Steep market downturns expose weaknesses in retirement income plans. And that was especially true earlier this year when the S&P 500 tumbled some 20% from its high.
The eureka moment occurs when retirees realize they have a gap. They must make sure they have enough access to cash that's unaffected by market swings to pay their monthly bills.
"It's a boomer problem," said Kelly LaVigne, vice president of consumer insights at Allianz Life.
If you can't pay basic monthly expenses like rent, electricity, prescription costs, food and gas with cash at the ready, you'll have to make a withdrawal from other accounts. The problem? You'll be withdrawing from accounts that hold assets that are worth less than they were before the market sell-off.
Dealing With Retirement Income Shortfalls
So, now you're forced with a dilemma of having to sell more shares of that mutual fund or stock to raise the same dollar amount as you did last year. This quandary will occur even if you opt to withdraw 4% from your retirement account that's half stock and half bonds. Financial advisors often recommend a split portfolio like this to provide income for 30 years.
The downside, of course, is you're depleting your nest egg more quickly than planned. You'll also miss out on the future growth of any shares you liquidated to pay the bills. And that could result in you running out of money later in retirement or forcing you to pull back on spending.
Let's say you have a $1 million nest egg, and you withdraw 4%, or $40,000, annually. In a flat market, that $40,000 withdrawal will reduce your account balance to $960,000. But let's say your portfolio falls 20%. Suddenly, the combination of a $40,000 and $200,000 drop in principal will shrink your nest egg to $760,000. That $200,000 paper loss is equivalent to five years of distributions.
Recent market turmoil shows the importance of having a guaranteed income stream sizable enough to cover all of life's essentials.
"You don't want to worry about whether you're able to keep the lights on or whether you'll have enough food," said LaVigne. "The lesson to be learned from this sell-off is: I don't want to be in this position again."
Show Discipline
And you most certainly want to limit withdrawals from retirement accounts when financial markets are in free fall. So, how do you build an income stream that can weather all financial storms?
The best way is to plan in advance of retirement. Start three to five years out, says Lance Sherry, a wealth advisor at Kovitz.
"Do regular cash-flow assessments a few years out, and stress-test it regularly to see if you've built up enough guaranteed income to weather the storm," said Sherry. The key is to be as accurate as possible with the spending assumptions you're building into your model, he adds.
The main sources of guaranteed income are Social Security, a work pension if you're lucky enough to have one, annuities and real estate rental income.
Sherry shares the ideal scenario. One of his clients who recently retired is pulling enough from Social Security and a work pension to fully replace his income from his working years. That's the goal. "He's not concerned about the market, because he has a 'steady paycheck' coming in on a monthly basis," said Sherry.
Tune Out Wall Street
If all your sources of guaranteed income add up to enough to pay your bills, you're in great shape. That allows you to tune out all the noise on Wall Street.
However, if you have a so-called "income gap" to fill, Sherry recommends a pecking order of assets and types of accounts to take withdrawals from. You need to make ends meet when the stock market is in correction.
Start with cash on hand. For retirees, especially those who recently stopped working, having enough cash on the sidelines to last at least a year is the best way to avoid tapping accounts impacted by market volatility.
"Money in the bank is your safety blanket, your safety net," said Sherry. "This is the first line of defense before we start to pull from other income sources."
Sherry doesn't want to see clients who need $10,000 each month to have to pull that from a stock account that is falling in value. "If you do that, you're not only taking a haircut when you liquidate stocks, but you're also capping your eventual growth of those equities you sold," Sherry said.
Be Smart About Tapping Taxable Accounts
Pulling cash from taxable accounts requires finesse. Investments you hold in taxable accounts are subject to the more tax-friendly capital gains treatment than tax-deferred retirement accounts. That's why Sherry recommends raising funds from taxable accounts next.
Asset sales from a regular brokerage account are subject to capital gains taxes. Most people pay 15% or less on gains, according to the IRS. In contrast, all dollars withdrawn from a tax-deferred account such as a traditional 401(k) or traditional IRA are taxed as ordinary income.
"We tell clients, pay the least tax on the liquidity you need," said Sherry.
Put Roth Retirement Income To Work
Your next retirement income target is your Roth account. Contributions to Roth IRA and Roth 401(k) accounts are funded with after-tax dollars. That means withdrawals come out tax-free. So, raising the cash needed from your Roth to pay bills is a tax-efficient way to go. The next retirement bucket to pull from is a traditional 401(k) or IRA.
Often, taking withdrawals from both Roth and traditional retirement accounts could be a prudent play. Rather than taking everything from your Roth and cutting too deeply into your balance or getting all the cash you need from your tax-deferred account and getting hit with a higher tax bill, it makes sense to find a balance between the two.
Cash Flow From Bonds And Stocks For Retirement Income
Since fixed-income assets typically have less volatility and smaller downdrafts than stocks, it makes sense to generate income from the bond portion of your retirement portfolio before you sell battered stocks, Sherry advises. "If we have to sell fixed income, we're not taking a significant haircut on it," said Sherry. He recommends building a bond ladder (a strategy in which you hold bonds that mature at different times) so that you can take withdrawals from the short-duration bonds that carry less interest-rate risk.
Selling losing stocks can be beneficial. You can take advantage of tax-loss selling and use losses in battered stock holdings to offset gains elsewhere in your portfolio, says Sherry.
There's another strategy for stock investors who are well-diversified from both a style and geographic standpoint. Sell stock winners so you can liquidate as few shares as possible to raise the money you need, adds Eric Bond, president at Octave Wealth Management.
For example, international stocks are in the green this year. Pulling from this bucket will give the other types of stock holdings in your portfolio, such as U.S. stocks, time to come back, says Bond.
Bond recommends being tactical when taking withdrawals and leaning toward selling assets that are performing better first. "Remember, if you're adequately diversified, that means you're always going to have a winner and you're always going to have a loser," said Bond.
That enables you to be a bit pickier when deciding what to sell and what to hold.
