SHOW NOTES: 2020-04-30 MiM

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Last Week’s Question of the Week: How is Social Security Funded? Is it through a Payroll Tax of 6.2% or 12.4%?

ANSWER: 12.4% combined.

HOST: As we plan for retirement, what different withdrawal strategies should we consider?

KLAAS FINANCIAL: This is a really important thing to consider since Baby Boomers, the generation born between 1946 and 1964, are retiring at a rate of around 10,000 per day. Today we are going to highlight some of these ways in which you can plan to have your income distributed to you from your investable assets.

The goal is fairly simple…
a) Distribute your income in a way that you don’t run out of money in retirement.
b) Create a flexible plan that can adjust with your own situation.
c) Take risks into consideration.

There are a few common approaches for retirement income withdrawal strategies which include:

  • The most popular retirement income strategy is a Systematic Withdrawal Strategy of your money from an existing mutual fund portfolio. With this strategy, a fixed or variable amount is withdrawn at regular intervals. In this case you only withdraw the income (such as dividends or interest) created by the underlying investments in the portfolio. Because your principal remains intact, this prevents you from running out of money and affords you the potential to grow your investments over time, while still providing retirement income. However, the amount of income you receive in any given year will vary, since it depends on market performance. There is also the risk that the amount you’re able to withdraw won’t keep pace with inflation. This approach only touches the income — not your principal – so your portfolio maintains the potential to grow. However, you won’t withdraw the same amount of money every year, and you might get outpaced by inflation.
  • One of the guidelines that works together with the systematic withdrawal strategy is the 4% Rule as it is commonly known. It is not actually a rule, but rather a guideline published by retired financial planner William Bengen in 1994. He promoted that percentage as a safe annual withdrawal rate after testing it on the toughest financial crises in history, including the Great Depression. Using this rule, you would withdraw that percentage of your savings in the first year of retirement, then take the same dollar amount but adjusted for inflation in the years that follow.

Example: You have saved $1 million dollars in your portfolio. The first year you would draw out 4% or $40,000. Assuming 3% inflation, the second year, you would withdraw out $41,200.

Things to keep in mind:
a) The chance of success of not outliving your money is high if you invest at least 50% of your savings in stocks according to the analysis.
b) The 4% rule is inflexible and fails to consider changing spending patterns in retirement. Therefore, the idea is not always practical.

  • Dynamic Withdrawal Strategy: Essentially it means that, unlike the relatively inflexible 4% rule, you will alter your withdrawal amount when, for example, investment returns are substantially different than expected. Dynamic strategies allow you to spend more money when market returns support this, up to a ceiling that you set in advance.

    Of course, when market returns are substantially down, your withdrawal amount may be less than what you are accustomed to.

    “Guardrails” are sometimes put in place to make sure you don’t take too much — or too little — from your savings. One of those guardrails involves limiting withdrawals if they represent too large a portion of your total nest egg. Dynamic strategies can be very complicated so make sure you fully understand them before putting them in place.

HOST: What is the time-segmentation strategy?

KLAAS FINANCIAL: The time segmentation strategy also regarded as a “Bucket Strategy” has you take your retirement savings and place it into separate account types (or buckets) based on your goals.

The idea behind the bucket strategy is that you divide your portfolio into different timed segments, based on when you need your money, leaving the rest in more aggressive investments designed to promote growth in a portfolio.

Those buckets could be labeled as emergency savings, living expenses and long-term savings. Your first two buckets might include three to five years’ worth of living expenses, whereas your long-term account can perhaps allow for more aggressive investments which continue to grow long-term and are not counted on to provide your short-term income.

A bucket strategy reduces your exposure to investment risk because you don’t have to sell stocks when the market is down. You have cash on hand to pay your expenses, which can protect your savings over the long haul. As you use the cash from the first bucket, you replenish it with earnings from the second and third buckets. But you still must figure out a safe withdrawal strategy from your buckets.

Another strategy is a “Flooring Retirement Income Strategy” which somewhat opposes the investment and risk management style of a systematic withdrawal strategy.

This strategy prioritizes spending goals between needs and wants which can be challenging. Once you account for taxes, housing, food and health care expenses you have notably listed 80% or more of your expenses for a year.

The foundation of this strategy is to create a floor of income provided to you from Social Security, pensions, annuities, or laddering bonds. The upside to this strategy is that it offers security to those people who are more risk adverse. The downside to this strategy is that by buying a secure retirement income you often give up returns for safety. The likelihood is that overall, you will decrease your wealth as compared to a total return systematic withdrawal strategy.

HOST: What other items should we remember as we consider these retirement strategies?

KLAAS FINANCIAL: Review your other income sources such as Social Security or a pension before you select your income pull strategy. This could have a bearing on which plan you choose. Review your plan at least once a year. Markets rise and fall, and situations change, and you may have to revamp your strategy.

Factor in taxes. Remember that most of your portfolio is often comprised of a lot of pre-tax savings (401k, 403b etc.) on which you will be paying income tax. Make sure this is included into your retirement income plan. Therefore, choosing a Roth IRA or Roth 401k may be of value in retirement.

Make sure you understand how RMDs come into the picture at age 72, and factor in this income coming from your pre-tax sources.

Work on eliminating almost all debt prior to retirement. If you lack debt as you begin retirement, your fixed expenses will be minimal which will be a great way to enjoy the next season of your life.

Flexibility in retirement income can really help you. Not having to have the exact same dollar amount each year is being pretty realistic and can certainly allow your portfolio to grow because you can adjust as you go.

This Week’s Question of the Week: At what rate are Baby Boomers (born between 1946-1964) retiring at per day? Is it 5000 per day or 10,000 per day?

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Catch C.J. Klaas and Maleeah Cuevas on Money in Motion every Thursday on Madison's 1310 WIBA from 8:05-8:35am.