Below are ten financial decisions you need to address before you retire. It is a good starting point for most pre-retirees but does not take into account your unique circumstances, lifestyle, or wishes. You will want to contact your financial advisor about specifics. Aim to revisit most of these plans on a regular basis throughout retirement.
1. Retirement Spending Plan
The primary goal of any retirement plan is to provide you with the income you need to have a comfortable, stress-free retirement. To accomplish this, you need to know exactly how much income you will require during retirement. It may sound daunting, but you can develop a retirement spending plan with a little bit of effort.
Schedule an evening with your spouse to write down all of your monthly fixed and variable expenses. Develop a few basic categories that make sense to you and total up the expenses. Enter those categories in a system that will allow you to connect your online banking and credit card accounts to track your actual expenses against your projected expenses. Make a note of any expenses that will go away in retirement. Also, be sure to include any new expenses that may start or increase during retirement. You can begin today by accessing our free financial planning and budget tracking software at RightCapital.com. Please email us a email@example.com with any questions.
After understanding your budget, continue tracking and adjusting your spending plan until you are satisfied that you can account for at least 90% of your expenses. If you have not been previously monitoring expenditures, it will likely take you six months to a year of tracking.
When you know what your spending plan is, make sure your resources are capable of generating that income. This capability will be dependent on a number of variables, all of which will be impacted by your investment philosophy.
2. Investment Philosophy
What is your investment philosophy? Do you buy individual stocks and bonds? Do you use actively managed mutual funds or indexed funds? You can read more about our investment philosophy in our article Ten Beliefs That Make You a Better Investor. Talk about your investment philosophy with your spouse. Make sure it reflects common ground and, of course, common sense. And then write it down, so you always know your if your investments are aligning with your philosophy.
No one can predict the future, and that includes the financial markets. This core belief drives our investment decisions. As such, it is essential to diversify your portfolio around low-cost investments like Dimensional Funds or similar index funds. The investments should be well diversified and allocated in a way so you can rest easy even when the next 40% stock market plunge hits.
To create a portfolio you can live with through all of the various market swings, start by having a good understanding of your investment risk tolerance.
3. Investment Risk Tolerance Assessment
Do you know how much your investments would have dropped in the 2007 – 2009 market meltdown? If you were investing during that time, what did you do? Would you make the same decisions when you depend on your investments to generate your retirement income? Did you follow your investment philosophy?
An excellent objective risk tolerance assessment is beneficial to understanding how naturally comfortable you are with large fluctuations in your investments. We use this free assessment by Finametrica with our clients to understand their comfort levels.
Understanding risk tolerance needs to be balanced with your financial goals. For instance, if you have a very low risk tolerance, but you need higher returns to accomplish your goals, you need to either invest outside your comfort level or adjust your goals. A financial advisor will give you an objective perspective with these decisions, particularly during times of extreme market stress.
If you don’t have access to a suitable risk assessment tool, you can do some simple math to start thinking about your risk tolerance. In 2007 – 2009, the US stock market lost over 50% of its value. If you had 80% of your money in the stock market, you can assume that you would have lost approximately 40% (80% x 50% = 40%) of your investment portfolio. Put this in actual dollars when you think through your reactions and emotions. If you have a $1,000,000 portfolio and it becomes a $600,000 portfolio, are you prepared to deal with that? If not, you may want to revisit your portfolio allocation. We talk about this process more in our post, How Far Can Your Investments Drop? The biggest mistake you can ever make is to decide that “this time it is different, the markets aren’t coming back.” If you sell your investments after a 40% loss, you may never recover from that mistake.
Now that you have your spending plan, investment philosophy and an understanding of your risk tolerance, you can generate your retirement projections.
4. Retirement Projection
Retirement projections estimate the probability of you having enough money to retire and meet your goals.
This is typically done with a Monte Carlo analysis. A Monte Carlo analysis takes historical or projected market returns, inflation, and your spending projections and randomly generates thousands of possible outcomes. The results are typically expressed as a percentage. We like to see our retirees at 80% or better probability of success. At this rate, it doesn’t mean you have a 20% chance of failure. It merely means you have a 20% possibility of needing to make some common sense adjustments to your income during retirement.
These adjustments to your income need to be made by following the processes developed for your income generation plan and your income flexibility plan.
5. Income Generation Plan
How do you get income out of your investment portfolio so you can spend the money?
We believe the best way to generate retirement income is by rebalancing your investments back to your allocation plan annually and at market extremes. Rebalancing to generate income has numerous benefits:
- It forces you to sell high and buy low
- It keeps the portfolio risk level consistent
- It prevents you from selling stock investments in a down year
- It frees you from only investing in high dividend stocks
You need to have a series of rules to follow when rebalancing:
- Sell the winners
- Replenish the cash for distributions
- Buy the laggards (typically the bond investments)
- Never sell stocks in a down year
- Completely deplete the bonds and cash before selling equities at a loss
6. Income Flexibility Plan
How much income should you take from your investment accounts? These accounts need to last you the rest of your life.
There are many different theories about how much money you can safely take out of your retirement account. One of the most quoted is the 4% rule. The 4% rule states that – based on historical data – if you take 4% out of your investment accounts and take annual raises based on inflation, you will never have run out of money. It also assumes you have at least 60% of your investments in the stock market. You can read extensively about the 4% withdrawal rate by Googling it. If you read enough, you will quickly realize most people who quote this rule have little to no understanding of the studies it was based on.
Several other withdrawal systems have successfully never run out of money (based on historical returns) and allow you to take more than 4% of your investment accounts. First, establish a starting percentage distribution. Then find the upper and lower withdrawal limits that are 20% above and below your starting withdrawal rate. These systems allow you to spend more money in your earlier retirement years when you are healthier, have more energy, and typically want to spend more money. This withdrawal system does require you to make common sense adjustments to your income as the future unfolds.
We follow a set of income rules:
- Take an inflation raise in years that the markets go up
- Keep your income the same in years that the markets go down
- Reduce your income by 10% if you exceed your upper percentage withdrawal limit
- Increase your income by 10% if you fall below your lower percentage withdrawal limit
The goal of the income generation plan along with the income flexibility plan, is to prevent you from ever running out of money, no matter how volatile the markets become.
7. Income Tax Optimization Plan
You will likely have more control over your income taxes during your early retirement years than at any other time in your life. Between the time you retire, and when you have to start taking money out of your IRAs (age 70 1/2) you should investigate:
- Roth IRA conversions. You can convert some of your conventional IRAs to a Roth IRA to prevent your income tax bracket from increasing dramatically later in life.
- Individual stocks with a low cost basis. With these, you can earn up to $77,200 (as of 2018) of income as a married couple and pay no capital gains taxes.
- Medicare premiums. These increase based on your income. See if you can adjust your tax situation before age 65 to keep lower premiums. Medicare Part B premiums start at $134.00 and can increase to $428.60 per month based on income. (As of 2018)
- Social security income. This can be considered tax free, 50% taxed, or 85% taxed, based on your total income.
All of these scenarios require an integrated projection. You don’t want to convert an ordinary IRA to a Roth IRA only to find that your social security income is now taxable. Making mistakes here can cause significant increases in your current tax rates and increase your cost of Medicare.
8. Social Security Plan
When should you take social security? You are eligible for reduced benefits at age 62, full benefits at age 67 and increased benefits if you wait until age 70 to start taking distributions.
Social security decisions are often driven by your emotions and trust of the government. Many baby boomers are distrustful of the government and the social security system. No matter what the math may show, you may think you want to take your social security benefits as soon as possible, before the government takes them away, or social security runs out of money. You may also fear you may die prematurely and never make up the lost benefits by deferring to a later date.
For people who have more confidence in the system, it almost always makes sense to defer taking your social security benefits until age 70. With typical life expectancies, this will get you the maximum benefit.
9. Medicare/Health Insurance Plan
What is your plan for health insurance in retirement? Almost everyone will have Medicare as their primary health insurance starting at age 65. The typical scenario is to sign up for Medicare Part A and B, a Medicare Supplement (Medigap) Plan, and Medicare Part D (if it is not included in your supplement).
If your Medigap plan is through your employer, you will not have many other decisions to make. If you buy your Medigap plan from the marketplace, you will need to choose from multiple levels of coverage noted as Plan A, B, C, D, F, G, K, M, or N.
You will also have the option of choosing Medicare Part C (Medicare Advantage) which provides the benefits of Medicare A, B, usually D, and a Medigap policy for approximately the cost of your Medicare A, B, and D premiums. These plans can vary significantly by state, by benefits, and by availability of doctors.
Your current health, how often you visit your doctor, and how often you travel are all critical inputs to your Medicare/Health Insurance Plan. Medicare’s website is a great place to start if you choose to tackle this one on your own.
10. Estate Plan
Last but not least is your estate plan. Your estate plan should cover any of your end-of-life wishes. It should also account for the possibility of a temporary loss of your ability to make financial or health decisions on your own behalf.
Every estate plan should include a Last Will and Testament, Durable Financial Powers, Durable Health Powers, and a Living Will. Some more complicated family situations and very high net worth retirees should look into having trusts created in addition to the other estate documents.
Spending a little bit of time and effort on your estate plan can save your loved ones a significant amount of distress in the future.
A great financial planner will guide you through each of these financial decisions. If your advisor is not addressing all these aspects of your retirement, you may be working with an advisor who presents simple projections as a financial plan with the sole intention of selling you investments or other products.
These ten plans are only part of the bigger financial planning picture. Financial planning is a process, not an event. Every year the rules can change, your circumstances can change, and your goals will even change. For help with these plans and more, contact us at firstname.lastname@example.org or call 513-588-8080.