Tuesday, June 2, 2015

Retirees must plan how to draw down savings

Your financial life, like climbing a mountain, does not end when you reach the summit, your retirement. Getting down safely, or making your retirement income last, requires a set of different strategies. How can you withdraw your money without depleting it?

For years, you work, live below your means, save and invest. Your savings and investments grow moderately at first but faster over time. Your balances and net worth climb upward at a sharper angle now, just as mountain slopes steepen above the surrounding foothills.

Now you can see the summit. This is your retirement. You reach the point where you feel secure about funding your preferred lifestyle after your working years.

But this summit, alpine or financial, is no finish line. Your ascent is complete, but now your goal changes quite a bit. Getting down the mountain safely is just as challenging. You face new risks different from those on the way up.

Your definition of risk changes in retirement. While building savings, volatility of markets is your risk. Once you retire, risk is the potential shortfall of funding your needs — usually because of longevity, spending or lower-than-expected investment returns.

Because going back to work is harder, you probably have limited options to react to shortfalls. If you have to sell investments during a significant market decline, those assets can no longer recover.

When you save, the order of returns doesn’t matter. Whether poor returns happen this year or the next, you get to the same place. But when you retire, the sequence of returns can change the trajectory of your income substantially.

Withdrawing assets to fund your retirement spending also reduces the power of compounding. In an ideal world — one that many investors think exists — you live off of dividends and returns without touching your principal. However, even if you shift to a portfolio heavy on income-producing assets, this strategy is not likely to work persistently over a multi-decade retirement.

Here are a few tips that help you come down from the summit with a better chance that your money will last as long as you do.

• Set a cash bucket aside. You need a multiple-bucket strategy for your retirement. To supplement Social Security and any other non-investment income, you want a bucket to hold cash of around two years of expected withdrawals. This way, you don’t have to sell something while it is temporarily in decline.

• Replenish the cash bucket when you rebalance your portfolio. When stocks or bonds grow to be larger than their target weight, capture the gain and put it into the short-term bucket for upcoming expenses.

• Make a spending plan. Expenses can vary during phases of retirement — typically high in the early years because of more activities, lower in the middle, and then higher later because of health-care costs. Your planning should accommodate all these expenses.

• Spending from principal is OK if you position the rest for longer-term growth. Research suggests that if you withdraw 4 percent of your retirement assets, adjusted for inflation each year, you probably will not run out of money.

• Mind the tax consequences. If you withdraw money from tax-deferred retirement accounts, you owe ordinary income tax. A distribution from a Roth IRA is tax-free, while money from a brokerage account is subject to capital-gains taxes. Large withdrawals can bump you into a higher tax bracket and also increase your Medicare costs.

• Maintain a safety margin. Keep some money left over in case you live longer than you expect, expenses are higher or your investments return less than you plan for.