While it doesn’t seem like it, saving for retirement is easy. You set aside a certain amount each month, or each paycheck, and invest it in your IRA or 401(k). That is, of course, an oversimplification. But once you retire and need to figure out how to replace your paycheck, the process becomes a lot more difficult.
There are several ways to replace your paycheck once you have retired. Consider the following:
The Accumulation Phase
While you are working, you are in what is known as the “accumulation phase.” You have a couple of big decisions to make: how much you can afford to save for your future and how you’re going to invest those savings dollars. If you are lucky enough to have an employer-based retirement plan, you simply decide what percentage of your paycheck you can put into the plan and then choose from the menu of investment choices that the plan offers. (For more, see: Will Your Retirement Income Be Enough?)
If you are saving for retirement outside of an employer plan, saving is a bit more involved. You must be disciplined to put money away on a regular basis without the benefit of payroll deduction, and you need to develop an investment strategy.
Accumulating is more complex than this simple explanation. You also want to make sure that you build a portfolio that is properly diversified. Your mix of investments should reflect your tolerance for risk as well as your need for risk.
You should also keep an eye on the costs of your portfolio, which isn’t always easy. Mutual fund expense ratios, trading costs, account fees and management fees can all add up and hurt the performance of your portfolio. You also need to manage the portfolio so that it stays appropriate as you move through the stages of your life.
Social Security Benefits
Most of us are eligible for a Social Security benefit. The timing of when you begin your benefit will be a big part of your retirement income plan. Most people begin receiving benefits at age 62, even though they know they will receive a smaller benefit. It often makes more financial sense to wait until you reach your full retirement age, which is 65 to 67, depending upon your year of birth.
If you wait until your full retirement age, then you will be getting your full benefit. You can also receive a higher benefit by delaying it until you reach age 70. Each year you delay, your benefit will increase by 8%, up until the time you turn 70. When you should start your benefit depends upon your financial situation. (For more, see: Retire from Work, Not Personal Financial Planning.)
Pensions used to be a big part of the retirement puzzle, but not many of us are lucky enough to have one these days. If you happen to be eligible for a pension, you may need to decide when to start receiving benefits.
Like the Social Security decision, many plans allow you to take a reduced benefit at an earlier age and a full benefit at another. You will also typically have to decide whether to take a benefit for the rest of your life, or to take a reduced benefit and provide for your spouse at your death. Your best strategy? Again, it depends.
Managing Cash Flow
Finally, you’ll need to come up with a plan on how to start drawing cash flow from your investment accounts. Note that I said “cash flow” and not “income.” All too often, I see retirees trying to generate enough income from their investment portfolio to meet their spending needs. They think of income as interest and dividends and will tend to focus on investments that pay higher levels of both. Unfortunately, that mindset can often lead to problems with their portfolio.
When chasing higher yields, investors are taking on more risk. When they go after higher dividends, we often find them heavily concentrated in large dividend-paying stocks. This approach leaves them with little or no exposure to other important asset classes. I recommend taking a cash flow approach, where the cash flow is made up of a combination of interest, dividends, capital gains and occasionally principal, from the investment portfolio.
The tax status of your retirement investments will also have an impact on your cash flow decisions. You may have some money in after-tax investment accounts, some in tax-deferred accounts like an IRA, and some in tax-free accounts, like a Roth IRA. By properly managing your distributions, you can exert some control over the taxes that you will pay in your retirement years.
Making the transition to retirement involves a lot of financial planning. You have several decisions that need to be made and many of them will have long-lasting effects on your retirement lifestyle. It is crucial to understand the implications of each decision and to make choices that will benefit you the most in retirement. (For more from this author, see: Don't Invest Without a Diversified Strategy.)