You spend a large part of your life saving and investing with retirement in mind. Then, when the time finally comes to retire and convert your savings into income, you are left to develop a strategy that has to accomplish two things:
- Protect the wealth you’ve accumulated over the years.
- Grow your savings during retirement to comfortably afford your lifestyle for the next 30+ years.
That’s a tall order! At this point, you will need to create a retirement income strategy and tweak your portfolio accordingly - in the years leading up to and throughout retirement.
Pay Attention To Your Risk Capacity
We read a lot of financial articles about risk tolerance, and how it impacts retirement planning. However, during retirement, risk capacity is the name of the game. Risk tolerance focuses on how much risk you can tolerate. Risk capacity is how much risk you need to take to accomplish your goals. While they sound similar, both risk tolerance and risk capacity can be very different.
Some people are comfortable with the ups and downs of the market, and don’t feel the need to dramatically change their investment strategy as a result of market changes. Other people are risk averse, meaning that they’re more likely to change their investment strategy (often by cashing out, or selling when the market is low) because they’re unable to emotionally cope with the negative side effects of risk in their portfolio.
There’s no wrong answer when it comes to your risk tolerance. Everyone is different, and building a strategy that takes your risk tolerance into account is key. Risk capacity, on the other hand, is a different ball game.
As you get closer to retirement, your risk capacity will decrease - regardless of what your risk tolerance is. Your risk capacity is a measure of how much risk you need to take to fund your goals. If you’ve already built a retirement nest egg, and are planning to start withdrawing from it soon, your capacity for risk will be a lot lower because you’ve already reached your savings goals, or are close to them.
Even if you love risk in your portfolio, and enjoy the thrill of high-risk-high-reward investing, paying close attention to how much risk you need to take as you near retirement is key. Your risk capacity may push you to become more conservative in your investments as you get closer to retirement.
Adjust the 4% Rule
The traditional 4% Rule states that you withdraw 4% of your total portfolio each year of retirement, adjusted for inflation, to create an income stream. In doing so, you have a 96% chance of outliving your money.
This is a relatively conservative withdrawal rate that is set up to help protect you against over-withdrawing in the early years of your retirement, and eventually run out of money. The idea behind the 4% rule is that the withdrawal rate is conservative enough to last you a minimum of 33 years if the markets experienced prolonged downturns (this is an approximate based on tests run by William Bengen in 1994).
However, the 4% rule can be tweaked and adjusted to better support your retirement income goals, while still accounting for what’s going on in the market.
Revise the 4% Rule Based on Your Portfolio Each Year
Although the 4% Rule is an excellent baseline to follow, you can be even more cautious by revising the rule slightly. Instead of calculating 4% of your portfolio’s original value at the onset of retirement, and continuing to withdraw that amount (plus inflation), you can revise your calculation each year based on your portfolio’s current value.
This gives you a clearer picture of how your portfolio is doing during normal market fluctuations, and makes sure that you’re still withdrawing at a rate that’s conservative (regardless of how the market has impacted your portfolio). Using this updated 4% Rule, you’d be withdrawing a little bit less during a “down” market, and a little bit more during an “up” market. This fluctuation in income should be relatively minor, and helps to make sure your withdrawal rate is even more sustainable throughout retirement.
Create Savings Buckets to Diversify Your Portfolio
Although the traditional 4% rule for portfolio withdrawals is still often used by financial planners, you have another option: the “bucket” strategy.
While the bucket strategy may be more complicated than the relatively straightforward 4% rule, it sets you up to have consistent income throughout retirement while still prioritizing not running out of money. The bucket strategy looks like this:
When you retire, you reorganize your portfolio into three “buckets” that you’ll withdraw from throughout retirement. Each bucket has its own time horizon, and is set up with different asset allocations based on when you plan to start withdrawing from each particular bucket. The three timelines I like to use are:
- An initial bucket invested in cash that covers 1-3 years of living expenses in retirement.
- An intermediate bucket, comprised of bonds of varying durations, that covers years 3-7.
- A long-term bucket made up entirely of equity investments for use 7+ years down the road
This strategy helps to balance the need to continue to grow your savings to use throughout retirement (sometimes using riskier investments, depending on your strategy), with your need to protect the portion of your portfolio that you’ll be converting to income shortly after retiring.
Work With a Professional
Finally, investing the time and resources to work with a fee-only, fiduciary financial planning professional can be essential for individuals and couples nearing retirement. A financial planner can help to create a retirement income strategy for you and your spouse or partner, adjust your portfolio in the years leading up to retirement, and continually monitor your withdrawal strategy throughout retirement. Working with a financial planner can help you to ensure that you’re creating the best possible income strategy for yourself based on your lifestyle goals, taxes, life expectancy, the total value of your portfolio, and more.
If you want to learn more about how a financial planner can help guide you to and through retirement, reach out! I’d love to talk to you about your retirement savings strategy.