It's nice to think of retirement as the life phase that involves minimal problem-solving. You roll out of bed every morning and do what you want. You've put in your career time, after all. The days of deciding how to streamline work processes and choosing which vendor to fire should be well behind you.
Except that retirement brings a new set of questions to answer. They're not career-changers, but they are life-changers. Once you leave the workforce, the answers to these three questions will shape your quality of life for the next three decades.
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1. Will my money last?
In the 1990s, a financial advisor named William Bengen wanted to help retirees make their savings last. He crunched numbers against historic stock market data to identify what he labeled a "safe withdrawal rate." This is the amount retirees could pull from their savings each year without risking running out of money -- no matter how poorly the stock market performed.
Bengen initially concluded that the safe withdrawal rate is 4% in the first year. After that, retirees could adjust that 4% to keep pace with inflation. Later, Bengen updated his magic number to 4.5%, confident this rate would allow the money to last for 30 years.
If the rule holds true, it gives retirees an answer to that burning question of how long the money will last. For example, an invested portfolio worth $1.5 million should stay solvent for three decades if the retiree withdraws $67,500 in Year 1 and makes inflation adjustments thereafter. Right?
Not exactly. The model has its drawbacks, as Bengen himself has stated. It makes many assumptions about portfolio asset allocation, tax rate, and how often the portfolio is rebalanced. Also, a retiree's expenses may grow faster or slower than inflation, and Bengen's rule doesn't address that scenario at all.
There's another major factor, as well. The 4% rule doesn't account for Required Minimum Distributions (RMDs). These are IRS-mandated distributions you must take from your 401(k)s and traditional IRAs. They're also the subject of the next big money question you need to address.
2. How do RMDs affect me?
You are required to start taking RMDs by April 1st in the year following your 72nd birthday. RMDs give Uncle Sam the opportunity to collect on some of those taxes you've been deferring while you saved for retirement. You don't want to skip out on these, because the penalty is severe. If you withdraw less than the required amount, you'll owe a 50% tax on the shortfall.
Your RMD for the year is your account balance as of December 31st in the prior year, divided by a factor that's tied to your age. That factor is called the distribution period. At age 72, the distribution period is 25.6. We can convert that into a percentage by dividing it into 1, which equals 3.9%. On $1.5 million, your RMD is $58,593.75. That's a fairly conservative number, and less than Bengen's recommended 4.5% in the first year.
In later years, though, your RMD will exceed the withdrawal recommended by Bengen's rule. At age 84, for example, the RMD will equal 6.45% of your portfolio. If we assume annual inflation of 2%, your withdrawal rate in that year under Bengen's model will be 5.71%.
You can't exactly tell the IRS you need to reduce your RMDs to follow the 4% rule. Nor should you assume that RMDs will aggressively drain your savings. This is when it's useful to remember that Bengen's model plans for the absolute, worst-case scenario. In an average financial climate, an equity-focused portfolio could actually grow under the 4% rule -- meaning you could die with more money than you had the day you retired. That makes sense, given the average long-term return in the stock market is 7%, adjusted for inflation.
Get a feel for how RMDs will impact your portfolio by running your own scenarios using an RMD calculator online.
3. How will I pay for healthcare expenses?
Healthcare expenses may be the biggest drain on your retirement budget. A Fidelity study estimates the average couple will need $285,000 for medical expenses in their retirement. Shocking, right? And that number doesn't include expenses associated with long-term care -- which can add up to $7,500 or more monthly.
Big, out-of-pocket expenses can easily upset your plan to stretch your nest egg for 30 years. If you're under the age of 65 and you have a high-deductible health plan, you can start funneling money into an HSA. Alternatively, you could increase contributions to your other retirement accounts. You might also consider whether you're a good candidate for long-term care insurance.
If you've already left the workforce, make sure you apply for Medicare on your 65th birthday. And be conservative with your spending. RMDs mandate what you withdraw, but they don't mandate what you spend. Set aside extra cash in a high-rate savings account and use that to cover surprise medical expenses.
There is no formula for retirement
Rules and predictions abound for retirees. But real life will likely deliver a scenario that falls outside your projections. The best preparation is to stoke your savings while you can, and then live well within your means once you leave the workforce.
