Planning for financial independence, formally called retirement planning, for most people means building a nest egg. As retirement approaches, it becomes time to shift your thinking from accumulating retirement funds to using those funds. Making this shift can be challenging and fraught with difficult emotions. It’s not uncommon for retirees to worry that, if they stop working and start consuming their savings, the poor house is only a step away.
One way to ease these fears is to plan for getting a “paycheck” out of that nest egg. The first step in arranging for a dependable monthly retirement income is to add up all the income sources you will have. These might include Social Security, a pension, annuities, and part-time work. Consider these first, before you start looking at what to withdraw from retirement plans such as a 401(k), IRAs, and personal investments.
The next step is to figure out your expenses. This means doing some cash-flow projections and a realistic spending plan. Be sure to figure in “one-time” expenses like saving for a new car, home repairs, and travel.
Now you need to decide how much you can afford to withdraw from your investments each month without the risk of running out of money. That will depend in part on the gap between your income from other sources and your expenses.
If retirement accounts, IRA’s, and taxable investments make up the bulk of your paycheck, it’s best to withdraw conservatively. Most financial planners agree that a withdrawal rate of three to five percent is reasonable. However, some planners are comfortable with six percent. One talk show host suggests eight percent is doable. I strongly disagree. If at all possible, you should provide for your essential needs with no more than four percent.
The experts do agree that you should never plan on withdrawing the amount you expect your portfolio to earn on average—say six or eight percent—in the coming years. Do that, and the wrong sequence of market declines could deplete your nest egg before your retirement years end.
What asset allocation should you maintain in retirement? The most recent study suggests 60 to 70 percent should be in stocks, real estate investment trusts (REITS), commodities, and absolute return investments. In considering the balance of your portfolio, it’s important to also pay attention to your sources of income. Let’s say you receive a monthly check from a private or public pension. I would treat this and Social Security benefits as equivalent to bonds in a portfolio. Thus, assuming you are comfortable taking some risk, the remaining portfolio might be more heavily weighted toward stocks and REITS in order to provide assets with a good chance of keeping ahead of inflation over time. Most private pensions are not indexed for inflation.
What if you don’t have a pension and must rely more heavily on your 401(k), IRAs, or other retirement accounts? I recommend keeping six months to one year’s worth of investments in cash and cash equivalents such as short-term bonds and certificates of deposit, while the rest of the portfolio might be in stocks, REITS, commodities, absolute return investments and intermediate term bonds.
Other factors in determining asset allocation include your tolerance for investment risk and your age. The younger you retire, probably the more aggressive your account will need to be.
Whatever you do, don’t make the mistake of putting all your retirement assets into CDs and bonds. Make sure part of your portfolio is invested in stocks, which in the long run will help keep its purchasing power from eroding. A balanced portfolio can provide both dependable retirement income and long-term financial security.