You’ve worked hard, dodged financial bullets and had enough foresight (or luck) to be able to put away a low-seven-figure retirement nest egg. Your 401(k) or individual retirement account has more money in one place than you’ve ever had anywhere else, but it doesn’t take a financial-planning genius to realize if that money is to last 20 years or more, there’s not much room for error.
During my 40 years in the financial industry--first as a tax planner and then for three decades an advisor--I’ve come to realize that there are common denominators to successfully navigating retirement from a financial standpoint no matter your net worth.
I won’t pretend that it isn’t easier to manage when the retiree has the good fortune to have many, many millions of dollars banked away for retirement. So in this, the first of a series of articles, I'm going to focus on retirees who managed to save money while working, who have accumulated a reasonable amount of net worth.
Not considered rich by Wall Street standards, this group of “Good Savers” has nonetheless done well for themselves, led a moderate lifestyle, and followed the rules. They believe they have enough to fund retirement but don't really know how to make the most advantageous financial decisions at this point.
For this series, I’ll start with common retirement investing mistakes. In part two we’ll look at a spectrum of planning dos and don’ts, ranging from deciding when to retire to avoiding unnecessary tax bills. In part 3, I’ll offer tips on an often overlooked aspect of planning--insurance.
But first, let’s set the scene.
The Good Saver
Who is a Good Saver? This group has worked a full career, is between ages 62 and 66 and are weighing their retirement options. They have most of their savings in 401(k) accounts, own a home that is partially paid for, have consumer debt consisting only of car loans or leases, and no longer have kids who are financially dependent. A typical pair of Good Savers might have the following net worth statement:
In addition to the above, the Good Savers Couple has the following:
- Sedan lease payments of $500 per month.
- SUV payments of $500 per month.
- A credit card that is paid in full each month.
- Mortgage payments of $1,500 per month (4% interest rate).
- Life insurance of $500,000 per person.
- Updated estate documents.
- Social Security benefits estimated at $2,000 per month each at age 62 and $2,750 each at age 66.
- Monthly spending of $6,000, not including mortgage, car payment, lease payment, travel, gifts and charitable contributions.
- Annual travel expenses estimated at $20,000.
- Annual gifts estimated at $8,000.
- Annual charitable contributions estimated at $8,000.
Based on this example, the Good Savers Couple has total monthly expenses of $11,500. The monthly amount needed in addition to Social Security would be $7,500 if benefits are taken at age 62; or $6,000 if benefits are taken at age 66. On a portfolio value of $2,150,000, this would equate to withdrawal rates of 4.1% or 3.3%, respectively, without considering taxes.
So what are the best and worst financial moves someone in this position can make in retirement?
Thinking About Investing
As Good Savers, you've likely invested a large portion of your 401(k)--if not the entire thing--in a target-date fund. Their primary features of regular rebalancing around age-targeted asset allocations make them easy to implement a “set it and forget it” approach to investing.
But there can be a downside to many target-date funds in retirement. As the investor approaches retirement, these funds move to a higher weighting in bonds, theoretically to reduce the risk of losing money prior to needing to start withdrawing money. In fact, most target-date funds hold 70% or more in bonds once the target retirement date has been reached.
What’s the problem with this? In these times of earlier retirements and longer lifespans, a retiree’s savings likely still need meaningful growth in order to maintain lifestyles and still last for decades. However, an allocation overly weighted toward bonds would likely be too conservative for a Good Saver early in retirement.
That said, a Good Saver’s nest egg with too much of an allocation to riskier investments also leaves that retiree vulnerable to falling short.
How should a retiree determine an appropriate investment strategy?
Investment Strategy for Retirees
Let's say our Good Savers wish to draw $6,000 per month from their investment portfolio, a drawdown rate of 3.3%. Worried about big swings in the stock market, they decide to invest their entire portfolio in a fairly aggressive U.S. bond fund, paying 3.3% annually. Our Good Savers are quite confident of their strategy. After all, they will not need to withdraw from principal to fund their monthly cash flow needs.
Unfortunately, as inflation continues to compound, these retirees will find that they will either have to draw down on principal or reduce their lifestyle--this doesn't consider potential market loss from interest-rate changes and/or defaults.
If inflation occurs at 3% annually, after five years, what used to cost $6,000 per month will now cost about $7,000 per month. Thus, by investing solely in bonds, our Good Saver retirees will have a choice:
- Reduce their living expenses by about 15%; or
- Supplement their cash flow with investment principal.
Of course, the second choice will lead to accelerated depletion of principal: As principal is reduced, income will also decline.
A better approach to funding retirement cash flow is to set aside a pool of six to 12 months of liquidity. This pool can be used to draw monthly amounts and can be replenished periodically as rebalancing is done. By utilizing this strategy, the portfolio can be invested to produce a long-term return that will exceed inflation.
Christine Benz of Morningstar agrees, stating, "There is also a benefit in my mind to retirees from rebalancing in that they're able to harvest their cash flows by selling appreciated positions. Now a lot of retirees naturally want to try to live off of whatever income their portfolio kicks off. That might be part of the equation for many retirees, but given how low yields are today and how low they remain, I think rebalancing is a natural way to source cash flows and take risk out of the portfolio on an ongoing basis.
For example, assume the same facts as above except that our couple keeps only $60,000 in liquid funds and invests the remaining $2,090,000 in a diversified portfolio of 60% stocks and 40% bonds. The diversified portfolio is expected to produce a long-term total return of approximately 7%, of which 2% will be realized from interest and dividends.
Thus, in the first year, our Good Saver retirees will receive about $42,000 from interest and dividends and will draw about $30,000 from the liquid funds to cover their cash flow needs. If the portfolio actually realized a 7% return during that year, they would have remaining funds of approximately $2,224,000 (including liquid funds). By utilizing this strategy, our Good Savers have provided adequate cash flow for their living expenses while accumulating additional principal to offset the effects of inflation.
To illustrate how rebalancing can replenish liquidity, assume that our couple's investments have shifted from a “60/40” allocation to the following:
To rebalance the portfolio and replenish liquidity, our couple will sell $56,000 of stock investments; purchase $26,000 of bond investments; and add $30,000 to cash accounts.
Thus, when funding retirement cash flow needs, your long-term investment strategy must not be compromised in order to protect against inflation. Next in part two of the series: retirement planning dos and don’ts.
Sheryl Rowling, CPA, is head of rebalancing solutions for Morningstar and founder of Rowling & Associates, an investment advisory firm. She is a part-time columnist and consultant on advisor-focused products for Morningstar, and she continues to actively work in the advisory business. Morningstar acquired her Total Rebalance Expert software platform in 2015. The opinions expressed in her work are her own and do not necessarily reflect the views of Morningstar or of Rowling & Associates LLC.
The opinions expressed here are the author’s. Morningstar values diversity of thought and publishes a broad range of viewpoints.