If you’ve recently retired or are approaching retirement, you may be wondering about the best way to turn your retirement savings into a monthly paycheck. It’s critical to manage cash flow when you retire, to ensure you don’t outlive your funds.
As a Californian, I’m used to drought and conservation, and when I think about how water is stored, where it flows from, and how it is used, I see how managing cash flow in retirement is a lot like managing water. This isn’t an exact metaphor, but it can help paint a picture of how the process of managing retirement savings can work. (For more, see: 4 Keys to a Satisfying Retirement.)
Your investment portfolio is like the snowpack in the mountains. As snow melts, water flows into a reservoir behind a dam. Mechanisms within the dam control the release of water to the water district and, ultimately, the consumer.
This fluid process involves three tiers:
- The investment portfolio (the snowpack).
- Reserves (the lake behind the dam).
- The checking account from which you pay monthly expenses (the water district and consumers).
Managing cash flow in retirement should start with the creation of a financial plan that includes these elements:
- Estimated annual spending to support your desired lifestyle.
- The timing and amount of any periodic or one-time expenses you can reasonably anticipate.
- The target rate of return you need from your investment portfolio in order to support your plan with a low probability of outliving your resources.
- The amount and source of all reliable income you’ll have during retirement, such as a pension, Social Security, 401(k) funds, etc.
Ideally, you’ll stress-test your plan by running it through simulations, so if you follow the plan, you’re unlikely to run out of money during your lifetime. During the planning stages, you and your advisor should construct a portfolio that will meet the risk, return and risk tolerance parameters identified in the plan.
Filling Your Reserve Reservoir
Your next step is to create and fund your reserve reservoir. Like the lake behind the dam, your reserve should have a minimum desired level of funding, and a maximum level, too. The funding requirement should be based on how much you’ll need to cover any shortfall between known and reliable income sources, and planned annual expenses – plus an allowance to cover known extraordinary short-term cash needs.
- A recommended minimum is enough money to cover 12 months of income shortfalls, and a maximum level to cover 36 months of shortfalls.
- Start by funding your reservoir at the high water mark and set up all income sources – Social Security, pension, part-time work, required minimum IRA distributions, etc. – to flow into the reservoir account.
To create your “monthly paycheck,” your reservoir account should be linked to a new or existing checking account from which you’ll pay monthly bills, make ATM withdrawals and cover day-to-day and week-to-week expenditures. If you use a credit card (to pay household expenditures and make management easier, or to accumulate perks like rewards points) you should pay the credit card off every month from your checking account.
Set the account up with a small cushion of a couple months' worth of cash and fund it with a recurring monthly (or twice-a-month) transfer from the reserve account to cover monthly expenses. This essentially replicates the paycheck you were used to getting while you worked. (For related reading, see: 4 Mistakes to Avoid with Your Retirement Plan.)
Keeping the Reservoir Full and Money Flowing
Now that you’ve got the structure in place to create a regular paycheck, you’ll need to maintain the whole system. At the end of your first year of retirement, examine the performance of the investment portfolio and your current level of reserves.
If you planned well and did a good job managing expenses, your level of reserves should have decreased by about 12 months’ worth of income shortfall coverage. If your reserves are lower than you expected, it could be a flag that you need to review your spending and recalibrate your financial plan. (For related reading, see: Embracing a Short-Term Boring Retirement Plan.)
You’ll need to decide whether you want to replenish your reserves back to the high water mark, and the decision will be based in part on how your investment portfolio performed. There are four possible scenarios:
- If it exceeded the long-term target return (good for you!), go ahead and replenish your reserves.
- If your portfolio return was negative, defer your decision to replenish the reserves for another six to 12 months.
- If the portfolio return was between zero and the long term target, then you may consider doing a partial replenishment of the reserves, but not all the way to the maximum. One approach here is to do a pro-rata refill. For example, if the target return for the portfolio is 6% and the portfolio only gained 3%, then you refill the reservoir half the distance to the high water mark.
- Finally, if, due to excess income or an extraordinary income event, the level of reserves exceeds the maximum target, then you should direct the excess back into the investment portfolio for reinvestment.
Having a solid, stress-tested plan for how you’ll manage cash flow in retirement can ensure you have the money you need to live the lifestyle you desire, without the worry of running out of money, even in times of drought. (For more, see: What to Do to Prepare for Retirement.)
Geoffrey M. Zimmerman, CFP®, is a senior advisor and chief compliance officer with Mosaic Financial Partners.