It's day one of your retirement.
You've saved up dutifully, so you head straight for the pool, order an umbrella drink and plan for the great sunny days ahead. That’s great. You deserve it.
All the same, you have a fixed amount to draw from in retirement. So, yes, you should enjoy every moment by the pool, but exactly how many umbrella drinks can you afford?
Old-school wisdom says you can use 4% of your retirement savings during your first year, and that amount plus more for inflation each year going forward. Under traditional schools of thought, that rule is supposed to keep you afloat for three decades because the model assumes that your investments will keep earning money to replenish what you spend.
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But times have changed, and that old rule is based on the assumption that you won’t retire smack dab in the middle of a recession.
LearnVest Planning Services certified financial planner™ Rachel Sanborn says, “If the market goes down in the early years of your retirement, it may mean selling at a bad time and can have a serious impact on your retirement nest egg.” You might hit your golden years when the market is doing just fine, but our new world order means you need to prepare yourself, either way.
Here are the new rules of retirement planning:
1. Have an ‘Emergency Fund’ for Retirement
Because you can't predict what the market will do, just in case the market goes south right as you enter retirement, you should have other money available. “Those first couple of years are crucial,” Sanborn says. “If someone can avoid drawing on their investments when the market is bad, they’ll be much better off financially throughout retirement.”
Here are some ways to give yourself a cushion in case the market tanks right as you take your first sip of that umbrella drink:
- Keep a ‘retirement emergency fund’: Sanborn recommends keeping 18-24 months' worth of living expenses in a money market fund at all times. That way, you can keep paying for groceries and basic expenses without being forced to sell your investments when the market is down.
- Use guaranteed products instead of variable investments: While you’re waiting for the market to recover, you can rely on income from investments like annuities, which use a lump sum of money to create a stream of payments either later, in the case of a deferred annuity, or right away, in the case of an immediate annuity. You can use these to essentially buy a “floor” below which you know your income won’t drop. That said, Sanborn notes, these sorts of investments have pretty significant costs and other cons, so check with a financial planner before making the leap.
- Go for investments that pay regular interest: During this waiting period before the market recovers, you might rely on investments such as bonds that pay out high interest, stocks that pay high dividends or real estate that pays monthly rental income. If the market goes down—or looks like it will—as you’re approaching retirement, it becomes really important to start finding these types of income sources, Sanborn recommends.
- Consider a reverse mortgage: If your home is fully paid off and you’re searching for other income sources, you might look at a reverse mortgage (which allows homeowners 62 and older who wholly own their homes to access the equity in their primary residence) as a backup line of credit to hold off selling other investments, Sanborn says. That way, you don't have “to take money you don’t need and pay interest on it,” Sanborn tells us. “If the market took a dive, you could fund your monthly expenses with the line of credit until the market goes back up.” At that point, you could once again look at selling your investments profitably to pay off the amount you borrowed. This strategy could help if you aren’t prepared to save a full 18-24 months of living expenses in cash, as recommended above. For more info, check out the pros and cons of reverse mortgages.
2. Decide if You’re Saving Up an Inheritance
Sanborn says that you should plan to have enough saved up so you can live off of at least 60% of your current (pre-retirement) income, and preferably more, like 70% to 80%. 60% “should be enough to cover minimum expenses,” she says, “especially since a lot of big costs, such as mortgages or children’s education expenses, are usually paid off by retirement.”
All the same, if you’ve been saving all these years with an eye to replacing 60%-80% of your prior salary, you probably aren’t accounting for extra money you might want to give your heirs as an inheritance.
However, if you saved up more than the bare minimum 60%, then you could plan to leave an inheritance: The old 4% rule for withdrawal (that you’ll take out just 4% of your investments per year, plus inflation) is intended to make sure none of the principal—the original amount you put in—is touched, Sanborn says, leaving the amount you started out with as an inheritance for future generations.
Start by having a “retirement emergency cushion” that you can dip into if the economy tanks, as we discussed above. During the years the economy is normal (not in a recession), you can use the 4% rule. As long as the market is on a general upswing, you shouldn’t make much, if any, dent in your principal, so you can leave it as an inheritance for your loved ones.
If you don’t plan to leave an inheritance, keep reading.
3. Do the Math Based on Your Life Expectancy
If you aren’t planning to leave an inheritance, there’s a more versatile way to figure out your withdrawals. You just have to do a little math. Here’s how to figure it out:
The I.R.S. publishes life-expectancy numbers to help calculate for retirement, in Appendix C of Publication 590. You can look up your age to take a guess at how many years you’ve probably got—and therefore how many years you should save for. The reason life expectancy differs by age is that, while there's an average life expectancy for everyone at birth, if you make it to 65, then your life expectancy is higher than it was at birth. If you make it to 75, then it's higher than it was at 65. Look up your retirement account balance as of December 31 of the prior year, and divide that balance by your life expectancy.
For example, as the Wall Street Journal explains it, if you retired at age 62, your life expectancy (according to the I.R.S.) would be another 23.5 years. Let’s say that, in this example, you had $1 million saved when you started retirement. $1 million divided by 23.5 means you can withdraw $42,553 this year.
Every year, you should recalculate and set a new income for yourself. So, if your balance grew the next year, you would take out more money using the same formula. If your savings shrank, then you’d withdraw less.
The bad part about this method is that your withdrawal amounts change each year. The good part, however, is that this method should account for the real value of your portfolio, so you’re neither depriving yourself needlessly nor tearing wildly through your savings.
4. Remember That Every Situation Is Different
These are only generic rules, and retirement withdrawals are extremely complicated. Sanborn tells us that conventional wisdom is always changing, and there’s new research all the time, which means you may want to consult a financial planner when you're nearing retirement age.
Paying yourself in retirement, Sanborn notes, is a lot like paying yourself if you’re a small business owner, and it’s just as nuanced and variable. Tweaking your retirement “salary” each year isn’t just okay—it’s a good thing.