If you’ve saved an adequate amount of money to comfortably fund your retirement, you probably think you are in the home stretch. The only thing left to do is sit back and enjoy your nest egg, right? Not so fast. You may still have to navigate some rough waters, so it may not all be smooth sailing.
For one, you will still have to manage your savings to yield the income you desire to finance your lifestyle.
Financial planners favor three main approaches to converting retirement savings into retirement income: probability-based, safety first and using “buckets.” A less common strategy involves weighing utility. Click on the tabs to learn about how they work.
According to Wade Pfau, a professor of retirement income at The American College in Bryn Mawr, Pennsylvania, the probability approach is the most prevalent. This way, your savings are invested in a portfolio with assets such as stocks and bonds chosen based on your risk tolerance. You then use the income generated from the portfolio and might even have to dip into the principal to meet your expenses.
Pfau says this approach is more popular because it mimics the pre-retirement approach, which people already understand. “It’s a more natural way for people to think about retirement income.”
The approach is based on William Bengen’s finding that, historically, starting off with a 4 percent withdrawal rate from a retirement portfolio and adjusting for inflation each year yields a high probability that you won’t run out of money over a 30-year retirement period.
You could also use a higher withdrawal rate if you are willing to dynamically cut your spending in the future if the need arises — for instance, after a market downturn.
“If you are not comfortable making adjustments, you will probably want to start with the more conservative (4 percent) rule in the first place so that it is dynamic to the upside, not to the downside,” says Michael Kitces, director of planning research at Pinnacle Advisory Group in Columbia, Maryland. “That cuts down to what kinds of trade-offs you are comfortable with.”
According to Kitces, people have a greater appreciation of the 4 percent rule after the financial crisis, considering that it is geared to such worst-case scenarios. In the years prior, when the market was doing very well, people wondered if the 4 percent rule was too conservative.
This approach has its detractors, too. Harold Evensky, chairman of Evensky & Katz, a Coral Gables, Florida, financial advisory firm, says that retirees using this retirement income strategy must deal with inconsistency. “They are not getting a consistent cash flow. They never know, even from one day to the next, what the cash flow is going to be because dividends and interest rates are constantly changing. So it’s a nonsensical way to plan.”
Paula Hogan, CEO of Hogan Financial Management, a Milwaukee financial advisory firm, points to another shortcoming. She says, during the financial crisis, “people who had their base standard of living covered with inflation-protected income and then put at risk in the market what they were able and willing to lose were fine. People who had money that they needed for groceries in the market were not fine.”