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How to Make Your Retirement Savings Last Forever

Eshani Haque

With life expectancy and inflation rates rising, Americans are increasingly delaying retirement as they fear their nest egg running out.

How should one combat this? Well, you could always plan for a shorter retirement, simply because it would be easier to manage costs over a shorter time frame. You could also take up a part-time job during retirement, and make small investments from any accumulated wealth to ensure a steady source of income.

Apart from these, strategic planning and a few calculated measures can also help solve this problem.

Cutting Down on Spending

This is the first step to making retirement savings last a lifetime. Slashing your expenditures simply means you will need to withdraw less from your retirement accounts each year, which boils down to a lower tax bill. This is because most sources of retirement income (such as withdrawals from retirement accounts funded with pre-tax income, withdrawals from annuity, and a pension income) are taxable under the ordinary income tax rate. Even social security income is partially taxable for some individuals. Heavy tax bills in retirement can eat away a major portion of your yearly withdrawals.

The key to lowering taxes in retirement is to stay tax-free for as long as possible, as tax-free savings will keep growing due to the power of compound interest. In this regard, it is important to know which retirement accounts to withdraw from first. To allow tax-free savings for a longer period of time, think about withdrawing from the accounts that were funded with post-tax income, simply because you will be not be taxed on it again.

In order to further dodge taxes, you can try converting your traditional 401(k) or IRA accounts into a Roth IRA, as withdrawals from the latter are not taxed as ordinary income. Traditional 401(k)s and IRAs require you to take the required minimum distribution (RMD) past the age of 70 ½, under which you will be taxed on the amount withdrawn.

Conversion into a Roth IRA will enable tax-free savings for as long as you want as it does not involve RMDs. However, make sure to consult your tax advisor regarding the tax implications of a Roth IRA conversion. That said, with a Roth IRA conversion, you will be able to save a huge amount in taxes over the long run.

Withdrawal Rate

When it comes to annual withdrawals in retirement, the age-old tradition is to follow the 4% rule. While the rule is a good guide to an annual withdrawal rate, with changing circumstances, relying solely on this rule might not be the best thing to do. Under the rule, you withdraw 4% of your nest egg value in the first year, followed by inflation adjustments in the subsequent years.

For instance, if your total retirement savings is worth $1 million, you will withdraw $40,000 in the first year. If the inflation rate is 2.5% the next year, you will withdraw $1000 (inflation amount: 2.5% of $40,000) more, i.e., $41,000. The rule assumes a portfolio that consists of 50% in stocks and 50% in bonds. If followed the correct way, proponents of this theory say there is a 90% chance your nest egg will last 30 years, which certainly isn’t a bad figure.

However, with lower bond yields in recent years and stock returns forecast to be modest for the next several years, the theory might fail to yield desired results. Taking these into consideration, some theorists have come up with a 3% safe withdrawal rate.

Although a tad conservative, this approach is believed to be sustainable through retirement even under an inflation rate as high as 7%, something that the 4% rule can’t live up to. However, keep in mind that the approach assumes an asset allocation of 50% each in stocks and bonds. So, in case you make alterations to this stock-to-bond ratio, you might have to make adjustments to the withdrawal rate.

You may want to take note of Trinity study’s findings. The updated study found that the 3% withdrawal rate had a 100% success rate over a 40-year retirement period, even when the stock allocation was increased to a maximum of 100%. Meanwhile, the research produced a success rate of 98% with 25% in stocks and 75% in bonds.

Vanguard’s "dynamic approach to spending" allows flexible annual withdrawals equal with market performance. So, you start with a certain withdrawal rate -- say 5% -- in the first year, and if the market performs sluggishly in the next, you can cut down your withdrawal rate. Conversely, when the market is favorable you can raise your rate of withdrawal. However, the withdrawal rate should never go below 2.5% or above 5%. This timely adjustment to your withdrawal rate is another great way to ensure lifelong savings. Essentially, it has a success rate of 92% over 35 years of retirement with an equal mix of stocks and bonds.

Comparing these withdrawal strategies, a pre-set 3% withdrawal rate is certainly easier to follow. Given the 100% success rate over the long term with an appropriate stock and bond mix, this is no doubt a safe way to protect your portfolio from early exhaustion. However, most financial experts are in favor of a more versatile approach to spending, with a withdrawal rate that fluctuates as and when market conditions change.

Stock Allocation

The traditional approach is to cut back on stock allocation in your portfolio as you age. Experts now believe that with an extended retirement period, one needs to hold more stocks in order to sustain high inflation rates over the course of retirement. That is to say, you should gradually increase stock weightage through retirement, keeping it low in the beginning. In the initial years of retirement, your stock exposure should be as low as 20%, and slowly tread up to 70% in the final years.

Without a steady source of income, one is extremely vulnerable to market downturns during the initial years. If the market takes a hit during this time, considerable stock exposure would make it very difficult to overcome the dent in portfolio. Now, considering historical data, stocks on average have shown a 7% annual rise in the long term.

So, as your retirement years go by and after you have built substantial portfolio wealth, you can gradually increase your investment in stocks to bolster your portfolio and make it last through retirement.

Delay Social Security Benefits

Social Security can be viewed as a form of insurance that provides monthly checks during old age and offers a hedge against inflation. When you start taking social security benefits at full retirement age, you are eligible to receive the full benefit.

Delaying your benefits even after the full retirement age will earn you a credit of 8% each year for as long as you withhold. However, past the age of 70, you will not receive additional benefits for delaying the claim. Take this example: your retirement age is 67 and you start taking benefits at the age of 70. In this case, you will receive a credit of 24% (8% in each of the three years) over and above your full benefit, i.e., each of your monthly checks will increase by 24%. This approach is essentially for those who expect to live longer than the average life expectancy. For those who are certain to not cross the average life span, delaying might not offer additional benefits.

Bottom Line

While the above-mentioned ways are a good guide to make retirement savings last a lifetime, any financial decision that you make in this regard should take into account your financial situation and life expectancy.

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