Navigating the Retirement Risk Zone: How to Avoid Running Out of Money, Part 2
» Article by Chad Leatherwood, CFP®, Wealth Advisor | Featured in the May 2018 edition of The Rational Optimist™
In part I of this article, we discussed the importance of your financial decisions during what has been called the Retirement Risk Zone, or the period 5-10 years before retirement through the 5-10 years after your retirement date.
During this period, exposure to a sequence of return risk is a serious concern. With this risk, a series of negative returns early in your retirement while you are making withdrawals can have a devastating effect on your portfolio’s ability to last through your retirement.
A popular strategy used for dealing with a sequence of return risk is the 4% rule. Four percent has been considered a safe starting rate of withdrawal from a portfolio for a retirement that is expected to last about 30 years. With this method, 4% is the starting withdrawal rate from the portfolio and the amount withdrawn is increased each year for inflation regardless of what is happening with the markets.
There are different approaches beyond the 4% rule to consider. One of these methods is simply taking a fixed percentage without inflation adjustments. With this approach, if the portfolio goes down during a bear market, withdrawals would automatically be less based on the account value going lower. On the flip side, if the portfolio is growing over time, higher amounts would be withdrawn as the value increases.
Still, another method that is based one life expectancy could be considered. This is how Required Minimum Distributions (RMD) from Retirement accounts are calculated. With this kind of approach, a greater percentage could be withdrawn as you grow older and your life expectancy decreases.
A Safety-First Approach While longevity is an advantage, it can also be a risk to your wealth. Some prefer taking what well know retirement researcher and professor, Dr. Wade Pfau, Ph.D., CFA calls a “safety-first” approach to income planning.
As an example of this kind of approach, expenses can be divided between needs, wants and legacy goals. These requirements can be satisfied with relatively safe sources of income, often from a combination of Social Security, Pensions, and Annuities.
With an income floor created, the risk for longevity and sequence of return is mitigated. When establishing the income floor, it is essential that sufficient inflationary increases are built-in.
With basic needs covered, your discretionary expenses (wants), can be covered by your portfolio, potentially using one of the withdrawal methods discussed above. Legacy planning goals might be satisfied by the investment portfolio or even life insurance.
Which Approach is Right For You? There is no one-size-fits-all solution for safely navigating the retirement risk zone and mitigating the risk of running out of money later in life. In this article, I covered some important considerations and some of the methods for creating a sustainable retirement income.
An approach or combination of approaches may be crafted to address your unique situation, preferences, and goals. If you are at this crucial stage of life and would like to learn more, or discuss your current strategy, please reach out to us.