3 Steps to Employ a Goal-Based Retirement Spending Strategy
You’re nearing retirement. That’s both a milestone and a caution. It means you’ve worked long and hard, and are now ready to enjoy the fruits of those labors.
However, it also means that you need to have the right retirement spending strategy in place to ensure that your money doesn’t run dry in the middle of your “golden years.”
This is particularly true for soon-to-be retirees who depend heavily on their investment portfolio rather than a guaranteed pension plan.
According to a whitepaper written by Colleen M. Jaconetti, Michael A. DiJoseph, Zoe B. Odenwalder and Francis M. Kinniry, Jr., there are three steps you’ll need to take in order to maximize your ability to live the life you want while minimizing risk.
Retirement Spending Rules: Prudence Wins Out
You’ll most certainly need spending rules in place to help ensure that your outflow doesn’t outpace your inflow. However, you must avoid the temptation to use a broad set of rules that seems as though it can be applied to every retiree.
Your situation is unique, and that demands retirement spending rules tailored to your specific needs, goals and situation. This can be tough to do, simply because there are many factors far outside your control.
Retirement spending rules should vary based on a number of factors.
For example, the longer your investment time horizon, the less you can spend overall because you must make your income stretch as far as possible. The more conservative your asset allocation is, the less you can spend over time.
There are also commonly applied rules that seem to make a lot of sense, but ultimately lack the flexibility needed to create a tailored strategy for your needs.
Two examples of these are the 4% spending rule and the percentage of portfolio rule. Both can work, but that doesn’t mean that they will work for you, specifically.
Construct Your Portfolio the Correct Way
To ensure that you have adequate income during retirement, you’ll need to construct your portfolio the correct way to enable retirement spending.
There are many options here. One is the total-return approach. Another is the income-focused approach. Both are identical in many ways.
For instance, both of these methods focus on spending at least a portion of the income generated in your portfolio. In some instances, you might spend all the income from your portfolio.
The two methods cited above differ when it comes to how you handle spending more than you earn from your portfolio, though. One method requires that you reallocate your portfolio to enjoy higher-earning assets. The other focuses on spending your capital appreciation to cover the shortfall between financial needs and natural portfolio yield.
However, there is a third option – the asset-dedication approach. This is a variation of the total-return approach mentioned above and focuses on following the rules of asset dedication theory, rather than asset allocation theory.
Really, this approach is all about setting specific goals and then structuring your portfolio to achieve those goals, while simultaneously breaking your portfolio into three segments (cash, bonds, and stocks).
There is also the question of what assets you should put your money into.
As mentioned, the asset dedication approach focuses on dividing your portfolio into stocks, bonds, and cash. Of those, bonds should definitely make up the largest share for a number of reasons.
Perhaps the most important reason is that only high-quality corporate bonds can provide a predictable return and the assurance that you’ll receive back the capital you invested when they mature. Stocks don’t do that.
Make Use of Tax-Efficient Investment and Withdrawal Strategies
Finally, you need to ensure that you’re making use of tax-efficient investment and withdrawal strategies. Otherwise, a significant portion of your wealth will not go to you, but to Uncle Sam.
That benefits no one. You can do this by using the right types of retirement accounts. For example, you’ll need to first spend your required minimum distributions, or you will take a penalty.
Next, you should spend the income generated by assets in taxable accounts. Next, spend income from taxable assets. Last, spend income from tax-advantaged assets.
Make sure that you have merged your IRA with your investment strategy, too. Doing otherwise puts you at increased risk. Instead, use it to house assets that provide you with the most potential for creating taxable income, as well as for distributing capital gains.
Bonus: The Baby Boomer Breakdown
As a bonus tip, understand that the asset dedication approach can yield some significant benefits, even during the late accumulation period just before retirement.
For instance, a 50-year old investor with $1,300,000 in an IRA and Roth IRA planning to retire early can save 20% of their gross income per year and actually retire early.
With a marginal tax rate of 30% and steady contributions of 20% of gross annual income, combined with the savvy use of bonds, it is actually possible for our example investor to save $2,000,000 plus spending cash by the time they turn 60 years of age.
In the end, those approaching retirement age must ensure that they have an investment strategy tailored to their specific financial needs and goals, that those goals are firmly set and speak directly to the lifestyle they want to enjoy during retirement, and that they have a solid retirement spending plan in place to maximize the lifespan of their wealth without encountering shortfalls.