If you’ve been reading this blog for some time you know the core theme has mostly been about earning money, growing & investing money, and tax strategies around money but I honestly never thought about decumulation until I had another deep dive conversation with AI about retiring.
Decumulation Strategies Recommended By AI
Decumulation strategies in retirement are the techniques and approaches used to systematically withdraw funds from your savings and investments during retirement. Unlike the accumulation phase, where the goal is to build wealth, decumulation focuses on ensuring that your money lasts for the rest of your life, while also meeting income needs and minimizing taxes. The complexity arises from balancing factors like longevity risk (outliving your money), market risk (volatility), tax management, and personal spending goals.
Here’s a more in-depth look at some key decumulation strategies:
1. The 4% Rule
- Overview: The 4% rule is one of the most well-known decumulation strategies. It suggests that retirees withdraw 4% of their portfolio each year, adjusting for inflation, and that their savings will last for at least 30 years. This rule was designed based on historical market performance, and it provides a simple framework for determining how much to withdraw.
- Limitations: In periods of low market returns, this rule may be too aggressive, potentially causing retirees to deplete their savings faster than expected. It also doesn’t consider individual factors like varying spending needs or tax considerations.
2. Systematic Withdrawal Plan (SWP)
- Overview: A systematic withdrawal plan involves withdrawing a set percentage or dollar amount from your portfolio at regular intervals (monthly, quarterly, or annually). The amount can be fixed or adjusted based on market conditions.
- Customization: You can structure the withdrawals to be flexible depending on market performance. For instance, you might reduce withdrawals during a market downturn to preserve capital or increase them when returns are strong.
3. Bucket Strategy
- Overview: The bucket strategy divides your retirement savings into different “buckets” based on time horizons and risk levels:
- Bucket 1: Short-term (1-3 years), which holds cash or low-risk assets to cover immediate expenses.
- Bucket 2: Medium-term (3-10 years), with more balanced investments like bonds or dividend-paying stocks to provide income over the medium horizon.
- Bucket 3: Long-term (10+ years), where you invest more aggressively in stocks or growth assets to ensure long-term growth.
- Benefit: By having different buckets, you can minimize the risk of having to sell investments at a loss during market downturns, giving the long-term growth assets time to recover.
4. Annuitization
- Overview: This strategy involves purchasing an annuity, which provides a guaranteed income stream for life or for a fixed period. There are various types of annuities (immediate, deferred, fixed, or variable) that offer different levels of income security and risk.
- Pros: Annuities provide certainty and can protect against longevity risk (the risk of outliving your savings).
- Cons: Annuities can be expensive, often have high fees, and once purchased, the money is no longer liquid (you can’t access the lump sum). Also, inflation may erode the value of fixed payments unless you opt for inflation-protected annuities.
5. Required Minimum Distributions (RMDs)
- Overview: Once you turn 73 (as of 2023), you are required to start taking withdrawals from certain retirement accounts, such as traditional IRAs and 401(k)s. The IRS calculates RMDs based on your account balance and life expectancy.
- Tax Implications: These withdrawals are taxed as ordinary income, which can have significant tax implications, especially if large withdrawals push you into a higher tax bracket. Proper planning is crucial to managing taxes effectively.
- Strategy: One approach is to take RMDs strategically, supplementing them with other sources of income to minimize the impact on taxes.
6. Tax-Efficient Withdrawals
- Overview: A key aspect of decumulation is tax efficiency. By understanding the tax treatment of different types of accounts (e.g., taxable, tax-deferred, and tax-free accounts), retirees can minimize their tax burden.
- Strategy:
- Withdraw from taxable accounts first, especially assets with long-term capital gains (taxed at lower rates).
- Next, tap tax-deferred accounts (like traditional IRAs and 401(k)s), where withdrawals are taxed as ordinary income.
- Lastly, use tax-free accounts (like Roth IRAs) to withdraw funds without tax consequences, allowing them to grow tax-free for longer.
7. Dynamic Spending Approach
- Overview: Instead of withdrawing a fixed amount or percentage, the dynamic spending approach adjusts withdrawals based on portfolio performance and personal needs. In years where the market is performing well, retirees might withdraw more, while in down years, they might reduce their spending to protect their portfolio.
- Benefit: This flexibility helps avoid withdrawing too much during market downturns and helps preserve capital for future growth.
8. Social Security Optimization
- Overview: Delaying Social Security benefits can be an important part of a decumulation strategy. For each year you delay past full retirement age (up to age 70), your benefit increases by 8%. This provides a guaranteed higher income later in life, which can be valuable for managing longevity risk.
- Strategy: Some retirees use their savings to delay Social Security as long as possible, maximizing the guaranteed income stream and reducing the need to draw from investment accounts in the later years of retirement.
9. Spending Smoothing
- Overview: Instead of having large fluctuations in income and withdrawals, spending smoothing involves trying to keep retirement income stable across different phases of retirement. This reduces the risk of depleting assets too early due to high initial withdrawals.
- Example: Early in retirement, when people are more active and might spend more, they may withdraw at a slightly higher rate, while later in life, when spending typically decreases, they reduce withdrawals. Balancing between different phases ensures a steady stream of income.
10. Reverse Mortgage
- Overview: A reverse mortgage allows homeowners aged 62 or older to borrow against the equity in their home. This can provide a source of income during retirement, especially for those who are house-rich but cash-poor.
- Pros: Provides tax-free income and doesn’t require repayment until the borrower sells the home or passes away.
- Cons: It reduces the equity in the home and can be complex, with high fees and costs.
11. Glide Path Strategy
- Overview: A glide path approach adjusts the asset allocation in your portfolio over time, typically becoming more conservative as you age. The goal is to reduce exposure to riskier assets like stocks as you near and enter retirement.
- Implementation: Many retirees adjust their asset allocation to match their evolving risk tolerance, shifting more into bonds or other low-risk assets in the early part of retirement while keeping some exposure to stocks to ensure growth later in retirement.
Key Considerations for Decumulation:
- Longevity Risk: Estimating how long your retirement savings need to last is challenging. Some people may live much longer than average, making it crucial to have a plan that accounts for longevity risk.
- Market Risk: Market volatility can significantly impact a retiree’s portfolio, particularly in the early years of retirement (known as “sequence of returns risk”). Strategies like the bucket approach or dynamic spending can mitigate this risk.
- Inflation: Inflation can erode the purchasing power of fixed-income streams over time, making it important to include growth-oriented assets, such as stocks or inflation-protected bonds, in a portfolio.
- Healthcare Costs: Retirees often underestimate healthcare costs, especially in the later years of life. Factoring in Medicare premiums, long-term care, and out-of-pocket expenses is critical to avoid depleting assets prematurely.
By combining several of these decumulation strategies, retirees can better navigate the complexities of managing their income, ensuring their savings last as long as needed while also optimizing for taxes and market conditions. Each retiree’s circumstances—risk tolerance, health, financial goals, and tax situation—will influence which strategies make the most sense for their unique retirement plan.
AI Is The Future – FULL STOP
I am truly enjoying using AI on many different aspects of my life now. The appealing thing here is I don’t sense any ulterior motive from AI as I have with some financial advisors steering me into high fee products and services. AI has summarized in seconds what I might have had to watch on a dozen or more YouTube channel from experts. Note that I am writing the summaries and none of the deep dive info that would be too much noise for a blog post. If you haven’t boarded the AI train yet, you probably need to start or you’re going to be left far behind.
I can envision in a few years that AI will be able to review my entire investment portfolio and optimize a strategy for me and do it practically free. Will it be able to execute trades and boost my portfolio yields? Who knows but I’m willing to try with $10k to see what happens!
After reviewing the decumulation strategies, I have a whole new set of homework for AI to do. I’ll write a follow up eventually.
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Are you using AI for your retirement planning? If so let me know in the comments below.