Am I financially prepared for retirement?
Q: I am 67 years old and I am finally getting ready to retire. I have been pretty good about saving money in my IRA and 401(k) over the years and I now have about $600,000 in retirement savings. In addition, my home is paid off and I have another $150,000 in the bank. I want to be sure I am financially ready to retire. I’m especially interested in how much you think I can safely take out of my IRA each year.
A: Congratulations on your upcoming retirement. It sounds like you have been diligent in your savings over the years. Paying off your mortgage is a great benefit, too. As you move into this next phase of life, you will be glad you prepared yourself so well.
Your financial readiness for retirement is difficult to determine given the facts you provided. You are clearly in a better position than many, but I have no idea what your cost of living looks like or if you have any other debts or ongoing financial obligations to children or aged parents. Retirement, like so much else in day-to-day economic life, is all about cash flow management. You have built up a nice portfolio of assets. Now you need to make sure your cash flows work. I recommend you seek out a financial planner who can run some projections for you. The confidence the financial planning process will bring to you will be well worth what it should cost in time and effort.
Your question about how much you can safely take out of your IRA is also difficult to answer without more information. However, here are some important principles for you to keep in mind as you figure out what is right for your situation.
First, you want to be careful with how much you pull from your savings in the early years of retirement. Compounded returns are a key to retirement security. The more you take out early in retirement the less compounding can work for you in later years.
Second, you should test your withdrawal assumptions in a number of possible environments. The safe portfolio withdrawal rate is a topic that has been hotly debated in financial planning circles for many years. The rule of thumb has long been that portfolios can withstand a 4% withdrawal rate without depleting the real portfolio over time. That is a good place to start, but you really need to look at it more closely. Under some scenarios, 4% may be overly conservative; in other scenarios it may be overly ambitious.
For example, a 4% withdrawal rate makes sense if you earn a 7% portfolio return. If you earn 7% and withdraw 4%, then your net growth rate on the portfolio will be 3%, just about right to cover inflation. However, if your portfolio earns less than 7%, you may find your portfolio’s real value eroded over time by inflation.
Unfortunately, the real world rarely conforms to straight line return assumptions. Markets go up some years and down others. When you are withdrawing money from a portfolio, the sequence of portfolio returns makes a big difference in how much you can afford to withdraw.
When looking at withdrawal rates, I have found it best to consider several strategies under a wide range of possible return assumptions. The best tool I have found to help with this is something called Monte Carlo simulation. Monte Carlo simulation takes its name from the casinos of Monte Carlo and uses statistical methods to help gauge the impact of uncertainty on portfolio outcomes. This is another area where a financial planner can be of great help to you.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to firstname.lastname@example.org.