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Retirement ripples

Keith J. Hardman
Published on April 10, 2024

“Just as ripples spread out when a single pebble is dropped into the water, the actions of individuals can have a far-reaching effect.”
— Dalai Lama

As we have discussed in prior monthly newsletters, retirement planning is not without its challenges. In my October 2023 letter I detailed a number of risks facing retirees and thoughts on how to mitigate those risks. Without wanting to sound like “a broken record”, it is prudent to recognize again that these risks do exist and can potentially derail even the most meticulously crafted financial plan. Risks such as inflation, market volatility, and the uncertainty surrounding retirement timing are formidable adversaries that must be addressed.

Inflation, the silent diminisher of purchasing power, can swiftly erode the value of a hard-earned nest egg. Market volatility, plays a pivotal role in shaping the trajectory of retirement portfolios, with the sequence of returns during the initial years after retirement having an outsized impact on the longevity of our assets. Lastly, the timing and length of retirement itself can be a wildcard, as unexpected events or circumstances may force an investor into an earlier-than-anticipated transition, compounding the financial strain.

Beyond these tangible challenges, retirement also necessitates a profound psychological shift – a transition from a lifetime of prudent saving habits while employed to a paradigm of judicious spending. This mental hurdle is not to be underestimated, as decades of ingrained financial discipline can make the act of spending while not earning income through employment unnerving.

We acknowledge that retirement planning is full of intricacies – that is why it is imperative to adopt a strategic and holistic approach that safeguards financial well-being and enables thriving in the “golden years” of life. In the words of Noble Prize-winning economist William Sharpe, determining how to spend in retirement the assets built up over a lifetime is “the nastiest, hardest problem in finance.” Here we will explore strategies that encompass investing, spending habits, and tax-efficient techniques.

Prior to recent academic research, traditional rules of thumb were often used to determine how to “decumulate” assets during retirement. The oft-cited 4% withdrawal rate, under which a retiree spends 4% per year of the value of assets held at the moment of retirement for the remainder of their life, adjusted only by the yearly inflation rate, or the notion of replacing 60-80% of pre-retirement income, are often too simplistic to withstand the complexities of modern-day retirement challenges.

To counteract the shortcomings of traditional approaches to retirement, a new generation of dynamic withdrawal strategies has emerged, some of which offer promising solutions for greater sustainability and peace of mind. These strategies embrace flexibility, adaptability, and a holistic understanding of the retirement lifecycle.

Flexible strategies that can accommodate both the expected and the unexpected are critical. Many retirement plans can be sustained by making small, judicious adjustments to the plan, rather than requiring wholesale overhauls. For that reason, at PMA, we typically suggest that a client review their plan annually, at a minimum. The ability of a retiree to adapt, to pivot, and to seize opportunities as they arise is the hallmark of a truly resilient retirement plan.

As an example of flexibility, consider the power of working just one year longer than anticipated (for example retiring at age 67 instead of age 66). Research from the National Bureau of Economic Research reveals that this seemingly modest change in the retirement date can provide the same financial advantage as saving an additional 1% annually for thirty years. 1National Bureau of Economic Research, This finding highlights the profound impact that seemingly minor adjustments can have on our retirement readiness.

Additionally, adaptive spending strategies embrace the notion of flexibility, adjusting withdrawal rates in response to market conditions. In prosperous years, higher withdrawal rates can be sustained, while in leaner times, judicious reductions can help preserve the longevity of the portfolio. This approach allows for maximizing income when markets are favorable and can help protect against portfolio depletion during downturns. It is important to note that this approach requires ongoing monitoring and adjustment of withdrawal rates, potentially resulting in variable and unpredictable income streams. Also, the psychological impact of income fluctuations should be considered. When evaluating an adaptive spending strategy, one should assess their ability and willingness to adjust spending habits based on market performance, establish clear rules or guidelines for adjusting withdrawal rates, and understand the tax implications of variable withdrawals.

Furthermore, contrary to the assumption of a linear spending pattern throughout retirement, research has unveiled a non-linear trend, sometimes referred to as the “Spending Smile” curve. This phenomenon reflects the somewhat commonsense expectation that people are likely to spend more early in retirement (ages 65-75) on such things as travel and hobbies, which spending will moderate during the quieter mid-retirement phase, and then increase in later years (85+) typically as a result of new health care related costs.

Sustainable withdrawal rates can be higher when accounting for these spending adjustments over the retirement lifecycle. By embracing a dynamic income plan, retirees can live more fully during their most active years while prudently reducing their burn rate as needed later on, helping to ensure a more harmonious balance between present enjoyment and long-term financial security.

In addition to the consideration of the decumulation question, retirees should also consider proactive tax management – including such strategies as investment in tax-exempt municipal bonds if in a high enough tax bracket, Roth conversions, the use of Health Savings Accounts (HSAs), and charitable giving. And while these strategies are not for everyone, these are a few examples by which investors can diversify their income streams, achieve greater flexibility, and exert more control over their retirement tax burden.

For example, converting a portion of tax-deferred dollars into a Roth IRA account can be advantageous for investors who anticipate being in a higher tax bracket in the future. This strategy promotes tax diversification, hedging against the unpredictability of future tax rates and providing a tax-free income stream in retirement.

Health Savings Accounts (HSAs) are increasingly widely available through employers or individual trustees. If you are enrolled in a qualifying high-deductible health insurance plan and meet the other eligibility rules you can open and contribute to an HSA. If eligible, you can take advantage of HSAs triple tax benefits – tax-deductible contributions, tax-deferred growth, and tax-free withdrawals for qualified medical expenses – making them powerful retirement savings vehicles. HSAs can be leveraged to cover future medical costs, including Medicare premiums, without incurring additional tax liabilities.

Finally, charitable giving can work hand in hand with tax efficiency. While it feels good to give back, there are a number of tax advantages, too. Keep in mind that charitable gifts can include more than just monetary donations – gifts can also be in the form of shares of stock, or distributions from an IRA after a certain age. Charitable contributions can help lower one’s total taxable income, which could in turn reduce income taxes and even Medicare premiums in retirement.

The retirement road may wind and twist, but with the right preparation and a commitment to adapting to life’s ebbs and flows, we can navigate the retirement landscape with confidence and grace. It is a journey that demands patience, perseverance, and a willingness to embrace the power of little things – for it is in the accumulation of seemingly minor choices that true wealth and security are forged.

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