Retirement Preparation and Crucial Decisions


A hat with other stuff on the beachRetirement is like a flight destination: Once it's clearly within sight, there are things you need to do to prepare for landing. The final months leading up to your retirement are a critical time to reassess your finances and position yourself for lasting security.

As part of your retirement preparations, you have some fundamental decisions to make about your assets. Four of the most important topics are covered in this article. A professional financial or investment advisor can help you make your way through these decisions and discuss any concerns or questions you may have as you transition into this new life phase. Let's talk through some of the most important issues you may need to address.

1. How should you be invested now?

Your "asset allocation" — the investment mix for your assets — is as critical during your retirement as it was during your working years, when you were putting away money for the future. The biggest driving force behind an investment portfolio's performance is the way the portfolio is divvied up among various asset classes, or investment categories. Primary among asset classes are equities (stocks), fixed income (bonds), money market (cash or CDs), guaranteed assets (fixed annuities), real estate and alternatives. Each asset class has its own risk and return profile, and a well-diversified portfolio for retirement income generally includes investments from the various asset classes. As you move into retirement, you should revisit your investment goals. Your assets should be allocated in accordance with your new goals, how much time you expect to have in retirement, your objectives for investment returns and your tolerance for risk.

You now need to take a fresh look at the asset allocation strategy for your retirement portfolio, perhaps with the assistance of a professional financial or investment advisor. Assuming you will need to start tapping investments for income after you retire, consider moving a portion of your retirement portfolio out of growth-oriented investments like equities and alternatives and into investments such as bonds, bond funds, bond ladders and fixed income annuities, which seek to produce current income and adequate cash flow to help meet your retirement budget needs.

You should consider not getting out of growth investments entirely, though. If you retire at age 65 in good health, you have a good chance of living another 20 to 25 years, or perhaps even longer. Your allocation strategy should reflect the fact that retirement today lasts a lot longer than it did for previous generations, thanks to medical advances and increasing life expectancies.

It's a good idea for everyone, regardless of age, to reassess his or her allocation strategy at least once a year. You may want to do so more often in the event of a major life change, such as reaching retirement, or becoming single due to a separation, divorce or loss of one's spouse or partner. You may also want to do so when financial markets swing significantly.

2. How will you leverage your investments as sources of retirement income?

As you gear up for retirement, one of your key objectives should be crafting a strategy to draw from your retirement assets in ways that allow you to live with financial security. This strategy should take a number of considerations into account:

  • How you can create your retirement income “floor”
  • How much you can safely withdraw from your portfolio
  • How to satisfy your required minimum distributions
  • How to manage your taxes throughout retirement

How you can create your retirement income "floor"
Although the amount will vary from person to person, everyone will need a certain amount of annual income to act as retirement income "floor." This is the amount you’ll need to cover your essential expenses such as food, shelter, clothing and healthcare. We believe that your floor should be covered by a guaranteed income stream that you cannot outlive. Generally, your Social Security benefit and pension payout amounts are your starting point. Then, if you have a gap in covering all of your essential expenses, you may want to consider lifetime annuity income or other appropriate options for your particular needs.

With lifetime annuity income, you set up a contract between you and an insurance company. The contract states the amount you will pay in return for the insurer to provide you with guaranteed income payments for life. One type of income annuity, called a fixed income annuity, provides both tax-deferred growth and a minimum level of guaranteed income. It is particularly well suited to help you cover the gap in your essential expenses, as you can count on a specific dollar amount each month. Another option is a variable annuity, which also provides tax-deferred growth and lifetime income. However, the income from a variable annuity can increase or decrease based on market performance. The income amount you will receive typically resets monthly or annually.

How much can you safely withdraw from your portfolio
According to some investment professionals, you're less likely to outlive your retirement assets and better able to maintain purchasing power in the face of inflation if you follow the “Age 65/4% rule.” Under this guideline, you withdraw about 4% of your total portfolio once you reach age 65. You then increase the dollar amount of your initial withdrawal each year thereafter by the rate of inflation.

For example, let's say you retire with a nest egg worth $500,000. To follow the 4% guideline, you would withdraw $20,000 at age 65. Assuming annual inflation of 2%, you would take out around $20,400 during the second year, $20,808 the third year and so on. This method can be used to help fund your essential expenses, as you have a set amount of cash flow you can count on.

The 4% rule is by no means a hard and fast rule for everyone, but rather a starting point for distributions from your assets if you are retiring at 65. If you are retiring earlier, a 4% withdrawal is too high, and you’ll run the risk of running out of money too soon. If you are retiring later, at 72 or 75, 4% is too conservative, and you could withdraw even more without the risk of running out of money too soon.

Another option is to set a reasonable withdrawal rate each year as a fixed, specific percentage, such as 3.8% or 4.2%. Each year, you would withdraw only that fixed percentage of your portfolio value. Your distribution amount will vary each year, as the value of your portfolio is affected by the investment return of the previous year. This method works well for funding discretionary expenses, as some years you will have a larger amount and some years a smaller cash amount.

It's important for you to take a personalized approach to planning your retirement withdrawals. Whether you want to use the 4% guideline or set a fixed rate, work with your financial advisor to determine a reasonable retirement planning horizon. He or she will help determine your withdrawal rate while maintaining an asset allocation designed to provide for cash flow and the long-term growth potential of your nest egg.

How to satisfy your required minimum distributions
Generally, once you reach age 70½, IRS rules require you to withdraw at least a certain minimum amount from your Traditional IRAs and workplace retirement plans each year. This is referred to as your required minimum distribution (RMD).1 There is a specific calculation that must be run based on the value of all your Traditional IRAs and Employer plans — wherever they are held. A failure to meet your RMD could result in substantial IRS penalties — generally 50% of the amount you should have distributed.

There are a couple of exceptions to RMDs. Any Roth IRA of which you are the original owner is exempt from RMD rules. You can leave your assets in the Roth as long as you like, and may want to use these assets as a legacy for your beneficiaries. In most cases, you do not begin withdrawing from a workplace retirement plan if you are still working for that employer. (Some exceptions do apply, such as a SEP IRA or a Simple IRA, so you may want to discuss this with your financial advisor.) Your employer’s retirement plan may allow you to roll over your traditional IRA and retirement plans from previous employers. This allows you to effectively delay RMDs as long as you continue working. You should check this option with your current employer to see if the provision is available. And, remember, your minimum distribution amounts will be higher once you do stop working, which could push you into a higher tax bracket.

RMDs can be complicated to calculate, but a professional financial or investment advisor can help.

Case study: Filling a retirement gap

Harry is a maintenance worker for his local school district. He is retiring next year at age 67, and is looking forward to spending more time with his grandchildren and in the garage where he keeps his woodworking projects.

He estimates that he’ll need $28,000 in essential expenses each year in retirement, including $5,000 for health care coverage and $8,000 for each of the next three years to clear his mortgage. He also wants to budget $12,000 per year for discretionary “fun” in retirement, bringing his total retirement budget to $40,000 per year. Harry will receive a $12,000 annual pension and about $18,000 each year from Social Security. He has saved $80,000 in his 403(b) plan at work.

The good news is that between his pension and Social Security, he can cover all of his essential needs, and even has a surplus of $2,000 that he can use toward his discretionary expenses. However, his 403(b) plan assets will not be enough to meet the full $12,000 that he would like for discretionary expenses. He could withdraw about 5% initially, which gives him an additional $4,000. Added in with the surplus, that would give him $6,000 for discretionary income, which leaves him short by half.

Harry has some options and will need to decide how to handle his shortfall: He can scale back his discretionary spending for the first few years until his mortgage is paid off. He could try turning his woodworking hobby into a paying hobby. Or, he could turn a portion of his 403(b) into an income annuity that may give him a higher withdrawal rate plus a guarantee of not outliving his assets. The remaining portion can be invested for potential growth and to help offset inflation.

How to manage your taxes throughout retirement
Once you start taking withdrawals from retirement accounts, you will generally owe income tax on any tax-deferred amounts distributed. In addition to owing income tax, if you retire or separate from service before the age of 55, you may incur a 10% federal penalty on distributions of tax-deferred amounts. (In the case of an IRA, 59½ is the age at which you no longer have to worry about the early-distribution penalty.)

Generally, it makes sense to withdraw retirement money first from taxable accounts; this allows for the continuation of tax-deferred or tax-free growth in other accounts. Next, move on to tax-deferred accounts, such as Traditional IRAs and accounts in most workplace retirement plans. Last, start drawing from Roth IRAs, which are generally tax free. Roth IRAs often come last because, unlike Traditional IRAs and accounts in workplace retirement plans, they're not subject to RMD rules. This makes Roth IRAs good vehicles for handing down assets to your heirs. However, to avoid tax-bracket creep, you may want to use some of your tax-free Roth assets as part of your income plan.

The ordering of withdrawals outlined above may not be optimal for everyone. You should create your own strategy based on your tax bracket, whether or not you expect your tax rates to fluctuate, the risk levels you are willing to take in your investment portfolio, RMD rules and other factors. A professional financial or tax advisor can help you navigate the complex rules for distributions and associated tax liabilities.

Case study: Deciding between income sources

Maria is a history professor at a private university who will be retiring after this semester at age 68. She is married to Frank, who retired two years ago. This is a second marriage for both, so they have chosen to keep the majority of their finances separate. They live in New York City and are looking forward to having more time to enjoy all that New York has to offer, and to spend more time traveling now that they will both be fully retired. Maria is planning for a long retirement as her mother is still living at age 95. And, ideally, she would like to start gifting some of her assets to her two adult children and plan for a financial legacy as well.

She estimates that she will need $80,000 each year in retirement: $35,000 for her share of essential expenses and $45,000 for discretionary expenses. Maria has saved more than $1.2 million in her 403(b), which will afford her some flexibility in deciding how to pay for her retirement. She knows that once her required minimum distributions begin at age 70½, she’ll be drawing out somewhere around $45,000 per year. She also has $180,000 in her checking account.

She has several options to consider and key decisions to make:

  • She could begin her Social Security benefits now, at age 68, which gives her about $26,400 in income to cover some of her essential expenses. The remaining $8,600 that she needs each year for essential expenses can come from her checking account. She could also wait two more years to receive her maximum Social Security benefit of about $30,000. Then, she would have to pull $70,000 from her checking account to cover essential expenses for the next two years, but she would then receive about 16% more in her Social Security for the rest of her life.
  • Another consideration is how she might tap into her 403(b). She could choose a lifetime income annuity for a portion of her portfolio that will provide her with a guaranteed income stream for life. Or, she could instead wait two years and then begin her required minimum distributions. To help her pull some cash from her assets, she could draw down just the interest, and then set up her RMD.

These are complex decisions with tax consequences. Maria would benefit from working closely with her financial advisor and accountant to figure out the best strategy to maximize her income choices and her financial goals.

3. Who will make investment decisions for you if you become incapacitated?

As you embark on your retirement phase of life, you also need to think more about aging and the implications of growing older. If you make most or all of the investment decisions in your household, you need to plan for the possibility that you could someday become incapacitated and unable, either temporarily or permanently, to make such decisions. If that were to happen, who would make sure your assets continue to be managed for your benefit and for your spouse or partner?

Starting the conversation about what growing older could mean is often difficult, but the worst thing you can do is avoid the topic. Set a time for you and your spouse or partner, or your adult children, your best friend or your estate planning attorney to address how you would want things handled if you couldn’t manage your affairs anymore. One place to start is to discuss putting a durable power of attorney in place. This is a legal document in which you appoint your spouse, partner or anyone else of your choice to make financial and legal decisions on your behalf in the event you're unable to communicate your own wishes.

Another option is to hire a professional investment manager and ask him or her to set up a meeting with you and those you want to participate to plan for the possibility that you could lose your ability to make certain decisions. Choose a reputable individual or organization that will provide comprehensive, strategic management of your finances, healthcare decisions and other family requirements based on the needs and goals that you've outlined in advance.

Case study: Managing required minimum distributions

Joanne is divorced and is about to retire at age 69 from her job as a hospital administrator. She is entering retirement with $275,000 in a traditional IRA; a 403(b) plan containing $750,000; a savings account with $80,000; and a brokerage account with $100,000. She has estimated her annual expenses in retirement at $70,000 per year: $49,000 for essential expenses and $21,000 for discretionary expenses.

Retiring at age 69, Joanne only has one year to wait until she can maximize both her Social Security payments and her tax-deferred IRA and 403(b) plan assets. Since she has sufficient assets in her brokerage and savings accounts, she could pull the full $70,000 for her annual expenses from those accounts for her first year in retirement.

Then at age 70, she will collect her maximum Social Security payment of approximately $3,000 per month, or $36,000 per year, which will cover a large portion of her essential expenses. She can cover the $13,000 balance by annuitizing enough of her 403(b) assets to generate a guaranteed payment stream for the rest of her life. Calculating how much of her assets to annuitize is complex, and she can expect to annuitize somewhere around $175,000 to $200,0002, depending on the factors at the time she converts to a lifetime income annuity. She should discuss the details with her financial advisor.

Her discretionary expenses can be covered from her required minimum distributions on the remaining 403(b) plan assets and her IRA. The RMD amount, around $25,000 in the first year, is enough to cover her lifestyle budget of $21,000 and provide her with a cash cushion for any emergencies or opportunities that could occur.

4. How can you get your financial house in order for a more enjoyable retirement?

There are many financial decisions you have to make as your retirement date gets closer: when to sign up for Social Security, which Medicare and Medigap plan to choose, how to get your mortgage paid off, and so on. Then, you have to start managing your various sources of income across any number of financial institutions to create a cash flow that you won’t outlive. It is a tall order, and trying to manage it all can take a considerable amount of time now and in retirement.

One of the best ways to get your financial house organized is to pull together all of your various accounts (and those that your spouse or partner may have) and consolidate as much as you can with a single, trusted financial institution. Talk to their financial consultants, who can help you answer your questions, make investment decisions for your retirement years, and help you construct your retirement income plan. You can simplify by consolidating your assets and using a central “hub” to manage all of your investments and assets for income.

Before transferring assets, consider the differences in features, costs, surrender charges, services, company strength, and any tax consequences. Before making such decisions, consult with your own advisors regarding your particular situation.

Once your retirement finances are organized, you can spend more time enjoying your retirement years.

Launching into the next phase
The brink of retirement is an exciting time, yet can also create anxiety due to the number of decisions to be made. The planning issues we've outlined can be complex and time-consuming, and you might want to turn to a professional financial or investment advisor for help. Consider choosing an advisor who can coordinate all the above topics and help you develop an overall strategy.

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