Retirement: A Big Change

“Often when you think you’re at the end of something, you’re at the beginning of something else.”

– Fred Rogers (a.k.a., Mister Rogers)

There are few events or experiences involving more momentous change than retirement. In addition to the obvious changes to one’s income and finances, retirement can significantly impact physical and mental well-being. Sure, money is important, but so are your feelings about money, taxes, and risk. Moreover, you will likely revamp many of your daily routines and schedules entirely.

Retirement Brings Change

I will highlight one critical change in retirement that can radically impact both your finances and your psychology around money. I will then list several other elements, along with brief descriptions.

The 180 Degree Turn

The first element I am referring to is the cataclysmic change from working, saving, and contributing to your wealth to living off of it. This is a 180-degree financial reversal, and it can create immense anxiety.

Without doubt, premature wealth depletion is a risk we need to manage. It is possible to spend too much or take excessive investment risk that jeopardizes your retirement security. At the same time, academic studies clearly indicate that retirees drastically underspend (e.g., cite article) and leave significant legacy assets behind.

These two phenomena highlight the importance of having a well-developed financial plan to balance your spending with risk and legacy goals.

The problems:

• Many people come to me and talk about living off the interest and dividends from their portfolios
• Living off the interest is effectively understanding
• Hit the FFWD button, and your beneficiaries are likely to reap more benefits of your wealth than you
• This mentality is often rooted in a Depression-era mindset that naturally influences feelings about money and retirement. I know it well, as my parents instilled a similar mindset.

The solutions: Educating clients around the difference between market volatility and risk.

• Sequence of return risk
• Slippery slope: Chiseling translates into less dividends and interest
• Portfolio strategy
• Robustness of dividends
• Ability to purchase guaranteed lifetime income (pensions are becoming increasingly extinct)

There are other behavioral factors to consider when it comes to planning and investing. We share some of them in the last section below (The Behavioral Side).

Retirement: Not Just a Number

In my experience, the goal of saving and investing is ultimately to provide for a secure retirement and any gifting/legacy goals. Whether that need is immediate, impending, or far off in the future, generating retirement income will be a top priority.

Many people tell me they need $X dollars to retire. Some of these figures are based on nothing more than rules of thumb. For example, some people have relied on the 4% rule for withdrawing from a balanced portfolio. That is, it says you should be able to withdraw 4% of your assets in the first year of retirement and then increase that absolute dollar amount by the rate of inflation each year going forward without running out of money.

An example

If one has one million dollars, then they could take out $40k (4% of $1m) in the first year. If inflation goes up 2% the next year, then they would take out $40.8k ($40k x 1.02) in year two. Then the year three withdrawal would simply increase the previous year’s $40.8k by the new inflation figure. And so forth.

The issue I have with these approaches is that they ignore current market conditions. For example, our current market environment has incredibly low interest rates and dividend yields (as of May 2021). So it is unlikely the same amount of investments will be able to provide for the same amount of income as in previous periods with different market environments.

This is really just another way of saying the valuations of the market change. For stocks, higher price/earnings ratios mean fewer earnings per dollar invested. This usually coincides with lower dividend yields which mean fewer dividends per dollar invested. In the bond market, it just means less interest per dollar invested (i.e., lower yields).

Lower interest rates and dividend yields

Looking at the interest rates and dividend yields over the last few decades makes it clear how things have changed. It may be tempting to complain about the current valuations. However, I think it is worth keeping in mind that the way we have gotten to higher valuations is by rising market prices. In many cases, you’ve likely benefited from the higher capital appreciation which makes these levels of income low.

Conclusion

So for most people nearing or in retirement, I don’t think it is a good idea to equate retirement with a dollar amount of savings. The withdrawal rate is a critical piece of the retirement puzzle and it is not static. Running out of money in retirement is not a situation you want to open the door to.

I think the stakes are just too high to use rules of thumb. I’ve developed a strategy to more precisely estimate withdrawal rates based using current market inputs. So if you are nearing or in retirement, please get in touch to make sure.

Retirement Feasibility

Before one retires, it is sensible to first make sure they are ready to do so – both mentally and financially. In terms of finances, one of the first steps is to estimate one’s approximate retirement spending budget and start to consider any legacy-related goals (e.g., money to go to family or charitable causes).

It should go without saying that one should make sure their own personal retirement needs are the top priority; leaving money to heirs and giving money to charities are secondary. As they say on airplanes, put your oxygen mask on first. Only then will you be in a place to help others.

Once we have a better handle on how much income will be needed, we can then compare that figure to the assets (e.g., investments, Social Security, pension, and rental income) to determine whether one has enough to comfortably retire. As discussed in the previous section, one way to do this is to compute a withdrawal rate.

An example

Let us assume one currently requires $75k of income and they have $1 million in investable assets. If they have a pension providing $20k / year and Social Security will provide another $30k / year, then they will only need $25k of income from their portfolio (i.e., $75k – $20k – $30k). That figure works out to be just 2.5% of their portfolio (per year).

Based on my model for retirement income, this 2.5% figure seems reasonable even in the current market environment with low interest rates and dividend yields. However, if this figure came in at, say, 10%, then it would indicate their spending level was too high relative to their assets and could likely jeopardize their retirement security.

Of course, this is a very high-level litmus test. We would also need to consider various other factors such as their age(s) and potential healthcare needs (e.g., we discuss potential assisted living needs in the Risk Management section below).

Risk Management

One of the keys to retirement security is tying up as many loose ends as you can. In particular, we want to minimize the likelihood of liabilities popping up and derailing your retirement plan.

Most people have a good idea about future purchases (e.g., a vacation home) or financial obligations (e.g., kids’ college tuition). However, healthcare needs are not always so easy to estimate. Taking advantage of Medicare and supplemental insurance plans is helpful. However, other potential needs, such as personal care or assisted living, can be significant but difficult to estimate.

Some solutions for long-term care

1. LTC insurance: One solution is to purchase long-term care (LTC) insurance. While LTC insurance premiums have increased significantly in recent years, pure LTC insurance remains the lowest-cost option. However, many people dislike the use-it-or-lose-it aspect of LTC insurance. That is, like car insurance, you hope you won’t need to use it, but you still don’t like the idea of paying premiums for years and then receiving nothing in return.
2. Hybrid insurance: The insurance industry responded to the use-it-or-lose-it issue by blending pure LTC insurance with life insurance products that allow early access to the death benefit if, and when, policyholders are unable to perform certain activities of daily living (ADLs). These can include bathing, continence, dressing, eating, toileting, and transferring.
3. Life insurance: What does life insurance have to do with LTC? As highlighted above, many life insurance products can provide accelerated benefits. That is, the owners may be able to withdraw funds from the policy (i.e., its death benefit) if they are unable to perform certain ADLs.
4. Medicaid: Medicaid (note: this is not the same as Medicare) can help cover long-term care (LTC) costs for individuals who meet strict financial and medical eligibility requirements, often after they have spent down most of their own assets and income. Unlike Medicare, which offers limited coverage for skilled nursing or rehabilitation, Medicaid can pay for ongoing custodial care in nursing homes. Moreover, Medicaid may also support home- and community-based services.
5. Family care: Another route is to rely on family support and effectively self-insure. Of course, this requires having family members willing to take on this role.
6. Reserves: Another solution for LTC is to set aside or use existing assets to fund potential LTC needs. For example, some people will set aside specific assets (often in a new account earmarked for the purpose) precisely for the any future LTC neds.

Given the potential financial magnitude of decisions around LTC and its impact on one’s estate, LTC risk is worthy of serious consideration. For people with substantial wealth, this might be a rounding error. However, they may still want to use LTC insurance to minimize the risk that LTC spending compromises broader tax, liquidity, or investment strategies.

Even if one does not have substantial wealth, leaving assets to family may still be a priority, and LTC poses a risk to that goal. In these situations, purchasing LTC insurance may be a more attractive option. Alternatively, it is also possible to plan for Medicaid access by transitioning assets out of one’s estate (e.g., via a personal care agreement, gifting, etc.).

I encourage clients to discuss various options with their families. It is worth noting that the decision to insure or not may ultimately impact other family members more than the insured. For example, many children are likely to inherit their parents’ remaining assets. If their parents are likely to leave a significant inheritance, then they may ultimately bear the impact of decisions around LTC risk.

Note: The choices made here may reduce the amount of assets left (e.g., money used to fund a life insurance policy with accelerated benefits) or increase one’s spending through retirement (e.g., to pay for LTC insurance). This may affect retirement feasibility discussed above and/or the investment strategy.

Decisions regarding SS can be worth more than $100,000!

One of the keys to retirement security is tying down as many loose ends as you can. In particular, we want to minimize the likelihood of liabilities popping up and derailing your retirement plan.

Most people have a good idea about future purchases (e.g., a vacation home) or financial obligations (e.g., kids’ college tuition). However, healthcare needs are not always so easy to estimate. Taking advantage of Medicare and supplemental insurance plans is helpful. However, other potential needs such involving personal care or assisted living can be significant, but difficult to estimate.

Some solutions for long term care

1. Insurance: One solution is to purchase long-term care (LTC) insurance. Unfortunately, LTC insurance prices have increased significantly in recent years.
2. Family care: Another route is to rely on family support and effectively self-insure. Of course, this requires having family members willing to take on this role.
3. Reserves: A third and increasingly popular solution is to create or use existing assets to fund potential LTC needs. For example, many life insurance products now offer accelerated benefit features for precisely this purpose.

Given the potential financial magnitude of this decision and its impact on one’s estate, it is worthy of serious consideration. I encourage clients to discuss various options with their families. In many cases where children are to inherit assets, the decision to insure or not may ultimately impact them more than the insured.

Note: The choices made here may reduce the amount of assets left (e.g., money used to fund a life insurance policy with accelerated benefits) or increase one’s spending through retirement (e.g., to pay for LTC insurance). This may affect retirement feasibility discussed above and/or the investment strategy we discuss next.

Investment Strategy

At the risk of pointing out the obvious, it is imperative to use a conservative approach to investing during retirement. Indeed, nobody wants to run out of money or be forced to reduce their standard of living during retirement.

One aspect of a conservative approach is to use the right tools – investment vehicles that have low or reasonable costs and are tax-efficient. Below I offer three suggestions to help guide these decisions.

• Use low-cost exchange-traded funds (ETFs) and direct investment
• Avoid costly and tax-inefficient mutual funds with high turnover
• Avoid variable annuities (except possibly for advanced estate planning – see last module)

Note: If a financial professional makes any recommendations that conflict with these ideas, then they and/or their firm are likely receiving commissions or other kickbacks for selling specific investment products.

Calculating what you need from your liquid assets

Once we have reasonable estimates for a retirement budget (which, again, is not written in stone), we must determine how your assets will provide for that spending. Of course, some have other guaranteed sources of income that will cover part of this budget (a pension, Social Security, etc.). So we subtract these sources of income from your total spending budget to determine how much income we need specifically from your liquid investments.

Now we need to build a portfolio that provides the income we need while allowing enough flexibility to accommodate for changes (or surprises) down the road.

Start simple: A balanced portfolio

In general, I recommend investment strategies that start with a balanced portfolio. If we assume a simple portfolio with just stocks and fixed income (e.g., bonds + cash) allocations, then the goal will be to balance multiple factors including:

• Need for growth: Some people need growth in order to meet their needs. This factor can help determine the minimum allocation to growth investments (e.g., stocks).
• Capacity for risk: Some financial situations can only afford to take a certain amount of risk. This factor can help determine the maximum allocation to growth investments.
• Tolerance for risk: Each investor can only stomach so much risk. Very few people can sleep at night if their portfolio were to fall 20, 30, or 40%. This factor also helps determine the maximum allocation to growth investments.

Other details

This section has brushed some details under the rug here. As highlighted above, decisions around Social Security are a key factor. Maximizing these benefits is a multi-dimensional challenge. One may be tempted to look at their own life expectancy for deciding to file or delay. I like to compare this to market-based options since Social Security income can be viewed as an inflation-adjusted annuity.

If a spouse or partner is involved, then this requires a little more thought to maximize the total benefits including spousal options. Moreover, Social Security decisions can also impact taxes. I touch on this angle in the next module on tax efficiency. The bottom line is that Social Security decisions should account for the broader planning context and not be made in a vacuum.

For more information on my preferred strategy for investment income, you can visit this page or watch this video.

Tax Efficiency
Note: This section covers the types of taxes we face, but our Tax Strategies page highlights the strategies we employ to mitigate them.

I break taxes down into two different, but related dimensions. The first is what most people focus on: income tax. The second dimension focuses on those investment-related taxes triggered by dividends, interest, and capital gains.

Income tax

When it comes to income tax in retirement (and before), one broad approach is to attempt to level out the realization of income. You might ask, what does that mean? First, one must understand that we have a progressive tax system in the United States. That is, tax rates generally increase as income rises (on marginal dollars of income).

Consider a situation where one has the choice between earning $100k in a single year or $50k in each of two years. The latter scenario typically results in a lower tax bill since a higher marginal tax rate would apply to the second $50k when stacked on top of the original $50k in a single year.

This notion can be generalized. For example, one can level out the realization of income throughout their retirement as to minimize poking their head up into higher brackets. Unfortunately, it is not always this simple.

Income-related factors

Whether they are called taxes, subsidy reductions, or something else, we should also be mindful of minimizing the impact of other costs that are triggered by levels of income. Here are three examples:

IRMAA: This is short for investment-related monthly adjustment amount. In a nutshell, you will end up paying more for your Part B or Part D premiums if your adjusted gross income (AGI) is above a certain level.
NIIT: This is short for net investment income tax. In a nutshell, this is effectively an additional tax on passive investment income that applies if your modified adjusted gross income (MAGI) is above a certain level.
Social Security: The amount of Social Security (SS) that counts as income (and is thus taxed) can be zero, 50%, or 85% depending upon your overall income. As a result, additional income in a given period can make more of your SS income taxable.

It is worth noting that these additional costs can be triggered by just one extra dollar of income. The spike-like nature of these costs can make them more punitive than the tax credits and other benefits that phase out gradually with higher levels of income (e.g., educational, childcare, and earned income credits).

Big picture

Suffice to say, it is important to take a step back and look at the bigger picture when thinking about income-related taxes and costs. Below I highlight a few of the primary tools we can use to optimize our individual tax situations:

Roth conversions: We can use spare capacity within a given tax bracket to move IRA money to the tax-free side via Roth IRA conversions. This strategy typically targets the period BEFORE required minimum distributions (RMDs) start and may encourage you to delay Social Security. The idea is to utilize a period of low income (i.e., before SS or RMDs) and use it to convert IRAs to Roth IRAs at lower tax rates.
Withdrawal strategies: We can decide whether to take money from taxable accounts, traditional retirement accounts (e.g., 401Ks and IRAs), or tax-free retirement accounts (e.g., Roth IRAs). A withdrawal from a traditional IRA will trigger income, but not when taken from a Roth IRA.
Beneficiary designations: Consider strategically assigning beneficiaries to your traditional and Roth IRAs. Even without full stretch benefits of previous years, directing traditional (Roth) IRAs to lower (higher) income children or beneficiaries can reduce the overall amount of income tax ultimately paid.
Charitable giving: There are varying degrees of deductions and tax benefits associated with giving. Don’t make the IRS an unintentional beneficiary! We discuss some of these further in the next module.
Annuities: In addition to providing guaranteed lifelong income, annuities also receive special tax treatment from the IRS in both taxable and retirement accounts (e.g., IRAs). In particular, we can use these specialized rules to optimize tax efficiency.

While many people want one or more rules of thumb, the unfortunate truth is that the tax code is complex and everyone’s situation is unique. Even with access to the most sophisticated planning software, I find I must conduct my own external analysis and optimizations in order to truly maximize results for my clients.

Investment-related taxes

The income-related taxation I just described is usually the 800lb gorilla, but that does not mean we should ignore other areas to minimize our taxes. Indeed, I find investment-related taxes offer more low-hanging fruit.

As highlighted above, I mostly use low-cost, tax-efficient exchange-traded funds (ETFs). Many people attribute their tax efficiency to low turnover (and hence fewer capital gains), but the benefit is stronger than that. Indeed, I often say ETFs are the best invention in the history of investing for the taxable investor.

The ETF advantage

Why do I say this? I will not delve into the details here, but ETFs have a special blessing from the IRS that effectively allows them to rebalance their portfolios without triggering capital gains for their investors (the curious can read this article). In contrast, mutual funds often distribute significant capital gains to their investors when they buy and sell within their portfolios.

Of course, if you sell an ETF you purchased at a higher price than you bought it, then you will pay taxes. However, its returns can compound at a higher rate when there is less tax friction along the way. Moreover, if one holds onto an ETF until they pass, then their heirs will likely receive a step-up in basis (according to the tax law as of this writing – May 2021).

This step-up feature is why tax-efficient equity investments should often be held in taxable accounts or tax-free accounts (e.g., Roth). If all of that growth took place within a traditional IRA, then the growth would eventually be taxed as ordinary income when it was distributed. This notion is part of what is called an asset location strategy (placement of assets in accounts with different taxation) – not to be confused with asset allocation (i.e., the division of assets into different asset classes).

There are more strategies (e..g, municipal bonds), but this section is already quite long. However, I do discuss a few more advanced planning strategies in the last module.

Philanthropy

I am always happy to help facilitate philanthropic activities. Many times, my clients already have charitable causes in mind. Other times, I am asked to conduct due diligence.

For example, I have come across charitable causes that were more charitable to the executives and staff employed by the entity than to the actual cause. Whether this occurred by design or chance, the actual cause received less money or benefits than the employees. Intentions are one thing, but execution is another.

It is also worth monitoring the financials of different charities. Significant financial mismanagement can make causes less efficient and reduce their long-term viability.

Tax-efficient giving

Tax efficiency is another angle to consider. For those already inclined to give, there can be significant tax benefits if gifting is properly structured. Donating money that has yet to be taxed is one way to increase tax efficiency.

For example, one might consider qualified charitable donations (QCDs) directly from their IRAs (there are, of course, restrictions and eligibility requirements). These donations would go directly to the chosen charities in full without requiring tax being paid as with normal IRA distributions. Moreover, they would lower RMDs in future years since the IRA balance would be reduced.

Alternatively, one could use a donor-advised fund (DAF). In this scenario, they would contribute to the DAF and receive the tax benefits in that year. However, they would not have to choose the specific charities right away. They could make grants to charities of their choice (again, some restrictions and eligibility requirements apply) from that fund down the road as they please.

Logistics

In addition to the details highlighted above, there are various legal and administrative logistics worth mentioning. On the legal side, there are several estate planning tasks I believe everyone should get sorted.

• Last will and testament: Allows you to specify what happens to your estate (i.e., property in your name) after your death.
• Living will: Also known as a directive or advance directive (to physicians), this document allows people to indicate their wishes for end-of-life medical care in the event they cannot communicate their decisions themselves.
• Powers of attorney (POA): These documents can give others the authority to make decisions regarding your healthcare, finances, etc. Note: While successor trustees can access and control assets within a trust, a POA with specific language is required for others to access and manage retirement accounts (e.g., an IRA or 401K).
• Trusts, legal titling, and beneficiary designations: These tools can help make things go where you want after death while avoiding probate. The last thing many people want is for their estate to get caught up in the courts (i.e., probate). It is important to understand these maneuvers supersede directions in a will. Note: Trusts are not just for the very wealthy.
• Guardianship: If applicable, one should designate who should receive legal guardianship of children in the event of one’s incapacity or death.
• Letter of instruction: Technically, this is not a legal or binding document. However, a letter of instruction can help your affairs get sorted more efficiently after you pass. It would typically list relevant financial information (assets, records, agreements, etc.) and could be very useful to your family or an executor. Note: A secure, fireproof document storage box comes to mind.

Simplify

I also advise clients to simplify and automate their financial affairs to the extent they are comfortable. For example, many retirees are unaware of bill pay services offered by banks. Ditto that for automatically transferring investment income from their brokerage accounts into the bank accounts. Filling out one simple form to direct any dividends or interest to one’s bank account can save much time and effort.

In some cases, I can put virtually all of one’s recurring finances on autopilot. Of course, this should be regularly monitored to make sure all is in order. However, I find this kind of automation provides significant relief to many as their desire or capacity to keep all of their financial fairs in order can diminish through time.

The Behavioral Side

Given my analytical background and approach to problem-solving, my practice naturally leans toward the monetary side of planning and investing (i.e., maximizing after-tax performance). However, if there is one thing I have learned and adjusted to since I started my practice in 2010, it is that the behavioral side of investing, planning, and retirement is also important.

If you become a client, you will surely benefit from all those who came before you. Admittedly, my original engagement and financial planning processes left many people dazed and confused (apologies to them!). The good news is that I continue to broaden and refine my practice with a focus on improving both the underlying services, but also how we deliver them.

Behavioral Biases

Here is a list of what I believe are the 10 most common behavioral biases with brief descriptions:

1. Overconfidence bias occurs when investors overestimate their knowledge, skills, or ability to predict the market. This can lead to excessive trading, under-diversification, and ignoring risks. For example, a trader may repeatedly double down on a stock because they are convinced it will rebound, even in the face of contrary evidence.
2. Loss aversion describes the tendency for the pain of losing to be felt more strongly than the pleasure of an equivalent gain. As a result, investors may hold on to losing investments for too long in an attempt to avoid “locking in” a loss, even when it would be wiser to sell and redeploy the capital.
3. Anchoring happens when investors rely too heavily on an initial reference point, or “anchor,” when making decisions. This fixation can be misleading, such as assuming a stock is cheap simply because it has fallen from $100 to $50 without analyzing its current fundamentals.
4. Herding behavior refers to the tendency to follow the crowd rather than making independent, rational judgments. This can contribute to the formation of bubbles and market panics. An example is buying a stock solely because many others are doing the same, without evaluating its true value.
5. Recency bias is the habit of giving undue weight to recent events when predicting the future. Investors influenced by this bias might assume the market will keep rising just because it has performed well over the last few months, ignoring long-term trends or underlying risks.
6. Confirmation bias leads investors to seek out and value only information that supports their existing beliefs, while disregarding contradictory evidence. For instance, an investor might only read optimistic reports about a company they already own, which can prevent them from making objective decisions
7. Mental accounting involves treating money differently depending on its source or intended use. This can result in irrational allocation of funds, such as taking bigger risks with “found money,” like a bonus, compared to regular income, even though all funds have the same value.
8. Status quo bias is the preference for keeping things the same rather than making changes, which often leads to portfolio inertia. An investor might stay in a low-return investment simply because it is familiar, missing opportunities for greater returns elsewhere.
9. The endowment effect occurs when individuals value something more highly just because they own it. This bias can make selling assets difficult, even when better investment opportunities exist, such as holding inherited stock for sentimental reasons instead of reallocating to more suitable investments.
10. Availability bias causes investors to base decisions on information that is most easily recalled rather than what is most relevant. For example, an investor might avoid airline stocks after seeing news about a plane crash, even if the event has little bearing on the industry’s long-term prospects.