3 Keys to Retirement Readiness

William McNutt



If you were planning on retiring this year, recent events may have you wondering if you can still afford to tap your retirement assets. The answer hinges less on current events than it does on the long-range financial plan that you and your advisor have created. Three important factors help to determine when and how you can retire: how much you plan to withdraw annually from your retirement assets, how much of your required spend will come from investments versus other income, and how you diversify your assets.

Retirement plan

Deciding when to retire

Even in good economic times, deciding whether to retire can naturally cause anxiety. That emotion is even more understandable amid the sudden financial volatility triggered by the global coronavirus pandemic.

Rather than allow the current crisis to derail your plans, use this opportunity to reinforce your overall retirement spending strategy. Whether you’ve decided to retire now, or are thinking about it in the near future, understanding how your spending impacts your investment portfolio during your retirement years will help to make you retirement ready as well as prepare you to weather the ups and downs that inevitably happen in the markets.


Key #1: Your withdrawal rate and why it matters

Your retirement strategy must start with establishing a withdrawal rate that will allow the assets in your portfolio to support you—and fulfill your other goals—for the rest of your life. Tracking your withdrawal rate is essential to help identify whether you might be overspending based on the assets you own.

To calculate the amount that you’ll need to withdraw from your portfolio each year:

  1. Determine how much you want to spend annually while in retirement.
  2. Add up the amount of income you’ll receive from sources outside of your portfolio, such as Social Security and pensions.
  3. Subtract your amount of outside income from your total desired spend.

The difference represents how much money you will need from your retirement account annually. Dividing that amount by your total portfolio value produces your withdrawal rate. (See the example in Exhibit A.)


Exhibit A: Annual withdrawal ÷ portfolio balance = withdrawal rate



An initial withdrawal rate of 4-5% is typically sustainable. Over the course of retirement, though, you should expect to increase your annual withdrawal amount by 2-3% per year on average. Spending too much of your portfolio balance early in retirement, coupled with poor investment performance, can have profound impacts on how long your money lasts.


The impact of taxes and market volatility on your withdrawal rate

You also need to consider what types of retirement accounts you are withdrawing from. Account diversification can enable you to get the same amount of cash flow without paying as much in taxes. For example, if you need $100,000 from your traditional IRA each year, you must factor the taxes on your annual distribution into the withdrawal rate. By contrast, withdrawals from Roth IRAs and bank saving accounts typically don’t require you to pay income taxes. If most of your savings are in tax-deferred accounts such as a traditional IRA or 401(k), something like a significant change in the tax code could cause profound spikes in your withdrawal rate.

Market volatility can also affect your withdrawal rate. If your portfolio declines significantly, an initial withdrawal rate of 4% will comprise a much higher percentage of the lower portfolio value. For example, if the portfolio in exhibit A decreases from $2.5 million to $2 million, you will need to increase your withdrawal rate from 4% to 5% to maintain your annual $100,000 withdrawal. This could leave little room for increased expenses over the course of your retirement.

Ultimately, your target withdrawal rate should be based on multiple factors including your age, asset allocation, and goals for legacy planning. The amount of cash you withdraw will likely change over time. The more conservative your withdrawal rate, the less you’ll have to adjust during market declines.


Key #2: Know your portfolio reliance rate

Another critical number to know is your portfolio reliance rate, the percentage of your spending goal that comes from your portfolio rather than from external sources.

Together with your withdrawal rate, your portfolio reliance rate helps us evaluate your income’s sensitivity to market declines. For example, if you are withdrawing 5% of your portfolio annually and those withdrawals provide 10% of your income, you’re going to be less sensitive to market declines than if the 5% withdrawal provides 90% of your income.

Take the hypothetical example shown in exhibit B. This client, retiring at age 65, has an initial retirement portfolio of $2,500,000. He anticipates spending $150,000 and collecting $50,000 per year from Social Security. His initial withdrawal rate is 4% with a reliance rate of 66% ($100,000). With these assumptions: a 5% return-on-revenue, 2.5% inflation yearly, and no increase in Social Security, the client’s end-of-life portfolio balance will be $1.5 million.

However, if he experiences a 20% decline in his portfolio, his initial withdrawal rate will need to increase to nearly 5% to support his desired income, resulting in an end-of-life portfolio balance of –$265,262. Since 66% of his income is derived from the portfolio, this client will need to adjust his spending during down markets. If the client had a lower reliance rate or withdrawal rate, however, he might be able to weather down markets with no spending adjustment needed.

Exhibit B: Portfolio reliance rate = (desired spend – non-portfolio sources of income) ÷ desired spend



What reliance rate is appropriate for you?

The answer depends on factors such as the age at which you retire, your investment returns, the size of your retirement portfolio, and what amount you hope to leave in your estate. The lower your portfolio reliance rate—regardless of your withdrawal rate—the less impactful market declines tend to be.

Individuals who rely on their portfolio for a larger percentage of their income will be at higher risk than individuals whose retirement income is less dependent on their portfolio. And the higher your withdrawal rate, the riskier a high reliance rate might pose. Also, investors with high withdrawal and reliance rates tend to make more emotionally driven decisions—such as selling depreciated equities and going to cash—during market declines. Such choices work against the investor and can interfere with reaching retirement goals.

When planning for retirement, clients should seek to build a portfolio designed to preserve their standard of living. This is where asset allocation and diversification become vitally important.


Key #3: Always diversify your assets, even during retirement

In uncertain times, it’s tempting to opt out of the financial markets to avoid declines. But investing too heavily in cash or fixed income can be just as dangerous as investing too heavily in equities. Cash can be deceiving. It may look stable because you might not see how cash decreases in value. But over time, your purchasing power can erode, and inflation can quickly eat into your retirement plan. Fixed income, while suitable for short-term investing—especially in today’s low-interest-rate environment—won’t keep pace with inflation over the long term. Conversely, equities are not appropriate for short-term goals but can provide a significant boost to your retirement savings.

The key is a portfolio that balances your current income needs with growth that funds your spending goals well into the future. One approach is to build a retirement portfolio that considers both your total returns and your income needs. This can be done by investing in less-volatile securities for short-term needs and in more-volatile securities with higher potential returns for long-term goals. Again, the right mix of shorter- and longer-term investments will vary from person to person.

Diversifying your assets in this way helps make your portfolio less susceptible to market declines, because you are not drawing income from a single investment type that is subject to market volatility. Instead, your retirement income sources might look like this:

  • Short term (next 1-2 years): cash and fixed income, offering low returns but high stability
  • Intermediate (3-10 years out): securities that generate a yield, such as bonds and high-dividend-paying stocks, which are somewhat more volatile but can be expected to outpace inflation
  • Long term (beyond 10 years): securities that are focused on growth via capital appreciation


Stress test your financial plan

After you’ve worked with your advisor to develop a solid financial plan, that plan needs to be stress tested regularly. Using historical market data, we can assess whether your retirement portfolio can sustain your planned withdrawals in all types of market environments. Our advisors also re-run these simulations during tumultuous periods in the market, such as we’ve seen early in 2020.


Expect and prepare for challenging times

Although no one could have predicted that the coronavirus would cause a 34% drop in the S&P 500 in March, history has taught us to expect significant market changes from time to time. A plan that doesn’t account for bear markets and multiyear declines is not a plan. While you cannot control the markets or economic environment, you can prepare for your retirement and the inevitability of volatility over the course of your retirement.

Before you retire, work with your Mercer Advisors financial consultant to develop a holistic financial plan and optimize your financial strategy. That solid foundation will put you in much better shape to be ready for retirement and to navigate challenging times.

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