestyle Cost?").
Addressing shortfalls
If you identify shortfalls, one or more of the following approaches might help, depending on how suitable they are for your time horizon and risk tolerance. It is a good idea to consult a professional financial planner before making any of these moves.
- Consider increasing the potential return on investment (ROI) by adopting a more aggressive, higher-risk investment strategy. However, keep in mind that there is no guarantee returns will improve -- and the potential for loss will be greater.
- Retire later; you can get a higher rate for your Social Security benefits and delay withdrawals from your retirement plans.
- Try to get more income from your investments by choosing vehicles that carry higher interest payments, pay dividends, provide rental income, or purchase annuities.
- Reduce your spending. Re-examine your discretionary expenses to see where you can make cuts.
- Work part-time or expand your part-time hours if you are already working.
- Use the equity in your home. Take out a home equity loan or line of credit; sell your home and downsize; or take out a reverse mortgage.
Once you've identified and addressed potential shortfalls, you can decide from which income streams to take money and how to make distributions from various assets, investments, or retirement plans.
Income and distribution strategies
Your goal is to formulate a withdrawal strategy that ensures that your income will last through retirement and enable you to maintain the lifestyle you want. Here are some possibilities.
- Systematic withdrawal plan. This strategy involves consolidating all your assets for retirement income -- with an appropriate mix of equities, bonds, and money market instruments. You then withdraw a fixed amount of income periodically (monthly, for example) and re-balance your investment allocations annually.
- Interest only. This strategy gives you variable income from dividends on equities and interest on bonds and other interest-bearing investments. Typically, it is best for people with large investments and low spending needs.
- Two buckets. This approach involves two "buckets" for investments: one to provide current income and one for portfolio growth. The growth investments would help you meet later income needs.
- Multiple buckets. This approach sets aside certain assets or income streams for specific purposes, methods of distribution, timing, or emergencies. Specific buckets can provide income, growth, and safety, respectively.
- Annuities. These can provide lifetime income and help reduce the risk of outliving your financial assets. You can combine them with other approaches, using a portion of your assets to purchase the annuities.
Making the nest egg last
What percentage of your savings can you withdraw each year without ever running out of money?
Numerous studies based on different withdrawal rates, time horizons, asset allocations, ROIs, and inflation rates have concluded that withdrawing 4 percent to 5 percent of the balance will not exhaust funds during retirement. However, these studies are based on averages over long historical periods - so the same conditions may not exist during your retirement years.
These studies have also confirmed other general principles for extending the life of retirement funds:
- Make low or moderate withdrawals at the beginning of retirement.
- Invest in less volatile, more diversified portfolios.
- Adjust withdrawal rates and spending habits to changes in income and portfolio valuation.
In addition, the sources of income that you tap for distributions can have important tax consequences. It is prudent to defer taxes on withdrawals as long as possible. Balances in a qualified retirement plan, such as a 401(k) or a traditional IRA, can increase more rapidly because earnings are not taxed as they grow. So in most cases it is wise to use up taxable accounts first (if that is possible). Then, tap into a 401(k) or other retirement plan, and/or a traditional IRA. Save your Roth IRA for last; distributions are tax-free, and tax provisions for beneficiaries are favorable - so this is a great account to pass on to your children.
Keep in mind that each person's goals and needs may differ. No single strategy or withdrawal rate will apply to everyone or remain the same throughout your retirement. What's most important is to know your risk tolerance and be prepared to change strategies throughout retirement.
Sources and bibliography
Silbiger, Steven. Retire Early? Make The Smart Choices. Collins, 2005
Forefield Advisors, Resolving Projected Income Shortfalls. 2006
Leimberg, Stephan and McFadden, John. Employee Benefit and Retirement Planning. The National Underwriter Company, 2005
The information provided in this article is meant to enhance the understanding of retirement planning. It does not suggest or imply tax, financial, or legal advice nor does it constitute such advice. Consult your financial advisor about the facts and circumstances of your own situation.
