Living off your portfolio is unfamiliar territory for new retirees, and although it’s sounds simple, there are a number of common pitfalls which many people encounter in their first few years of retirement. Â Here are three mistakes you should avoid to help keep your retirement cash flow safe.
1) Not including everything in your budget
A retirement income plan establishes a safe withdrawal rate designed to last for 30 or more years of retirement. Â For example, we may determine that a couple can safely withdraw $4,500 a month from their accounts, in addition to their Social Security and pension. Â They set up a $4,500/month transfer and this works well until they encounter a large, unanticipated bill. Â Then, they require additional withdrawals to cover their expenses and suddenly their plan to withdraw only 4% that year balloons to 6% or 7%.
When we create a budget, it should include everything, and not just your ordinary monthly bills. Â The following are some “unexpected” expenses that have caused retirees to request additional withdrawals in recent years:
- Home repairs, such as a new roof or AC
- Needing $35,000 for a new car
- Medical expenses not covered by insurance
- Property taxes
- Vacations
- Buying a Vacation Home
- Boats, or RVs
It’s easy to consider a 401(k) account or Pension Lump Sum payout as being all available, but it’s better to view the account as a 30-year stream of income.  Rather than looking at the account as a $1 million slush fund, consider it a $40,000 salary with a 3% raise each year.  A retiree needs to have an emergency fund just like everyone else and to budget and save for large expenses.  The principal of your retirement account cannot be both your permanent source of income and your emergency fund.
2) Reinvesting Dividends in a taxable account.
If you are taking withdrawals, or will need to take withdrawals, from your taxable account, I’d suggest turning off dividend reinvestment on all your positions. Â Have your funds pay dividends and capital gains in cash and hold the resulting cash for your withdrawals. Â This will save you from having to sell positions and creating taxes on capital gains in order to access your money.
You probably have substantial gains in mutual funds if you’ve owned them for a long time. Â Mutual funds typically use the average cost basis method, so if you have a 75% gain in the position, any withdrawal will be considered to have a 75% gain. Â ETFs and individual stocks use the specific lot method, and sales are generally considered to be First In, First Out (FIFO), unless you specify lots at the time of the trade or change your default cost basis disposal method to another option. Â While that does give an investor more flexibility in managing the tax implications of ETF sales than with mutual funds, I find that most don’t bother and simply go with the default of FIFO.
The easiest way for retirees to avoid this headache is have distributions paid in cash. Â If you end up with more cash than you need at the end of the year, you can always use the money to rebalance your portfolio. Â (Which is preferable to having to make sales in order to rebalance the portfolio, anyways.)
3) Ignoring the Low Interest Rate environment. Â
Today’s low interest rates present a challenge for retirees and many of the conservative ideals of the past are simply not providing the same level of financial security today.  This applies to both assets and liabilities.  On the asset side, keeping the majority of your money in a bank account or CD may be safe in the short-term, but with today’s historically low interest rates running below inflation, you’ll lose purchasing power each year.  We call this a negative real return.  A balanced and properly diversified portfolio has short-term risk, but is likely to increase your wealth over time.  If you’re investing for the long-term, make sure all your investments aren’t designed as short-term holdings, or they may be setting you up for eventual disappointment.
Many near-retirees have a goal of being debt-free, which is a laudable ambition, but with today’s low rates, you could lock in a mortgage in the 3% range. Â Selling investments or cashing out a 401(k) and paying taxes on the withdrawal to pay off a 3% mortgage could hurt your long-term financial strength, provided you are willing to hold investments that can potentially return more than 3%. Â By paying off their mortgages, some home owners inadvertently wind up house rich and cash poor, which does not give you much flexibility in paying your living expenses. Â From a cash flow perspective, you may be better off keeping a mortgage versus tying up a majority of your net worth in home equity.
One additional note on mortgages: eligibility for a mortgage is based largely on your income. Â If you are going to refinance a mortgage, do so while you are still working and before you retire. Â Once you are retired, it will be more difficult to underwrite a mortgage with no income, even if you have sufficient assets to buy the property outright.
These types of issues come up frequently with new retirees, and we give a lot of thought to the pros and cons of each choice. Â Individual situations can vary and there are sometimes reasons why no rule of thumb can apply 100% of the time. Â If you have questions about retirement cash flow and your personal portfolio, please send me a message and we can discuss your options.
