I have a framed picture in my office of a simple Venn diagram. The circle on the left is titled “Things That Matter” and the circle on the right is titled “Things You Can Control”. Where those circles overlap is shaded and titled “What You Should Focus On”.
The message is clear, you shouldn’t focus on everything that matters, and you shouldn’t focus on everything you can control. You should focus on things that both matter and that you can control.
So, when it comes to a financially successful retirement, what are the things that matter and that you can control? In my opinion, there are just a few:
- Timing Important Decisions
- Lifestyle Cost
- Risk Tolerance
- Tax Minimization
Timing Important Decisions
The timing of certain decisions in retirement is extremely important. I reference three potential decisions in the timing category: when you retire, when you start your social security benefit, and when you start your pension benefit (if you have one).
When You Retire
Retiring too early can cause financial issues in retirement and retiring too late can result in a waste of precious time.
Interestingly enough, most often, I see people retire too late instead of too early. Meaning, they worked extra years because they felt they weren’t financially ready to retire, when in fact, they were ready.
This is where working with a financial planner before retirement can be beneficial. They should be able to help you understand when you’ve reached that point of financial independence and no longer need to work if you don’t want to.
When you Start Your Social Security Benefit
The most important piece of information to know to optimize your social security decision is something you’ll never know, how long you’ll live. However, because it’s unknown we should also consider the other less meaningful, but still important factors, such as your tax situation, if you’re still working, if you have a spouse or ex-spouse (and what their benefit is), age of your spouse, how conservative/aggressive your investments are, and your personal risk tolerance.
My recommendations to clients on when to claim their social security benefit has ranged as early as 62 for some, all the way to 70 for others, and somewhere in between for most. There is not a one-size-fits-all solution to this question.
When You Start Your Pension Benefit
Similar to social security there isn’t a blanket recommendation on when to start your pension benefit. Many of the factors that are important in deciding when to take social security apply to your pension. In addition, there is one more complicating factor, interest rates.
With a pension benefit you can usually elect to take it as a lump-sum or as a monthly payment over time.
Your monthly payment is typically based on a simple formula like 50% of the average of your three highest earning years. So, if you’re three highest years you earned $150,000, $160,000, and $170,000 you would average those out, $160,000, and take 50% of that, or $80,000.
On the other hand, the lump sum benefit that is available to you is a slightly more complex calculation that considers an interest rate set by the IRS called the 417(e) rate. The higher this rate is, the lower your lump sum benefit will be. The opposite is true, the lower the interest rate, the higher your lump sum benefit will be.
A higher interest rate means future cash flows (or pension payments) are worth less, simply because inflation will eat that away. For that reason, the lump sum will be adjusted downward. If interest rates are low, it means future cash flows are worth more and the lump sum benefit will be adjusted higher.
Another way to make sense of this is to compare it to buying a house. If you know you can afford a $3,000 monthly mortgage payment and interest rates are low, say 3%, you can afford a home that is worth about $700,000. However, if interest rates were higher, say 6%, you could only afford a home worth about $500,000.
Timing in these three decisions (when you retire, when you take social security, and when you take a pension benefit) is extremely important and can result in differences of hundreds of thousands of dollars.
Lifestyle Cost
Planning your lifestyle in retirement and putting a number to what that lifestyle will cost is a crucial step in a financially successful retirement.
Let’s be honest, the vast majority (maybe 90% or higher in my estimation) don’t know the cost of their lifestyle. I’ve learned through trial and error that sitting people down and asking them to itemize out their expenses is a futile task, for a few reasons. 1) Those estimates are going to be way off most of the time. 2) Spending is lumpy. Month-to-month and year-to-year spending changes based on a lot of factors.
The best and simplest way I know how to calculate what your lifestyle in retirement will cost is this:
- Take your annual household gross income
- Subtract out your federal income tax, state income tax, and payroll tax annual
- Subtract out your 401(k) or other retirement savings annually
This is a good place to start, and we’ll fine-tune it with a few adjustments.
For example, if your household makes $300,000 per year and you pay $75,000 in tax and $30,000 in retirement savings your after-tax and after-savings lifestyle currently costs $195,000.
$300,000 income
-$75,000 tax
-$30,000 savings
=$195,000 after-tax and after-savings income
Now some people either run a surplus or deficit year-to-year. For example, if you’re after-tax and after-savings income is $195,000 but your bank account is growing by $20,000/per year on, then your actual lifestyle costs $175,000.
$195,000 after-tax and after-savings income
-$20,000 increase in bank account balance
=$175,000 true cost of lifestyle
On the flip side, if your bank account is decreasing by $20,000/year or you’re taking on $20,000 of consumer debt per year, your lifestyle costs more like $215,000.
$195,000 after-tax and after-savings income
+$20,000 decrease in bank account balance
=$215,000 true cost of lifestyle
You should also adjust for any lifestyle changes you plan on making in retirement. Will you be traveling more? Spending more on the grandkids? Golfing more?
Try and put a number to any of those significant changes. A popular one is travel. I have a lot of clients that would go on vacations every other year while they were working but want to do two vacations per year in retirement. So, we add another $20,000 to expected lifestyle costs.
The last adjustment is to figure out how much you’ll have to pay in tax to get the amount of money you need for after-tax spending. Again, working with an advisor can help you determine the most tax-efficient way to derive the income you need.
Bottom line, once you have this number and can project it out over a long period of time, adjusting for inflation and changes in lifestyle as you get older, you will have a really good idea of how much you need to have saved before you retire.
As a side note, this exercise is one of my favorites to do with clients.
Risk Tolerance
We look at risk in retirement from two different lenses. The first is “spending risk” and the second is “investment risk”.
Spending Risk
Let’s start with the wrong way to look at spending risk in retirement (which is how most people and financial advisors look at it) “What is the probability that I run out of money before I die?”
The right way to look at spending risk in retirement is “What is the probability that I have to adjust my spending at some point to avoid running out of money before I die?”
I hope no person, couple, or advisor would be dumb enough to keep spending a certain amount of money in retirement if you were on course to run out well before you die.
One of the great benefits of working with an advisor is they should be able to tell you when you should pull back on spending, when you have the option to increase spending, or when you’re spending is just right.
As I help people prepare for retirement, we give them a recommended spending level and guardrails based on their portfolio value. For example, based on your $2 million portfolio, social security benefit, age, and other factors you can spend $130k per year. If your portfolio reaches $2.5 million you can increase your spending to $150k. If your portfolio decreases to $1 million you should decrease your spending to $110k (these are just random numbers for example purposes).
We also give them a percentage probability based on an extensive analysis of how likely it is they will have to decrease their spending at some point. For example, there is an 8% chance that at some point in retirement, you’ll have to decrease your spending by 10% for three years.
These methods aren’t perfect, but they do provide a ton of clarity on the type of lifestyle you can expect in retirement.
Investment Risk
In my opinion, people are far too risk-averse in retirement. The idea of their portfolio dropping in value is more than they can stomach. However, I’m constantly trying to focus their attention on the true risk of investments. Risk is not the portfolio dropping in value. Risk is the portfolio dropping in value and then compounding that loss by continuing to take withdrawals before it’s recovered.
The solution is simple, let’s take that risk off the table completely by keeping an emergency fund, reserves, war chest, or whatever else you want to call it. Using statistics, we can determine how much we need to keep in this reserve.
A diversified stock portfolio of US large-cap stocks, US small-cap stocks, and international stocks has never had a negative total return over 10 years.
Since we know what your lifestyle is going to cost let’s multiply that by 10 years and make sure we keep that amount invested in something that doesn’t risk principal.
For example, if you need $150,000 in retirement and $50,000 of that comes from social security and $30,000 comes from a rental property (or pension, or part-time job, etc.) you will need $70,000 from your portfolio to cover the difference
$150,000 lifestyle cost
-$50,000 social security
-$30,000 pension (or other income)
=$70,000 shortfall (withdrawal from portfolio)
$70,000 x 10 years means we need $700k invested and available in something that doesn’t risk principal. My choices are typically a combination of a high-yield savings account, bank CDs, and individual bonds with high credit ratings. Based on today’s interest rates we could conservatively expect a 5% return on this safe money.
As an example, if you have a $2.5 million portfolio and invest $700k in the “safe bucket”, that gives you $1.8 mil or about 70% of your portfolio to be invested in a diversified stock portfolio.
While stocks are volatile day-to-day, month-to-month, and year-to-year, they aren’t very volatile decade-to-decade. Since 1970 the average decade returns in a diversified portfolio are 11% annually. With almost 95% of the decades returning more than 7% annually.
Since you have a clear and intentional safe bucket set up, you should feel stress-free investing the rest of your portfolio in diversified stock.
While you can’t control investment returns, you can control the amount of intentional risk you take with your investments which has a direct correlation to the probability you’ll grow your portfolio in retirement vs depleting it.
Tax Minimization
The last thing you can control in retirement is tax minimization. A lot of this actually happens before you retire.
Too many people get caught up in the all-encompassing statements of “Roth’s are better than 401(k)s” or “401(k)s better than Roths” or “real estate is better than both”.
Similar to the decision on when to claim social security, this totally depends on what your tax situation looks like now, what we project it will be in the future, and what you do with any tax savings we generate.
An advisor should give you the proper breakdown of how you should be saving your money in Roth accounts, pre-tax accounts, and taxable accounts. In many cases it makes sense to utilize all three.
In retirement, the way you draw money from your portfolio can result in differences of thousands of dollars every year. As an example:
Let’s assume a couple has $2 million in pre-tax 401ks, $500,000 in Roth IRAs, and $500,00 in taxable accounts. They collect a $60,000 social security benefit and need another $60,000 from their investments for spending.
There are a lot of different ways to structure their income for tax purposes, but let’s go with the most tax-efficient over time, not just today. If we were solely focused on today, we would have them withdraw everything from their Roth IRA and they wouldn’t pay any tax at all!
Instead, let’s see if we can preserve some of that Roth IRA money while still minimizing their tax.
Let’s assume they take $20,000 from their pre-tax IRA, $20,000 from their Roth IRA, and $20,000 from their brokerage account ($10,000 capital gain). By structuring income this way, they keep their ordinary income tax rate to 10%, their capital gains tax rate to 0%, and only $19,600 of their $60,000 social security is considered taxable.
Their federal tax bill would be $1,040. On $120,000 of income that’s an effective tax rate of less than 1%!
The best part, they only had to use 4% or $20,000 of their Roth IRA money which allows them to grow and compound the rest of it over time for more tax-free income.
If they were really smart and open to good advice, we’d also consider a different strategy of not withdrawing any Roth IRA money and converting some of the pre-tax 401(k) to the Roth while their tax rate is low. They would end up paying more tax this year, but potentially a lot less over time. That example can get complicated and is best saved for another time and place.
To summarize, if you have a plan on how to best withdraw money from investments in retirement to minimize taxes you can leave more in the account to grow and compound or to spend now.
Bottom Line
Don’t get fixated on what most people fixate on when it comes to finances in retirement. Politics, market corrections, negative news, inflation, real estate prices, what your neighbor is saying or doing, etc.
Focus on the intersection of things that matter and things that you can control. When it comes to finances in retirement that’s timing your decisions, cost of lifestyle, risk tolerance, and tax minimization.