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Three steps to help build your retirement paycheck

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This article was adapted from Merrill Edge Minute e-newsletter.

En español | Retirement planning doesn’t end when you stop working. In at least one sense, it’s just beginning, as you look at how to draw income from different kinds of financial assets to create a retirement paycheck for the life you hope to lead.

At the same time, you’ll want your investments to keep growing, not only to potentially help you outpace inflation but also to better protect you against outliving your assets. Here are three steps to consider when building your “retirement paycheck.”

Step 1: Estimate your predictable income

Begin with a comprehensive review of your available retirement income. Your first sources are those that are predictable because they generate a predetermined monthly payment. Other sources of income such as wages, rental income, etc. may play a significant role in your retirement income, but aren’t ensured to last your lifetime.

Generally, predictable sources of income are designed to last the remainder of your life and include:

  • Social Security
  • Employer pensions
  • Annuities1
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Step 2: Estimate income available from your portfolio assets

Next, gather a list of all your savings and investment accounts. This may take some digging through statements. By the time most people retire, they have accumulated a wide array of accounts. You may find now is a good time to consider account consolidation to simplify management. Make sure to include all sources of income, including equity and fixed-income investments.

Help your nest egg last throughout your retirement by creating a sound plan for withdrawing your assets.

This second income source comprises the cash and investments that can be sold each year to cover expenses not met by your predictable income sources. So the next task is to determine at what annual rate you can withdraw from this pool of assets to provide you with monthly income that, ideally, will last the remainder of your life. A traditional rule of thumb calls for drawing down no more than 4% of your assets each year.

Achievable spending rates

The rate at which retirees can prudently spend or draw down their investments in retirement and have them last their lifetime depends on age, gender, risk tolerance and the level of certainty desired. Use this chart to help you get a ballpark idea of the spending rates that may work for you.

Probability of success

95%

90%

80%

Level of certainty

High

Moderate

Low

Male

Age

55

3.0%

3.4%

3.9%

60

3.3%

3.7%

4.3%

65

3.7%

4.2%

4.9%

70

4.2%

4.7%

5.6%

75

4.8%

5.5%

6.5%

80

5.6%

6.5%

7.9%

85

6.7%

7.8%

9.7%

Female

Age

55

2.9%

3.2%

3.7%

60

3.2%

3.5%

4.1%

65

3.5%

3.9%

4.5%

70

4.0%

4.5%

5.2%

75

4.6%

5.2%

6.1%

80

5.4%

6.2%

7.4%

85

6.5%

7.5%

9.3%

Joint

Age

55

2.8%

3.0%

3.5%

60

3.0%

3.4%

3.8%

65

3.4%

3.7%

4.2%

70

3.8%

4.2%

4.8%

75

4.4%

4.9%

5.7%

80

5.2%

5.9%

6.9%

85

6.3%

7.2%

8.7%

The achievable spending rate is the maximum initial share of wealth that a client can spend while attaining a desired “probability of success.” The probability of success measures the likelihood that a retiree will be able to spend according to plan without exhausting her wealth. Spending is assumed to rise each year with inflation. Client is assumed to choose the allocation to stocks, bonds and cash that minimizes her expected lifetime shortfall—the amount, on average, she can expect to undershoot her lifetime spending plans.

Source: Calculations by Merrill Lynch Wealth Management, IMG Investment Analytics.

“Four percent is a good starting point, but it can also be overly simplistic,” says David Laster, director, Investment Analytics, Merrill Lynch. “Your own rate of withdrawal should be personalized and based on a variety of factors, such as age, gender and risk tolerance.” (See chart for details.)

  • Age – As a retiree ages, her annual spending might represent a larger share of her assets. For example, a 55-year-old female retiree seeking moderate (90%) certainty of not outliving her assets can spend 3.2% of her assets. A 75-year-old woman seeking the same moderate certainty might be able to draw down as much as 5.2%.
  • Gender – Since life expectancy is lower for men than for women, a man of 65 can afford to annually spend a slightly greater percentage (3.7%) of his assets than a woman of the same age (3.5%). Given their mixed longevities, a married opposite-gender couple would need to be even more conservative, drawing down just 3.4%.
  • Risk tolerance – Drawdown rates also depend in part on the level of certainty a retiree feels he or she must have regarding the sustainability of his or her assets. For example, a 55-year-old man who needs a 95% probability of his assets lasting his entire lifetime can safely draw down 3% of his assets annually in retirement. A man of the same age who is less conservative, however, may be comfortable with a lower probability of his assets lasting, say, 80%, and can withdraw 3.9% per year.

Christopher Vale, senior vice president, Merrill Edge Product and Strategy points out that these estimates are based in part on asset allocation.2 “If investors are keeping everything in cash, it very likely reduces the chances that their assets will last through retirement, even if they’re drawing down the minimum,” he says. Even in retirement, consider diversifying your portfolio for some growth potential, at least enough for results to possibly outpace inflation.

Keep in mind that it’s not only how much you withdraw but also the order in which you tap your assets that will give you the greatest chances at future financial security. By being strategic about your withdrawals, you can maximize the value of your savings and investments and help access them in the most tax-efficient way.

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Consider taking your withdrawals in this order:

1) If you have reached age 70½, take your required minimum distributions (RMDs) first. These must be taken from traditional IRAs and 401(k)s at former employers. You will pay tax on those withdrawals.

2) Next, draw from non-tax-advantaged accounts—for example, those that are not IRAs or workplace retirement plans such as 401(k)s. These do not accumulate tax-deferred, or tax-free, and therefore offer no advantage for delaying withdrawals.

3) Then, begin tapping your Roth IRAs and Roth 401(k)s, since you don’t pay Federal taxes on qualified Roth IRA distributions, although state and local taxes may apply.

4) If you still need income, draw non-RMD funds from your traditional IRA and 401(k)s at former employers. Drawing on these last allows these assets to remain tax-deferred and potentially grow for as long as possible.

Step 3: Estimate expenses and close the gap

Finally, project your anticipated expenses in retirement. Some budget items will be much higher later in life, while others will drop substantially. For example, you will likely spend more on healthcare, but probably far less on commuting. Housing costs may decrease if, for example, you have paid off your mortgage, or choose to downsize your home. Keep inflation in mind when estimating your future expenses.

Once you’ve laid out both your income and expenses, you will see clearly whether you have sufficient income to cover expenses. If there is a gap between the two that puts you in the red, you’ll need to decide which adjustments to make. Consider these options:

  • Reduce discretionary expenses – Determine the impact of reducing your budget in “nice to have” areas, such as travel and entertainment.
  • Work longer – If it’s more important to you to keep your spending plan as is, you might choose to stay in the workforce a bit longer, either full- or part-time. This will enable you to delay tapping your nest egg, or at least from tapping as much as you originally planned.
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  • Defer taking Social Security – Another way to grow future income and possibly cover the shortfall is to delay taking Social Security during the first few years of eligibility. Each year you delay, your monthly benefits grow by about 8%, until age 70, when you earn the maximum.
  • Take a more aggressive approach to investing – If you think you can tolerate the higher risk that comes with potentially higher-return investments, review your asset allocation. You may be able to grow your portfolio sufficiently to provide the needed income later on.

Keep in mind that creating a retirement paycheck is not a once-and-done exercise. Market returns may be more or less than projected. Life changes, such as a significant health event, can alter your plan. Or you may want to downsize your home, freeing up cash for interests such as travel or a favorite charity. By reviewing your plan at least once annually, you can work toward keeping your financial strategy aligned with your life goals—and that can help keep you on track for the retirement you envision.

Learn more and take action

  • If your 401(k) plan is through Merrill Lynch, try the Retirement Planning Calculator. It can help you understand how much you need to save for the retirement you envision.
  • Complete this worksheet to help you identify your expenses in retirement and how they stack up against your projected income.
 
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1 Payments from annuities are guaranteed only by the claims-paying ability of the issuing insurance company.

2 Asset allocation does not ensure a profit or protect against a loss in declining markets.

Neither Merrill Lynch nor any of its affiliates or financial advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.

Direct investment cannot be made in an index.

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