Uneasy about the future, many new or prospective retirees figure it's time to purge their portfolio of risk (translation: growth stocks) and shift the money into conservative, income-producing investments such as bonds, dividend-paying stocks, and bank certificates of deposit.
But such a seemingly sensible course of action is reckless in today's world. The concept of an income-only portfolio that earlier generations might have sailed by on is no longer viable. That is, unless you are one of a small cadre of well-heeled retirees with assets substantial enough to produce hefty cash flow.
Managing your retirement portfolio requires a new financial mind-set but not a whole new investing strategy. "It is more a behavioral shift than a financial one," says Tom Orecchio, a financial planner at Greenbaum & Orecchio in Old Tappan, N.J. For people who have spent 30 years steadily hoarding savings, the idea of spending that retirement cache on daily living while also trying to make it last for the rest of their days can be hard to grasp.
"What's our new plan?" clients on the cusp of retirement anxiously ask. Orecchio gently explains that there is a plan, and nothing is going to change radically overnight, or even in the near future. Simply put, the client's portfolio will slowly shift away from stocks into more conservative allocations as the years tick by.
The bottom line is that if, like many people, you are facing two or three decades of retirement living, even modest inflation will surely chew away at your portfolio's purchasing power. And unplanned expenses will crop up. It could be out-of-pocket nursing home care for a parent with dementia, soaring unreimbursed medical bills of your own, or even spur-of-the-moment fun, like a sailing trip with your sister in the British Virgin Islands. For financial fitness in retirement, you'll need long-term growth for years to come from your existing stock holdings.
So, plan to sit tight. There are, however, other transitions you can make to ease your way into a comfortable retirement. Here are five moves to consider as you prepare to shift from saving and building up to spending and drawing down.
1. Set aside cash: If you're nearing retirement, set aside cash in accounts such as money market mutual funds, short-term bond funds, or certificates of deposit, says Christine Fahlund, a senior financial planner at T. Rowe Price Group. Ideally, you should sock away enough to cover expenses for about three to six months so you're not forced to sell stock or bond holdings in a down market. As contrarian as it may sound, you might even consider starting a "phased-in" retirement by diverting money from funding a 401(k) plan in your last year of working, she advises.
Next, look for holes in your overall finances and plug cracks with your cash reserves. For example, use the cash to pay down debts with variable interest rates that are about to rise. Review your insurance needs. Securing a long-term-care policy while you are still in good health and premiums are low is worth considering. You might ensure a lifetime stream of income by converting part of your nest egg to an annuity.
2. Get organized: Take stock of your retirement assets. Your money is strewn in different accounts, including tax-deferred savings (such as IRAs, 401(k) plans, annuities, and Social Security) and taxable investment accounts (such as CDs, short-term bonds, and other securities). Perhaps you have a Roth IRA in your mix.
Quite possibly, you own several IRAs, in addition to 401(k) and 403(b) funds, from multiple employers both past and present. Roll all of them into an existing IRA, or open a new one if you don't have one already, suggests Fahlund. This eases bookkeeping when age 70½ rolls around and, by law, you must draw down some of the money from these tax-protected accounts. Plus, an IRA will generally have a greater choice of investments than your 401(k) offers.
3. Set a withdrawal strategy: Overzealous spending early in retirement trips a lot of people up. It's the most common cause of running out of money, Fahlund says.
As a general rule, if retirees limit their initial withdrawal to 4 percent of their investment portfolios—and then increase that dollar amount by 3 percent a year for inflation—they should stand a 9-in-10 chance of being able to sustain that income stream over 30 years, according to Fahlund. Individual situations vary, of course; you may want to consult your financial adviser.
Having a cash cushion in place can help prepare you to trim those withdrawals or hold steady if markets turn bearish, as they have this past year.
4. Keep an eye on asset allocation: Whether you're skittish about them or not, stocks (and stock funds) rule. They are the one investment that can provide the growth you'll need over a long retirement, Fahlund says.
A portfolio's asset allocation will differ from retiree to retiree, depending on individual factors like risk tolerance. In general, at retirement your holdings should consist of as much as 60 percent stocks, say the retirement portfolio managers at T. Rowe Price. That percentage should glide down and hover a notch below 40 percent even in your 80s. Other money managers may suggest significantly different allocations.
The key to charting a smart retirement portfolio is "risk management," Orecchio says. To ride out volatility, spread your risk across a diverse spectrum of equity investments here and abroad, including in emerging markets. Slice those broad categories into large and small companies. Diversify bond holdings by maturity and credit quality. Then rebalance yearly. In down markets, you might want to do so more frequently. "Markets will fluctuate over the next 20 or 30 years. You can be certain of that," he says. But a diversified portfolio will spread the risk.
A life-cycle, or target-date, fund can ease your angst. This single investment gives you all sorts of stocks and bonds in one package. Plus, you get to choose the mix you want. The funds are professionally managed, growing more conservative as you age. Lots of retirees are using such funds. New investors helped boost life-cycle-fund assets by 61 percent last year, according to the Investment Company Institute.
5. Tap in: Generally speaking, to get the most from your savings, pull from your taxable accounts first. Interest from bank CDs, bonds, and money market funds is taxed at ordinary income rates. For any dividends, interest, or capital-gain payouts, you will owe taxes the year you receive them. U.S. government bonds are free from state taxes. Municipal bonds are free from federal tax and state taxes, too, if you live in the state that issued them.
Enjoy the tax deferral on your retirement accounts as long as you can. Once you reach 70½, though, there is a minimum withdrawal schedule based on your life expectancy. There are exceptions, of course. For example, if you're still working and contributing to your employer's 401(k) plan, and the plan allows it, you don't have to take withdrawals from the plan until April 1 of the year after you retire. The rules on required minimum distributions are in IRS Publication 590, available at irs.gov. You may want to consult a tax adviser. You're taxed at ordinary income tax rates on the amount you withdraw (except any after-tax contributions). Not withdrawing as much as you should each year can result in a 50 percent tax penalty on the amount you didn't take. Missing required minimum distributions is perhaps the single biggest mistake for IRA holders.
Roth IRAs are the last accounts to dip into and, for many retirees, may ultimately prove to be a winning solution to not outliving savings. Withdrawals from Roths aren't taxed at all provided you're at least 59½ years old and have held the account for at least five years. You've already paid tax on your Roth contributions, and all the compounded growth is tax free. Ah, sweet salvation...in a far-off year like 2023.