If you’re approaching retirement, you are probably focused on a single issue: Do I have enough money?
This is indeed the crucial question. But as you try to figure out
whether you can comfortably retire, I would also encourage you to ponder
three less obvious questions.
1. Where are we in the market cycle?
Suppose you retired in October 2007 with a $500,000 nest egg. Those
savings were split 60% in the S&P 500 stock index and 40% in the
Barclays U.S. Aggregate Bond Index. You used a conservative 4%
withdrawal rate, which gave you some $20,000 in portfolio income during
your first year of retirement.
Result? By the end of February 2009, your nest egg would have shrunk to less than $320,000.
What you’re seeing here is the impact of the 2007-09 bear market — and a classic example of sequence-of-return risk.
The big worry: You retire, get hit with a market crash, and the
combination of tumbling markets and your rising need for spending money
quickly eviscerates your portfolio. Even if markets fully recover, your
portfolio may not, because it’s been so depleted.
Fortunately, in this instance, things worked out OK for retirees who
stayed the course. According to Baltimore fund manager T. Rowe Price
Group, as of March 31, 2014, your portfolio would have been worth almost
$515,000. “Looking at this can relieve people of some of their
anxiety,” says Christine Fahlund, a senior financial planner with T.
Rowe Price. “Lo and behold, after a fairly short period, you’re back to
where you started. That’s pretty darn good.”
What if you’re retiring today? It’s unlikely we’re facing another
economic meltdown, but there’s plenty of reason for caution. The S&P
500 has almost tripled since its March 2009 low. It yields just 2% and
trades at a relatively rich 18 times trailing 12-month reported
earnings.
From current levels, U.S. stock returns will likely be modest over the
next decade, perhaps averaging just 6% a year, and there’s a chance we
could see a nasty selloff. Meanwhile, bonds offer modest yields and
they, too, could fall sharply.
With that in mind, you might head into retirement with a cash reserve equal to perhaps five years of portfolio withdrawals.
How much should you allow yourself to withdraw each year, including
dividends and interest? Don’t be lulled into complacency by the strong
returns of recent years. I would stick with the 4% withdrawal rate that
many financial experts now advocate — and be mentally prepared for rough
markets.
2. What embedded tax bills do you face?
Let’s continue with our example of a $500,000 portfolio and a 4%
withdrawal rate. You pull out $20,000 in your first year of retirement.
But how much spending money will you have?
That’ll depend, in part, on where the money comes from. If you tap a
bank account or a Roth individual retirement account, you should have
$20,000 in spending money, with no taxes owed. Meanwhile, if you sell
stocks held in your regular taxable account, you may have to pay
capital-gains taxes.
What if you withdraw from a traditional IRA? The entire sum will likely be taxable as ordinary income.
Thanks to your standard or itemized deduction and your personal
exemption, the tax bill on $20,000 may still be quite small — unless you
have other taxable income, in which case you could lose a fair amount
to taxes. That tax bill will mean less money to spend, so you should
factor that into your retirement budget.
3. What are your monthly fixed living costs?
At issue here are monthly expenses that are pretty much unavoidable —
things like your mortgage or rent, groceries, utilities, phone, cable
TV, insurance premiums and property taxes.
While it’s easy to cut out discretionary spending, such as vacations and
restaurant meals, it’s harder to trim these monthly fixed costs.
As a precaution, you may want to ensure you have enough regular income
to cover these fixed costs, because you’ll have to pay them, no matter
how rough markets get.Where will the money come from? Calculate how much income you will
collect each year from dividends, interest, Social Security and any
pensions or income annuities. You can supplement that with occasional
withdrawals from your portfolio’s cash reserve.
If you won’t have enough regular income, you might delay Social Security
to get a larger monthly check or purchase an immediate fixed annuity.
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