How you take money out of your retirement accounts is an important decision. So, it should be a significant component of your retirement planning. This decision can impact your peace of mind and quality of life in retirement because it dictates how much you have to spend and how long your funds will last. Planning your retirement distribution strategy well in advance increases the likelihood you’ll accomplish your future consumption goals. Overlooking this aspect of your plan can leave you in a position where your circumstances dictate your retirement lifestyle.
Factors That Influence Your Retirement Distribution Needs
There are a number of factors that can influence how you will spend money in retirement. Many can be anticipated. Some can be controlled. And others are completely random. The combination of these factors will determine your retirement distribution needs. They include:
- Time Horizon
- Medical Costs
- Income Sources
- Using Capital
Time horizon, in the context of retirement planning, is your presumed life expectancy.
People are living longer. This complicates retirement planning because you need to consider the possibility of a very long retirement. Living 30 or 40 years in retirement isn’t uncommon.
Planning for a longer life means that you either have to save more or spend less to build a nest egg that can finance decades living in retirement. Planning for a longer life also increases uncertainty. Older ages correlate with increased medical costs.
The future cost of medical care is uncertain. Modern medicine, active lifestyles, and other factors contribute to increasingly longer lives. And the longer people live, the greater their need for medical care. Allocating resources in retirement to deal with medical contingencies, including long-term care, is an essential piece of sound planning.
The cumulative effects of inflation, even at low levels, can be significant over long periods of time. The cost of everything in retirement could quadruple over a long life expectancy. This is why it is important to consider the types of investments you own.
You should consider how effective your asset allocation is at generating income (on which you can live comfortably) and producing growth (to help you mitigate the negative effects of inflation).
Growth-oriented investments can help you keep inflation from deteriorating your purchasing power. But they can also be volatile (i.e., fluctuate in value).
Only you can determine the best approach to dealing with volatility. You may choose to ride out periods of market uncertainty or you may choose to own fewer risky assets. The conversation around risk and return is one you should have early and often with a Financial Advisor.
Ideally, your investments should help you achieve your retirement objectives without forcing you to liquidate assets at inopportune times or keep you up nights worrying about how safe they are.
Taxes are inevitable and their impact should be a part of your retirement planning. But the tail should not wagthe dog.
Distributions from qualified retirement accounts are subject to income tax. That simply needs to be factored into your calculation.
One way to do this is to “gross up” your spending requirements to cover taxes on distributions.
Most people have other sources of income in addition to their retirement plan assets. These may include Social Security or pension benefits.
Which of these sources forms your base will be determined by your focus on optimizing Social Security.
The timing of when to use which income source will affect your income tax situation, your cost of Medicare, and your total Social Security benefits.
There are two ways of looking at your retirement plan assets. You can view them as a (theoretically) permanent asset or as a wasting asset. In other words, you may use a capital retention strategy or a capital depletion strategy.
In a capital retention strategy your goal is to keep as much of your principal intact as possible. The point is to live off the earnings it generates. For the account to be durable over time, some of the capital would be invested in growth-oriented assets.
Growing the underlying assets is necessary to fund increasingly larger outflows as inflation drives the cost of your living expenses higher over time.
A capital depletion strategy has you living off a combination of principal and earnings. Growing the underlying assets is less important than using them to fund your retirement lifestyle. Unlike the capital retention strategy, here the goal is to deplete the account…just hopefully not during your lifetime.
At some point in the future, the account runs out of money. The key is to aim for this to happen as far into the future as possible. This strategy is most effective when you have other sources of income.
For example, you might want to deplete one qualified retirement plan entirely before applying for Social Security benefits. In this way you may be able to maximize your lifetime benefit.
A capital depletion strategy is the more common retirement distribution method. This is not because it is the optimal or preferable system. It’s typically the default method because people haven’t saved enough. Many people simply don’t have any other option…except to keep working.
Assumptions and Uncertainties in Retirement Planning
The assumptions you make about variables and contingencies have a significant impact on the success of your retirement plan and what you’ll be able to eventually draw from it.
You can’t really know how your investments will perform when you begin planning for retirement. You cannot know what bumps in the road or opportunities will emerge in your career. Nor can you know how your personal circumstances will unfold over time.
Retirement planning requires you to make some assumptions, deal with the uncertainties of life, and accept the risk and returns the financial markets deliver. You can’t control any of these.
The most important aspect of retirement planning is focus on what you can control. Save what you can, when you can. Save as much as you can as early as possible and be consistent about it.
When you need help, your Financial Advisor may be a great resource to help you build your retirement distribution strategy.