Last month we discussed some aspects of what the “new retirement” looks like, including the role of working longer past traditional retirement age, as well as properly structuring Social Security benefits. In the second part of our article we’ll talk about why a written investment and income plan is such a critical tool when planning your income and investment strategy in retirement.
Why in writing? The very process of articulating your goals and objectives on paper or screen can give an individual the grounding to stay focused in an unsteady investment environment. A good plan can provide continuity and coherence to investment strategy and activity. It should include a target asset allocation as well as restrictions based upon the investor’s age, need for income and growth, and tolerance for risk. It should also outline an investment strategy that can be pursued in a variety of market and economic conditions.
Here’s how to get started. You’ll need to get an accurate picture of your current spending, including normal monthly expenses, periodic recurring expenses, and one-time expenses such as vacations and travel. It also makes sense to add in some savings in a reserve account for the unexpected, and for funding significant future expenses (a new car, for instance). It needn’t be exact to the penny; you’re just trying to reasonably estimate annual consumption or spending. Don’t forget to include federal and state tax payments. Project your spending out for 5-10 years, and increase it each year by an inflation factor. We’ll use 2 percent per year.
Now examine your existing and anticipated income sources. This may include rental and loan payments, pensions you receive or will receive, as well as Social Security. As you did with expenses, project your income items out 5-10 years; recognize projected cost of living increases for Social Security and your pension, if it has a COLA feature.
If you have a large pension or are particularly thrifty, you may find that these income sources cover your projected spending. You will not need to withdraw funds from your investments. Many people, though, will need or want a portion of their retirement spending to come from investments. This decision point, whether or not you will need to withdraw from your investments, and how much, will get you started on the next step, coordinating the income distributions and expenses with an investment plan.
Let’s say you spend $77,000 annually, and feel it should increase by 2 percent each year to cover rising costs. You have Social Security benefits of $15,600 per year which we project will also increase by 2 percent per year, and a pension of $12,000 with no COLA. Today, you will need to withdraw $49,400 from your investments, or slightly more than $4,100/month to maintain your lifestyle. This represents roughly a 4.9 percent withdrawal rate from a million dollar portfolio.
Fast forward 10 years. Now your combined Social Security and pension income has grown to $30,643, but your spending (increasing at 2 percent per year) has grown to $92,022. You now need to withdraw $61,380 from your portfolio. If your investments have simply kept up their million dollar value over the past decade, your withdrawal rate has increased to 6.1 percent . In order to maintain a 4.9 percent withdrawal rate, your investment portfolio would need to have grown to a little more than $1.25 million. To reach this goal, that is, keeping your purchasing power intact for both your principal and your income, would require an average rate of return of over 7.5 percent on your portfolio.
Here’s something else to consider. Since simple mathematical projections don’t completely reflect the variable nature of returns in financial markets, a portfolio designed to achieve this rate of return would not guarantee success. When you are withdrawing from your assets, the range of returns that comprise your average is extremely important. A portfolio with an average return of 7.5 percent that fluctuated between 5 percent and 10 percent would probably have a greater chance of success (that is, not running out of money) than one that averaged 9 percent, but ranged between 18 percent and zero percent.
If you are married, it is critical for each person to understand how their total income will be affected if something happens to their partner. Insurance proceeds can help increase investment portfolio, but Social Security will be reduced, and pension payments to survivors may drop, or even end. This means a greater reliance on portfolio income, and makes an effective plan and allocation strategy even more important.