The transition from the saving/accumulation phase to the spending/distribution phase that often accompanies reaching financial independence is a lot like going on vacation. If properly planned, the difficult work is done in preparation for the trip. Once on vacation, you should be able to sit back and enjoy your hard work. Like any vacation though, there are still many decisions to make along the way and things will undoubtedly happen that require you to make adjustments as you go.
There is a change in mentality that accompanies the shift from accumulating assets to distributing them, and the event often brings a wave of new questions. Such questions include:
- How much can I spend?
- From which accounts should I draw?
- How often should I review my strategy?
- How should I allocate my portfolio?
A balance must be struck between maximizing the benefit of your hard-earned resources and ensuring the money lasts through the duration of your lifetime. A well-thought-out strategy helps you enjoy your financial independence the way you envision it.
Figuring Out How Much You Can Spend
The “Four Percent Rule” is the conventional wisdom when it comes to how much you can withdraw from your portfolio. The rule was based on a study that looked at historical data back to 1926 to determine the highest feasible withdrawal rate from a 50:50 stock and bond portfolio. Over this period of time, one could withdraw up to 4% of the initial portfolio value (adjusted annually by inflation) without the portfolio depleting over the duration of a typical 30-year retirement period.
While the “Four Percent Rule” is a reasonable starting point for understanding how much spending your portfolio can support, you must also consider the specifics of your unique situation. Start by figuring out your annual expenses, including both discretionary (travel and entertainment) and non-discretionary (housing, healthcare, food). Then, subtract any income provided by sources outside your investment portfolio (Social Security, pension, part-time work) to determine the amount that must be supported by the portfolio. If it is less than 4%, you are likely in good shape.
The Waterfall of Withdrawals by Account Type
You’ve figured out how much you can spend, now what? After considering other income sources (such as Social Security or pensions), most people find they must supplement their lifestyle by withdrawing from investment portfolios. It’s common for people to have multiple investment accounts, each with a different level of tax advantage. The general order of preference is to first withdraw from taxable accounts (e.g. brokerage), then from tax-deferred accounts (e.g. Traditional IRAs), and lastly, from tax-free accounts (e.g. Roth IRAs). Sequencing account withdrawals properly, taking advantage of proactive tax strategies, and being strategic with the timing of when you receive different income sources can dramatically reduce your lifetime tax bill.
Another point worth noting is how overall tax strategy tends to shift in the distribution phase. During the working years, the mentality is to do whatever is necessary to defer and minimize your taxes every year. During the distribution years, however, there tends to be more flexibility with tax planning and the focus should be on minimizing your taxes over the duration of retirement. This implies “filling” certain tax brackets today to prevent a large jump in tax obligations once things like required IRA withdrawals and Social Security eventually materialize.
When to Review Your Plan
Life is fluid and circumstances change, so it makes sense to review your financial plan periodically. Barring a significant life change, it’s probably unnecessary to revisit your plan monthly or even biannually. Once a year is a reasonable frequency to review goals, expenses, and other information to ensure you are tracking on target with your plan. Ideally, the financial independence life stage brings an increase in enjoyment and a reduction in stress, so a similar mentality should apply to financial management.
How to Allocate Your Portfolio
The traditional wisdom is that you should shift to bonds in retirement because they are “safe” and you have to preserve what you have saved. While bonds tend to be less volatile than stocks, they also tend to produce a lower return. This return discrepancy is particularly significant when you recognize that your expenses in retirement aren’t fixed, but rather increase with inflation (the cost of a stamp in 1980 was $0.15 compared to $0.50 today). In fact, over a typical 30-year retirement horizon, the average person’s annual expenses will increase by 250%! Also keep in mind, the average retirement horizon will continue to grow as medical advances extend life expectancy. Capping your rate of return (as bonds do) during a prolonged period when your expenses continue to grow can be dangerous, which is why we favor maintaining adequate exposure to stocks, even once you have reached the distribution phase.
We use a “buckets” approach to portfolio management, whereby the portfolio has both a steadier, lower return component (the bonds bucket) and a more volatile, higher return component (the stocks bucket). The bonds bucket can be used to fund expenses during periods when stocks produce negative returns, allowing the growth portion of the portfolio to remain untouched and resume its upward trend once the market recovers. This approach provides some mental comfort, making it easier to ride out periods of market volatility without panicking or making knee-jerk changes to what should be a long-term investment plan.
Enjoy the Ride
The transition to retirement is an unprecedented experience for people, and the associated mental and emotional shifts can be daunting. The fear of running out of money can detract from what should be a period of enjoyment, reduced stress, and harvesting the fruits of years spent working, saving, and investing. However, by implementing some of the concepts explained above, you can rest easy and ensure that you will enjoy the well-deserved trip.
About MD Wealth Management: We are an Ann Arbor financial planner that specializes in providing financial planning for physicians and retirees. We are CERTIFIED FINANCIAL PLANNER™ professionals and fiduciary financial advisors who operate on a fee-only basis, which means we do not sell financial products or collect commissions. As an Ann Arbor financial advisor, we enjoy working with clients both locally and remotely.