It’s Never Too Early to Plan for Retirement Income

by Steve Cassaday, CFP®, CFS

In the world that today’s retirees live in, the probability is high that withdrawals from an investment portfolio will be an essential part of retirement cash flow.

Pensions and Social Security are unlikely to be sufficient to meet the needs of most retirees. Unfortunately, there are many variables associated with portfolio withdrawals, and an understanding of them will help retirees make better decisions. There are three key questions that must be answered to properly address this issue.

How much will I need to live in retirement?

The best way to determine this is a simple household budget you and your partner complete together. This will require you to pretend that you are retired. It takes some concentrated effort to come up with a realistic spending figure.

You must be able to answer this question: How much money do I need coming in each month, after taxes, to live the way I want to live? Once you know this number, you can subtract your Social Security and pension income from it to determine the amount you will need to take from your portfolio as supplemental cash flow.

How much do I need in assets to generate my monthly required cash flow? This depends on several variables:

  • What is a sustainable withdrawal percentage? Opinions vary among experts. The truth is a sustainable withdrawal amount is unknowable since rates of return on your investment portfolio are unknowable. Although past performance cannot guarantee future results, the only barometer we have for future portfolio returns is historical returns. Studies based on historical data indicate that potentially sustainable withdrawal rates fall between 3 and 7 percent of the beginning portfolio value.
  • How many years will the withdrawal be required? Again, this is unknowable, so you should assume you will live to be 100. If your plan works through age 100, that is good because the chances of living to that age are actually quite low.

According to “The Book of Odds,” at 50, your odds of living to 100 are 1 in 37.34. They grow to 1 in 21.48 once you reach 80 and, at age 90, you have 1 in 8.85 odds of making it to the century mark. The older one is, the larger the safe withdrawal amount can be since statistically there will be fewer years of withdrawals.

For general illustration and informational purposes only, let’s assume the retiree believes a 5 percent withdrawal rate is sustainable and needs $2,500 per month or $30,000 per year for expenses. The formula to calculate the required asset amount is: annual income divided by withdrawal percentage expressed as a fraction; or $30,000/0.05 = $600,000

So, assets of $600,000 could throw off cash flow of $30,000 per year. It is important to note that individual situations can vary. This example is not indicative of any specific investment product.

  • What types of portfolios are best for withdrawals? We believe a portfolio that strikes a balance between reasonable returns and low volatility is likely the best choice. Historically, a portfolio diversified among stocks, bonds, cash equivalents and hard assets like commodities and real estate has generated competitive returns with manageable volatility.

How do I actually get the cash flow from the portfolio?

We recommend a combination of rebalancing and harvesting. First, recognize that what you need during retirement isn’t income; it is cash flow. Income comes from dividends and interest, and today yields are too low to provide meaningful returns.

Cash flow is generated by systematically rebalancing the retirement portfolio back to its target allocations among stocks, bonds, hard assets and cash. This can be accomplished by taking money from items that are above their target allocations and adding part of the proceeds to those below their target allocations. The amount left over is “harvested” as cash for withdrawals. A cash flow objective combines interest and dividends with growth for a total return approach to portfolio withdrawals.

Getting set for your retirement means having a clear view about what you will need in cash flow, determining whether that figure is achievable based on your accumulated assets and figuring out how to actually generate it. Following a few simple steps can help you get ramped up for a happy and more confident retirement.

As seen in the 11/30/2012 issue of Washington Business Journal


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