Transcript

Amy Chain: Hello and welcome. I’m Amy Chain, and tonight you’re joining us for a live webcast on how to achieve your ideal retirement. How can you give yourself the best chance to reach your retirement goals? Well, today we’ll talk about tax-efficient retirement spending strategies and smart ways to balance competing goals for income, legacy planning, and longevity protection.

Joining us today to discuss this important topic are Maria Bruno, of Vanguard Investment Strategy Group, and the director of Personal Finance at Morningstar, Christine Benz. Welcome, ladies.

Maria Bruno: Welcome, thank you.

Christine Benz: Thank you, good to be here.

Amy Chain: And I’m going off script here for a minute to say how honored I am to be in studio with you two, who I consider to be some of the brightest and most practical voices in personal finance. So I know we will all learn a lot, and I’m honored to be here.

Maria Bruno: Thanks, Amy.

Christine Benz: Likewise, thank you.

Amy Chain: Good. Alright. And as you all know out there, we’re going to spend most of tonight answering your questions. But before we get into that, there’s a couple of items I’d like to point out.

There is a widget at the bottom of your screen, and it’s there for accessing technical help. It’s the yellow widget on the left. And if you’d like to read some thought leadership material that relates to tonight’s topic or review replays of past webcasts, you can click on the resource list widget on the far right of your screen.

So we’ll jump into our discussion, but, first, we’d like to come to our audience and ask our audience a question. So you viewers out there should see a question on your screen now, and that question is, “Which of the following best describes you?” Your options are, “I’m retired, I plan to retire in five years or less, or I won’t be retiring for at least five more years.” So please respond now and we’ll share your answers in just a few minutes.

Now while we’re waiting for our viewers to join in, Maria, why don’t you kick us off by fielding a question that we got from a viewer ahead of this evening’s webcast. This question came in from Denise from Rockport, and Denise says, “How do I draw down on my savings to optimize income while minimizing taxes?

Maria Bruno: Okay, we get that question quite frequently, and it’s a good one. And I think it’s a good one to start with. I think it depends in terms of, as a retiree, what type of accounts you first have. So we talk a lot about tax diversification and that is when the portfolio has different account types, be they taxable, nonretirement assets or tax-deferred traditional IRAs or 401(k)s or Roth accounts. And it’s important because those accounts are taxed differently with contributions as well as when the monies are withdrawn.

So to optimize the most flexibility would be in a situation where you’ve got different account types and to be able to draw down strategically to minimize annual tax liability, for instance. The flip side to that is you can also maximize the tax-advantaged growth as well. But generally speaking, you want to do it in terms of a way to minimize the current tax rates. Oftentimes, when you look into taxable accounts first, that allows tax-advantaged accounts to continue to grow. But it is a balance. I mean, obviously, once you reach age 70½, for instance, you are required to start taking IRA distributions from traditional accounts. So, obviously, you need to take that. That might be a first source.

But if your goal, for instance, is legacy planning, for instance, then you want to think about passing along the most tax-advantaged accounts. Those would be Roth, for instance, or maybe taxable accounts that could enjoy stepped-up basis at death for the beneficiaries.

But generally speaking, I think a good practice is really think about it on an annual basis, think about the account types. And if you can be strategic, sometimes it makes sense to work with an advisor or financial planner to help. Those are some of the things that you can be an active participant in how you manage your portfolios.

Amy Chain: Great. Well, thank you. Looks like most of our audience has weighed in. We have about half of our audience reporting that they are retired and about another 30% of our viewers say they plan to retire in about five years or less.

Maria Bruno: Okay, good.

Amy Chain: So we’re skewing toward retirement questions this evening—

Maria Bruno: Okay, good.

Amy Chain: —which is appropriate given our topic. So let’s throw another question out to our audience. And while we’re waiting for them to weigh in, Christine, I’m going to ask you another question that we got ahead of time. So go ahead, viewers, and weigh in. The question should be appearing on your screen now. The question is, “How confident are you that you will reach your retirement goals: Are you very confident, somewhat confident, not confident at all, or you have not set any retirement goals yet?” And we should talk about that as well.

So go ahead, and weigh in. And, Christine, while we’re waiting for our viewers’ responses, let’s take a question that came from Hank in Naples, Florida. Hank, thank you for your question. Hank says, “What is the proper percent to be withdrawing each year from your retirement savings?” This is a big one that we get a lot too.

Christine Benz: This is a hot topic. And some of the most important research in financial planning has come down the pike in this area over the past few years. Investors are concerned that the old 4% guideline that they may have heard about is perhaps too lofty given that we’ve heard so many people saying, “Keep your expectations for market returns down.”

So a group of financial planning researchers did a piece a couple of years ago where they suggested that perhaps 3% was a better withdrawal guideline given muted return expectations. It’s highly individual-dependent, and I think you want to keep a couple of key things in mind. One is the asset allocation of your portfolio. So certainly if you’re someone who has a more conservative portfolio, if you’re only comfy with a fairly heavy weighting in bonds and cash, then you should be a person who is taking a lower withdrawal rate. If you have a more aggressive asset allocation, you should be okay taking perhaps even a higher withdrawal rate than 4%. So keep in mind the asset allocation.

Also keep in mind your time horizon. So older retirees some of them may say, “Well, I very much want to have money that I’m going to pass on to my children and grandchildren. It’s okay if I have to take less from my portfolio for me because that’s a priority for me.”

For other older retirees who don’t have that bequest desire though, they may have good reason to take more, certainly, than 4% from the portfolio. They can comfortably take more than that if they’re in their 80s, for example. So it is highly individual-dependent.

It’s also important to keep in mind that we’re talking about a couple of different things when we’re talking about withdrawal rates. So people might think, “Okay, 4%. You’re telling me that I should take 4% of my portfolio year in and year out.” And that’s really not what the 4% guideline says. The 4% guideline basically assumes that someone wants a fairly static standard of living in retirement. So you’re taking 4% of that initial balance and then giving yourself a little raise for inflation each year on that dollar amount. So that’s what underpins the 4% guideline.

Other retirees might say, “Well, I’m okay taking that fixed percentage year in and year out.” Just know if that’s your strategy that that’s going to buffet around your quality of life quite a bit depending on how your portfolio performs.

Maria Bruno: And, I mean, we’re hitting the two big questions right out of the gate, I think, in terms of how do I draw down, both how much but also from where. Those are the two in my opinion and probably your experience as well. Those are typically the two biggest questions that we get from people in retirement.

I think with both of them flexibility is key.

Christine Benz: Yes.

Maria Bruno: Because as Christine mentioned, it depends upon your goals and, you know, it’s not feasible to adhere to a very rigid spending pattern. You need to have some flexibility in terms of the markets and the impact to your portfolio. But then, also, expenses, unexpected expenses come up so there’s flexibility going to be there.

Christine Benz: What’s going on in your life. Yes.

Maria Bruno: Yes, exactly. We have done some new research at Vanguard that looks at dynamic spending, for instance, and the whole premise of that is—

Amy Chain: Explain what you mean by dynamic spending.

Maria Bruno: It’s exactly what we’re talking about in terms of setting a target, but having flexibility around that so to account for market volatility. So when the markets are up, you might be able to take a little bit more. Doesn’t necessarily mean you have to take all of that growth, but reinvest it in the portfolio which then gives you a buffer or a floor during the times when the markets may be a little bit more rocky. And I think many retirees actually do do that to the best that they can. So I think flexibility is key and we’ll probably use that word a lot tonight.

Christine Benz: Yes. Another thing to bear in mind, and we talked about how the retiree’s own expense pattern might vary over time, one of my colleagues has called it the retirement spending smile. So you’ve got the retiree who’s in his or her mid- or maybe even early 60s. Those are the go-go years of retirement typically. And maybe they extend well into the 80s. Every retiree is different, but typically those maybe that first decade is the high spending period of retirement.

Then maybe it tapers off a little bit. The retiree is still active but maybe not doing as much intensive travel and not spending quite as much. And then, toward end of life, you may have accelerated healthcare expenditures which would cause the spending to increase again. And, of course, every retiree is different, but when we examine retiree spending patterns in aggregate, they oftentimes look like that.

Amy Chain: That’s fascinating. I think you’re right. We hit the big ones at the beginning, and we’re going to get into some of the, “Okay, so how” questions as we get through tonight’s webcast.

Looks like as far as our viewers are concerned most of them, north of 80%, feel either very or somewhat confident that they’re prepared for retirement.

Maria Bruno: That’s good. Great.

Amy Chain: So maybe I’ll pause and say for those that maybe aren’t feeling that way, what would be the right way to assess one’s readiness for retirement or is your portfolio ready? I’ll just sort of throw that one out and maybe, Maria, jump in and let us know how Vanguard’s position on talking to clients for that.

Maria Bruno: Yes, I mean oftentimes it’s, “Well, what’s my number?” And it’s no one magic number because every individual situation is different. But I mean you have to start in terms of, especially if you’re married and your spouse, and you really need to think through, “Well, what does retirement mean?” Because sometimes there’s a disconnect between spouses. One may want to retire early, the other may want to work part-time. So really think through what your vision is, what your goal is, and then really start to then work through the numbers in terms of, alright, what have you accumulated? What are your income sources? Is that enough?

You really can’t go into that exercise until you really fully understand what that is going to look like and maybe to do some sensitivity around that in terms of, well, what if we wanted to do this or what if costs are more expensive or maybe we want to do more travel or whatnot? So really go through that exercise. It’s a budgeting exercise. It’s going through the balance sheet and getting a sense there.

The time to do that is not when you’re going to retire. I mean, certainly, sometimes retirement is unexpected due to work reasons, for instance, or health reasons. But do the best that you can to plan in advance in terms of do I have enough and get a sense of whether that’s achievable. That will give you a sense in terms of, no, I still need to work and I still need to maybe maximize my 401(k) contributions or my IRA contributions. So go into that savings mode.

And that’s a time to get help. I mean, I worked with clients over the years, and it’s usually that trigger point in terms of I’m thinking about retirement. Can I? What are the things I need to think about? And that can be a validation exercise or it can be actually working with an advisor throughout that transition phase. It depends.

Christine Benz: I would add a couple of things, too, Maria. I think the lifestyle considerations are huge. So in addition to whether you want to travel, also think about, “Well, is downsizing something that is on our radar? Is that something that we’re open to?” That’s a really big-ticket thing that retirees can do or pre-retirees do to help improve the viability of their plans. If they’re willing to move to a smaller home, they may have smaller maintenance expenses, smaller tax bills. Working longer, I can’t emphasize enough the value of continuing to bring some income in during retirement that can be very complementary to a retirement plan. So think about what your lifestyle in retirement will look like.

And, as Maria said, go through that modeling exercise. Look at those income sources. Look at what you might expect from a pension, if you’re lucky enough to have one. Use the Social Security website to see what your benefits will look like under various retirement ages. And then with your portfolio, run it through some of those basic stress tests. Use 4% as a guideline and see, well is 4% of my portfolio combined with Social Security and a pension enough to give us the lifestyle that we’re hoping to have in retirement?

Maria Bruno: And it’s not once and done. You really need to go back and revisit that financial plan and validate the goals and are you on track or not or may fine tune this along the way. And I think the more you do that, the more you can actually enjoy retirement and feel more confident that you’re meeting your goals.

Amy Chain: How often should investors be revisiting that plan?

Maria Bruno: Well, in terms of revisiting the plan, I mean, there’s a couple of things. One, would be I would suggest every few years to just go back and say, “Hey, are we on track?” I mean there’s certainly portfolio management decisions in terms of rebalancing your portfolio to make sure that the risk profile matches what your goals are. And also, potentially, depending upon your goals, you might want to change that asset allocation. So every few years is really a good exercise, at a minimum, to go through and just do the financials again.

Amy Chain: Now we just got a live question, I think, that ties that nicely. Peg is asking what a reasonable asset allocation in retirement should be. I know there’s a lot of variables here, but let’s get started on what that might be. Christine, why don’t you kick us off there.

Christine Benz: Well it does vary quite a bit based on the retiree’s own situation. I would say that probably the equity allocation is higher than many retirees might have thought it would be, in part, because when you’re looking at the raw materials from bonds in terms of returns that we might expect, yes, you need them in your portfolio as a stabilizer. Absolutely. But current yields are a pretty good predictor of what we can expect from our bond portfolios over the next decade. So you’re lucky to get 2% on a high-quality bond portfolio today. Two percent is not enough for most retirees.

My view is that most retirees do need healthy equity allocations and there are no one-size-fits-all answers, but I think certainly folks entering retirement ought to be thinking of upwards of 50% in many cases.

Amy Chain: Retirement’s a long game, right?

Christine Benz: It is. It’s 30 years or more for many retirees.

Maria Bruno: And I would agree. As you think about the long horizon, equities really provide that inflation protection that investors need at that stage. Bonds will help balance out that market volatility. Cash, you really need to think about cash as a short-term liquidity vehicle. Having that in a long-term portfolio is probably not a good idea because of you’re really not getting growth on that asset on a real or inflation-adjusted basis. So cash plays a role but not necessarily as part of a long-term portfolio.

Amy Chain: Or is not as a significant or core component of this long-term portfolio that needs to accomplish growth.

Maria Bruno: Right, I mean because there’s this notion of playing it safe. But yes, yields are very, very low right now, but you also need to think about the inflation-adjusted growth and that’s where bonds and stocks and a combination comes into play.

Most of the spending rules, as Christine had mentioned earlier, in terms of spending rules, it’s all predicated upon a balanced portfolio. And we see that with, and you may see it as well too in your conversations, but we see it with our investors who are in our IRAs. And we can map this to industry data as well. Investors seem to be balanced within their IRA accounts. So it is enriching to see that, in general, this balanced allocation is being embraced and embraced throughout retirement.

Amy Chain: Great. Christine, you spend a lot of time talking about your bucket approach to retirement saving. We’ve gotten a lot of questions about that this evening. And, in fact, John from Springfield has asked us if you could describe your bucket approach to retirement withdrawals. How do you do that if you have taxable and tax-deferred accounts? First let’s talk about what the bucket approach is and then let’s apply it to our conversation this evening.

Christine Benz: Sure. So first I’ll say I was not the originator of the bucket approach. The bucket approach when I write about it on morningstar.com, the strategy I’m talking about is the one espoused by Harold Evensky, the financial planner, sometimes called the dean of financial planning. Just a great expert on retirement planning.

And his simple strategy that he uses with his clients is that he holds a cash component aside to fund their near-term living expenses and he bolts that onto a long-term portfolio composed of stocks and bonds. And his basic finding in working with his clients was that having enough living expenses set aside, apart from the long-term stuff which would be more volatile, was that it gave his clients a lot of peace of mind. That he could manage their portfolio with an eye toward the long term as long as they knew that their quality of life wasn’t going to be disrupted by these periodic volatile periods in the market.

So that’s the basic thought, that you’re setting aside 6 to 12 months’ worth of living expenses in cash and that it will be essentially dead money because, as we know, cash yields are so, so low today. But the idea is that that’s providing you a buffer so you can live with some of the volatility that will accompany your longer-term portfolio.

So then, when I think about what should the rest of the portfolio look like, I think about putting the next, say, two to eight or two to ten years’ worth of the portfolio in bonds, generally a high-quality bond portfolio. And then the remainder of the portfolio for years ten and beyond of retirement that’s going into stocks.

So that’s the basic bucket thesis and then we’re periodically refilling that cash bucket as we’re spending it with whatever has appreciated most in the portfolio. Or we might have our income distribution sent over into the cash bucket automatically. So if we’ve got dividend-paying stocks or income-producing bonds, those are coming over into the cash bucket.

So that’s the basic strategy. Sounds simple, but then when you think about what most people bring into retirement, they might have multiple pools of money each with separate tax treatments. So those monies need to be kept separate. You can’t merge them altogether. So people may have those taxable assets, they may have traditional tax-deferred IRAs and 401(k)s, and they may have Roth assets. So those are the three main categories that people will bring into retirement.

So it gets back to whatever distribution sequence makes sense for you is the way you want to think about positioning each of those subportfolios. So using Maria’s general rules of thumb, if I’m tapping my taxable portfolios first, those would be where I’d want to be more liquid at the outset of my retirement. I’d want to be holding most of my cash there.

Then, if the tax-deferred accounts would go next in the queue, maybe those would hold sort of the intermediate-term component of my portfolio.

And then, if I have Roth assets, I’d want to think about those as being the last in my distribution queue. Generally; not always, but generally. And so I would think about holding my most aggressive assets there. So mainly stocks, maybe some junkier bonds if I wanted to hold them as a portion of my portfolio, those would go in the piece of my portfolio where I have the longest time horizon.

So, certainly, there’s more art than science and it really does depend on how much you’ve got in each of these kitties. So how much you’re bringing in with taxable, tax-deferred, and Roth. But that’s at sort of a general framework. You’ve got to overlay that distribution sequencing, the tax-efficient distribution sequencing over the bucket approach.

Amy Chain: I’m sure it also depends on what your actual spending needs versus spending wants may be. And, in fact, Timothy has asked us a live question about what role your spending needs today should play in your determining of your spending needs tomorrow. Maria, why don’t you kick us off on that one. What’s the connection between what my spending needs are today and what my spendings will be in retirement?

Maria Bruno: It will change. And that’s why going through this and really thinking through what the retirement goal is and understanding what the income sources are. I mean there’s two things. One is what do I need, but how am I meeting that need? So it could be through pensions. There’s a subset of retirees that still enjoy a rather rich pension. There’s also Social Security. So these are guaranteed sources of income.

So the way to think about it would be, “Here’s what I have coming in. Is this enough? If not, then I need to tap the portfolio, and how do I go about doing that?” And it may change. It may change over time, as Christine had mentioned, in terms of the smile in terms of the retirement needs. But it may vary as well in terms of the income sources or what the portfolio may be generating.

So I think you can have a sense in terms of what I need today and get a pretty good gauge of will it continue, but realize that it may or may not depending upon what your financial situation or your goals.

Christine Benz: I think it’s very individual-dependent. One of my colleagues did some research looking at that old 80% income replacement rate. So retirees have sometimes been coached to think about take 80% of the income you had while you were working and think about that’s how much you’ll need during retirement. What he found was just a huge divergence among subsets of retirees; that more affluent retirees, generally speaking, needed a lower percentage of their working income than folks who were at lower incomes, in part, because the lower-income folks were used to spending pretty close to what they were making, whereas the more affluent retirees may have been saving a big share of their paychecks. So it’s very individual-dependent.

Maria Bruno: It is individualized. And in those situations too, Christine, if someone is a lower-income earner, when you think about income replacement, Social Security—

Christine Benz: Will do more for them.

Maria Bruno: Exactly, has a higher income replacement than someone who was a high income earner. So there they may be spending, but they’re not necessarily spending from the portfolio. So these are maybe some guidelines to think about. But it is highly individualized, yes.

Amy Chain: Now Jignesh has asked us to talk about the unexpected. So where in this equation does the unexpected become part of your plan?

Maria Bruno: I guess two thoughts there. One would be the importance of having a liquidity reserve.

Christine Benz: Absolutely.

Maria Bruno: So regardless of what stage you are in your investing career you need a liquidity bucket, an emergency reserves, or the rainy day fund. While you’re working and you have steady income coming through, you might need to keep three to six months’ worth of living expenses. Depends how steady your income and predictable it is.

Later in retirement, you don’t have that cash flow coming in from earnings, but perhaps you have it through guaranteed income sources. If not, you want to keep a larger buffer there just to make sure that if you do have, you know, as homeowners, things break. Things need to get fixed and they need to get fixed ASAP. So maybe you need to extend that to 12 months or 18 months or maybe two years. There’s certainly an opportunity cost to being out of the market, but you need to have that buffer to be able to withstand some flexibility there if you don’t have steady income coming through to replenish that.

Christine Benz: I would agree. I think my guideline would be in the realm of six months to two years’ worth of living expenses in cash. Or another idea would be to maybe put six months in cash and then, if you wanted additional buffer, maybe go into some sort of very high-quality short-term bond portfolio for the additional 12 months’ worth of living expenses. But as Maria said, it’s important to plan for the unexpected expense because they occur throughout our lives.

Maria Bruno: They do and, you know, you have a portfolio of assets; they’re liquid, you can tap them. It’s a little bit different because if you’re fully invested, you’re susceptible to market conditions when you actually tap those monies. But the portfolio is accessible. It’s just a matter of making sure that the money is there in a readily accessible fashion if you need it.

Amy Chain: And it speaks to the point you made earlier about revisiting your plan and your assets that you have to meet that plan over time. If your circumstances change, certainly your plan to meet your needs might change as well.

Another topic we hear a lot about both this evening and ahead of this evening is bonds. We’ve got Allen from Minnesota writing in about bonds, Helen from New York writing in about bonds. Christine, let’s talk for a moment about how retirees or soon-to-be retirees should be thinking about bonds in their portfolio, especially given the very interesting bond environment that we’ve seen recently.

Christine Benz: Yes, it has been a lot of terror out there about bonds. I think, to some extent, a little bit misplaced. We’ve got retirees very worried about what rising interest rates, should they eventually materialize in some significant way, is that really going to kill their bond portfolios? And I think the fact is there may be a little bit of short-term volatility in bond prices or maybe it will be extended if higher bond yields unfold over a period of years.

But I think it’s important to remember that your bonds are not there as a return engine from your portfolio. You’re looking for something in your portfolio that has the potential to hold steady or maybe even gain a little bit in periods when the equity piece of your portfolio, when the growth piece of your portfolio is down in the dumps. And I believe that bonds will continue to serve that role as shock absorber even though given where yields may go over the next decade, or even more, they may not be a great return engine as they have been for retiree portfolios recently.

Maria Bruno: And if you think about retiree portfolios, higher interest rates mean higher dividend yields as well too. So for those who are looking to bond investments as a source of income, rising interest rates can be a good thing. I mean it comes with principle volatility, of course, but I think sometimes we lose sight of that as well.

But there’s been a concern around interest rates for a number of years now in terms of when and how. And we don’t know how quickly interest rates can rise. So you just need to be balanced and diversified I think.

Christine Benz: Right. And speaking of opportunity costs, I mean, there were a lot of investors who said back in 2010, “Rising rates are coming, batten down the hatches. I’m moving everything I otherwise would have had in bonds to cash.” And lo and behold, rates didn’t go up. Rates, in fact, went down. And the poor cash investor had to settle for ever lower yields on that portion of the portfolio, whereas the person who sat tight in bonds was able to partake of price gains in bonds over that time period.

Whether that’s repeatable is a very big if, but, nonetheless, it’s something that I think does underscore the risks of kind of going with that all-or-nothing scenario saying, “I know what’s going to happen so I will position my portfolio thusly.”

Amy Chain: I think it also speaks to the danger of having a portfolio strategy that depends on market prognostications.

Christine Benz: Exactly.

Amy Chain: I mean, you should be thinking long-term, thinking for a rainy day. If you can’t sleep through the night on a bad market day, you should question potentially whether or not you have the right allocation in your portfolio. Is that a reasonable statement?

Maria Bruno: Yes. And the other thing that we need to keep in mind is it’s really been a rebalancing conversation for the past couple years with a very rich bull market we’ve been experiencing. Some investors are scared to go into bonds because they’re worried about rising interest rates so they haven’t necessarily been rebalancing.

That’s absolutely paramount to portfolio management because here’s a situation where the equity allocation could be much greater than intended, the risk profile of the portfolio has changed, and especially as a retiree they may be overexposed into the portfolio if there is a market correction.

Christine Benz: Well also the retiree is maybe five or seven years older now and they haven’t done any rebalancing.

Maria Bruno: Yes, yes. Absolutely, yes. Yes.

Christine Benz: Yes.

Amy Chain: We have a follow-up question. “Can Maria explain a little bit more of the reason behind withdrawing or draw down from taxable, tax-deferred, and Roth last? I would have thought that the reverse, Roth first and taxable last.”

Maria Bruno: Okay, so the sequence of account types and how to draw down.

Amy Chain: Yes.

Maria Bruno: You need to think about what the goals are, again. And, certainly, this is the best situation if you’ve got the different account types to be able to be flexible with. But if you think about the taxation on an annual basis.

So when you sell assets in taxable or nonretirement accounts, you’re subject to capital gains tax rates which are lower currently than ordinary income tax rates. So when you sell these securities or these holdings or these funds, the tax bite may not be as great as if you were taking distributions, for instance, from tax-deferred retirement accounts where any of the pretax balance that is being drawn from is all taxed at ordinary income tax rates.

And you have to be careful because when you take the extra income, it could potentially even push you into a higher ordinary income tax rate or a higher marginal rate. And then the Roth, certainly, is tax-free so you can take distributions. As long as you meet the holding period requirements, there are no federal income taxes on distributions.

So the nice part about that is there’s a couple of things. One, with tax-deferred retirement accounts, as I’d mentioned earlier, you do need to take lifetime distributions. Roths you don’t need to. So you can pass those to your heirs if you don’t need those assets or you can use them later in retirement.

So when you think about it, you think about, “Okay, well how do I maximize the growth of the portfolio while being tax-efficient currently?” But you need to go back to your goals. That is a conventional drawdown, but you need to think also in terms of do I want to do some lifetime gifting or do I want to pass some assets to my beneficiaries?

If that’s the case, then it may actually be the reverse. You may want situations where you might accelerate some taxable distributions so that your heirs might get taxable assets. And then what happens with nonretirement accounts or taxable assets, there’s a stepped-up basis. So all that gain—

Amy Chain: What does that mean, a stepped-up basis?

Maria Bruno: The gain that these assets had incurred over your lifetime when your beneficiary inherits those, that basis actually becomes the market price at the date of death. So it can be a little complicated, but, generally speaking, that’s how that works. So there are some benefits in terms of depending upon what your goals are, which asset types to draw down.

And I don’t mean to scare retirees when I talk about this in this different context, but it just underscores the fact that opportunistic annual tax planning really can make a difference in terms of meeting your goals in the short term as well as long term.

Christine Benz: Here’s a spot too, Maria, I don’t know if you’d agree, but it seems like an area where having a tax advisor or a tax-savvy financial advisor to kind of coach you on a year-to-year basis because there may be years where you want to override that sequence that you just talked about where maybe, even though we talked about putting Roth assets last in the distribution queue, maybe for whatever reason you are getting absolutely clobbered with taxes in that year due to the distributions that you’ve already taken but you still need additional money. Maybe pulling from those Roth accounts and not adding to your tax burden potentially pushing yourself into a higher tax bracket is the right answer in that year. And a tax advisor can really help coach on those decisions.

I wish there were more tax advisors sort of set up and billing themselves as people who can help with this. Not just I’ll help you with your tax return, but I’ll help coach you on an ongoing basis which accounts to pull from.

Maria Bruno: Yes, and, actually, the reverse example of that could be a situation where retirees might have large deductible medical expenses at any given year, and that might be a situation where you actually want to incur more taxable income because you’re in a lower marginal rate. So looking at this on a year-by-year basis can actually really have the flexibility to manage that and it can add, really, a lot of value to the portfolio over the long term.

Christine Benz: I think retirees can also do themselves a service by thinking about, “Well, in a given year, am I better off doing itemized deductions because I have a lot of expenses? And maybe I even want to accelerate some sort of optional medical procedure that I have been thinking about because I know that this will be my itemized year. Next year I don’t expect to have as many deductible expenses. I’ll go with the standard deduction.” So I know many retiree households kind of make that decision on a year-by-year basis whether to go itemized or standard deduction.

Maria Bruno: And I think an interesting window, I mean, certainly you want to do this every year. But when you think about retirees and distributions that are being mandated at age 70 and for retirees who are thinking about deferring Social Security to full retirement or to age 70 and delay it, there’s that window where you might have some opportunities to be strategic annually in terms of how you draw down because realizing that at age 70 then you will have more taxable income because of the RMDs and because Social Security could be taxable.

So that window is actually a really good time to really think through, “Are there opportunities for me to reverse the order and reverse it maybe on an annual basis? Again, just some general guidelines that retirees can think about.

Amy Chain: You know, this actually speaks to a question we got from Bruce in San Antonio who says, “Why does everybody seem to advocate delaying Social Security payments when it may be financially advantageous to draw as early as possible and invest the funds for later use?” First, is it advantageous? Or what thoughts would we offer to Bruce?

Maria Bruno: Generally, the rule of thumb these days is yes. If you can defer Social Security until your normal retirement age and then up until age 70, there are delayed retirement credits for each year that you delay. And it’s 8% increase currently roughly.

Christine Benz: Roughly eight, yeah.

Maria Bruno: And it’s also an inflation-adjusted increase. So when you think about a return on an investment—

Christine Benz: A guaranteed return.

Maria Bruno: A guaranteed return, yes.

Christine Benz: Try getting 8% with an inflation adjustment.

Maria Bruno: And then you’re locking that in for your lifetime, but also locking that in, if you’re married, survivor benefits as well. So it’s really maximizing the long-term value or maximizing the value of that.

Now that’s intuitively that’s tough, right, because one of the variables is life expectancy, and we can’t predict that. But generally speaking with longer life expectancy, delaying Social Security is going to maximize the value of the payout over both spouses’ lifetime.

Amy Chain: And it sounds like it comes down to it depends on what you need. If you don’t need it, locking in an 8% return sounds like a pretty good plan. But if you do need the money, you might not have the luxury of making that choice.

Christine Benz: That’s right. And there may also be situations where someone has a knowable serious health condition where delaying doesn’t make sense. Claiming earlier than full retirement age may, in fact, make sense.

Amy Chain: And we’ve danced around this a little bit but, certainly, there’s help, right? So you can talk to a financial advisor. There are coaches that can help you make the right decisions here. And I’ll just point our viewers here this evening to our resource list widget which has more information on how to get some of this help at Vanguard and elsewhere.

Okay, let’s take a question about pensions. So, Maria, you mentioned pensions earlier and how some people still have them as part of your portfolio. Shane from California is asking if he has a pension, “Should I take on more risk with my retirement portfolio?” I think we could sub out pension for “If I think my assets might give me what I need, should I be taking on more risk over the long term?” Throw it out to the floor?

Christine Benz: The academic wisdom would say if you are in good standing in terms of meeting your income needs, don’t take any more risk with that portfolio then you absolutely need to, but I do think it depends on the individual.

What I like to suggest is that retirees by thinking about their income needs, think about how much of those income needs will be met through certain sources of income, Social Security and pension. And then if the answer, after you do that little bit of math, if you find that most of your income needs are being met through those certain sources of income, then I think you probably should think about positioning the portfolio fairly aggressively.

If it turns out that you’re practically just sipping from that portfolio for your ongoing living expenses and maybe just using it for mad money—and this is a really enviable position to be in. Not many retirees are in this spot, but if you are in that spot, I think it does make sense to think about having a more equity-heavy portfolio mix, particularly if your end goals for that portfolio is that you want it to grow perhaps for your loved ones because you don’t think that you will spend it during your lifetime.

Amy Chain: We’re getting a ton of questions tonight about annuities. Where do annuities fit into this conversation?

Maria Bruno: Okay, when we say annuities first, I think we’re talking about income annuities. And these are products that you give up a portion of your portfolio in exchange for guaranteed income for a certain period of time over your lifetime. So when you think about annuities, the first source of annuities for many of us is Social Security. So I always like to reinforce when you think about guaranteed income, Social Security is a lifetime income, and as we had just mentioned, a very generous one in terms of payouts.

Beyond that, it really is a situation of are you looking to guarantee a certain portion of your needs through a guaranteed income product? A low-cost income annuity can be very viable for retirees, maybe as a baseline of their expenses.

So think about what it is that you need to spend, what does Social Security cover, pension or anything else, and then do you really want to guarantee that remaining portion? If so, then a low-cost income annuity could be feasible. It’s a tradeoff.

Christine Benz: One caveat I would make, though, is that the payout that you receive from an annuity is keyed in large part off of whatever interest rates are currently. So we’ve talked about a few times how low interest rates are today. That pushes down on annuity payouts. It’s arguably not a terrific time to turn over a portion of your retirement kitty to an annuity because the payouts are so low.

But I would say I would have said this five years ago and payouts have stayed really low since then. So you don’t probably want to get too cute in terms of trying to time these purchases, but it’s arguably an inopportune time to be shifting a lot of a portfolio into an income annuity given how low yields are today.

Maria Bruno: Yes, and sometimes I get the question in terms of dollar-cost averaging, if you will, into income annuities and maybe staggering those purchases.

Christine Benz: The laddering.

Maria Bruno: Laddering them, yes, over different cycles. But, as Christine has mentioned, we’ve been in such a low-interest-rate environment for so long it really, over recent history, didn’t really make that much of a difference.

The other thing I think that may be of merit to discuss is a longevity insurance–type product. So there’s deferred-income annuities where you purchase today at a lower cost, but the payments don’t start maybe until age 85, for instance. So for many of these types of products, you actually have to live until that time frame to be able to enjoy those benefits. But they really protect against the longevity risk of the portfolio later in retirement. So there’s an increased interest in those types of products when we think about managing longevity risk.

Christine Benz: Absolutely. And one thing I like about that sort of product, though I think there aren’t a ton of these products yet. I think the market is becoming more populated due to some changes in Treasury regulations that made them allowable within retirement accounts.

Maria Bruno: Yes.

Christine Benz: They’ve sort of addressed required minimum distributions. But I think that the attractive thing about it is that it lets you plan for a knowable time horizon for your portfolio. So you might look at this and say, “Well for sure I think our portfolio will tide us through age 85, but what if one of us lives to be 97?” And, actually, the statistics are pretty high that of a married couple one of you will make it to age 90 or 95.

Maria Bruno: Fifty percent.

Christine Benz: Fifty percent of married couples.

Maria Bruno: A 65-year-old couple today 50% of them will live, one of them will live to age 92 so it’s very real.

Christine Benz: So that’s the beauty of this product that is going to kick in and provide you for income when you’re not sure that your portfolio will still be around to supply you the income that you need.

Maria Bruno: But they’re insurance products.

Christine Benz: Yes.

Maria Bruno: And insurance comes with a cost. And the more bells and whistles that may be applied to these products, it does come at a cost. So you really need to be educated in terms of what the products might be and how they fit into the overall plan.

Christine Benz: Certainly. The variable products are often costly, often complicated. You really need to read the fine print, and it can be tricky for consumers to get all the information they need to make good decisions about some of the more complicated variable products.

Amy Chain: Make sure you know what you’re buying if you’re considering an annuity.

Christine Benz: Absolutely.

Amy Chain: I’m going to change gear on us here. As we approach year-end, we’re heading into more than just hockey season. We are heading into RMD season. And I know, Christine, this is something you’ve recently written about. So why don’t you first give us an overview of RMD season and why we should be talking about it now, and then I’ll get into some of the questions that I’m seeing coming in from clients.

Christine Benz: Okay. Our morningstar.com readers love to hate their RMDs, their required minimum distributions. These are the distributions, as Maria talked about earlier, that have to come out of your traditional tax-deferred IRA and company retirement plan accounts once you turn age 70-1/2.

So you have to take these distributions by December 31 of each calendar year, otherwise you will pay an enormous penalty of 50% of the amount that you should have taken and didn’t, plus you’ll pay ordinary income taxes as you will with any traditional tax-deferred distribution. So you’ve got to take your RMDs.

The key point I would make is that I think it’s really easy to tie RMDs. If you haven’t already taken distributions from those tax-deferred accounts, to tie it in with your portfolio review. And I would say that you should be doing that portfolio review annually.

So you’re looking at that portfolio first, that’s the starting point—and here I give a plug for our Morningstar X-ray tool that will kind of look at your total allocations—and look at where you potentially want to make some changes in the portfolio.

So Maria talked about how a lot of retirees who haven’t done much maintenance of their portfolios may, in fact, be pretty equity-heavy relative to their asset allocation targets. So maybe you, after looking at your portfolio’s total asset allocation, decide you want to do some pruning of your equity exposure. Well, there’s your RMD. You can take that required minimum distribution from the account that needed trimming anyway.

So I think it’s a good way to sort of tie a year-end maintenance regimen, accomplish a few different things with that regimen. So you’re meeting your RMDs and you’re also getting your portfolio in slightly better shape for the year ahead.

Amy Chain: Now George is asking a question, Maria, that I know you’ve discussed quite a bit with viewers in past webcasts. George is asking about whether or not he should be considering converting IRAs to Roth IRAs before starting his RMDs. What do we think?

Maria Bruno: Yes, I think retirees should consider it. It’s not necessarily something everyone should do.

Amy Chain: And let’s recap what the impact would be. Why would you consider this? What would be the benefit of considering this?

Maria Bruno: So with Roth conversions, you are taking a distribution from a traditional IRA and the proceeds then are invested in a Roth IRA, for instance. And it is a taxable event. There are conversion income taxes that are due. It’s ideal if you can pay those income taxes through nonretirement accounts. That really maximizes the value, the after-tax value of the conversion.

The benefit to that would be is one way to perhaps manage RMDs prior to age 70-1/2 because, again, with Roth IRAs, there aren’t lifetime distributions so you don’t have to take these distributions beginning at age 70-1/2 so they can continue to grow tax-free. So it’s one way to build the tax diversification that we had talked about once you’re retired, for instance. If you’re working, you can direct those cash flows into the different account types.

But it’s one way to build the tax diversification so, in essence, what you’re doing is you’re converting from traditional to Roth, you are lowering your traditional IRA balances, and as a result of that, you are lowering the subsequent RMDs to come from that. So it’s a way to manage the overall tax liability in a staggered way.

Christine Benz: One point I would make just to follow up, though. I agree that it’s something to consider but you do want to consider, to some extent, what has happened with your portfolio. We’ve had great market appreciation. Generally, the conversion thing is a great idea if your accounts are depressed. It’s a way to kind of find a silver lining in a lousy market. And I’m not going to guess about what market returns will be in the future, but there’s a chance that you may have an opportunity down the line, even within the next couple of years, to do the conversion when your balance is a little more depressed than it is perhaps today. So that’s another thing to keep in mind.

I guess that sounds a little like market-timing, and I wouldn’t suggest that anyone engage in market-timing, but keep that on your radar too.

Maria Bruno: And I think that goes to the point of you don’t have to convert everything in one year.

Christine Benz: That’s right.

Maria Bruno: In fact, a series of partial conversions is often the most prudent route if someone is contemplating this because you have to be really careful in terms of if you convert too much you could be actually bumping into a higher marginal tax bracket and paying more tax than you would have otherwise.

There’s other implications too in terms of if you’re a Medicare recipient, it could impact premiums. So you need to think about what that additional income could do and be really guarded in terms of converting just enough to maintain those lower tax brackets.

Christine Benz: I know we want to get too into tax gobbledy gook here, but one safety valve for someone who does a conversion and decides that that was the wrong thing to do, I found out that I triggered this tax bill, is to recharacterize so you can essentially undo the conversion. That’s something to investigate if it turns out that you made a conversion that had some unintended consequences.

Maria Bruno: Don’t panic.

Christine Benz: Right. It’s actually a very generous provision.

Maria Bruno: It is. It doesn’t happen that often. Yes.

Christine Benz: You get a do-over.

Maria Bruno: And you have until October 15 of the following year. You have that window. So there’s ample time that if you find out, whoops, I converted too much or I don’t want to pay the liability, or whatever the case may be, there’s a window there to unwind that.

Amy Chain: Now year-end tends to be the time when people consider taking their RMD. But does it have to all happen at year-end? Mary Jane is writing in and asking us whether or not you have to take your RMD as a lump sum; can you take it a little bit at a time over the course of the year? Christine, what do you think?

Christine Benz: I think either strategy is perfectly fine. For that retiree who wants to take it on a monthly or maybe quarterly basis, that’s perfectly reasonable. My bias is toward thinking about pulling your RMDs from the most appreciated portions of your portfolio. For most investors, I think, doing that portfolio review just once annually is plenty. But it’s certainly up to the individual investor. I don’t think that there’s a wrong way to go about it. Just be sure to take those RMDs.

Maria Bruno: And I think I just wanted to add two things. One is I get this question a lot, “Well, what if I don’t need my RMD?”

Christine Benz: Yes.

Maria Bruno: So it’s a mandatory distribution, but it’s not a mandatory spend. So many retirees, or some retirees— I shouldn’t say many because most actually need the proceeds to live off of. But some are in that envious position where they don’t need that RMD. Well, you really can reinvest it in a taxable account. The key there is to be as tax-efficient as possible. So think about what your goal might be for that money and then invest it in a very tax-smart way.

The other thing, Christine, and I don’t know if you want to touch upon this because you wrote about this in your recent blog, QCDs. I think there’s probably some merit to discussing QCDs and the permanent extension of that given retirees that may be charitably inclined.

Christine Benz: That’s right. It’s a great provision for charitably inclined retirees. And I’ll just say QCD is a qualified charitable distribution and what that means is that you are going to take a portion or maybe all of your RMDs up to $100,000 and steer them to a qualified charity. So the money goes directly to the charity; you never put your mitts on it.

And the virtue of doing that is that it can help reduce your adjusted gross income, which is one of the key line items to keep an eye on in your tax return. So that maneuver, if you were going to make charitable contributions anyway, will oftentimes beat taking the money out, putting it toward a charity, and then taking a deduction on your tax return. You’ll tend to be a little better off just sending it straight to the charity so that income never touches your adjusted gross income.

So it’s a neat thing that was made permanent a couple of years ago so retirees can now take advantage of it. We used to have to wait until the very end of the year.

Maria Bruno: Or the beginning of the following year.

Christine Benz: Right.

Amy Chain: Good. Now as we come to the close of our hour here, I’m going to give you each a chance to help our viewers avoid one of the biggest retirement mistakes you see people make. So, Maria, I’m going to put you on the spot and say what is the biggest mistake you would want our viewers to make sure they take care to avoid?

Maria Bruno: I would think the rigidity of a spending pattern because I can’t underscore how often I get this question in terms of the 4% spending rule and balancing that. So this notion of being locked into this hard number really is not a reality. So to have some flexibility, make sure you’re properly balanced, and have this flexibility rather than trying to get into this methodological number.

It is a balance because you are trying to balance current needs with future needs. But it is a balance and you certainly want to enjoy your retirement. So it’s finding that balance and remaining flexible.

You know, longevity risk I often say it’s a two-sided coin. It’s outliving your assets, but it’s also you don’t want to pass away and leave this big bucket of money that you could have spent and enjoyed it during your lifetime. So it’s finding that balance and not necessarily being locked into this spending pattern that may or may not be right for you and your particular situation.

Christine Benz: I think the big one when we look at the numbers is taking Social Security too early. When we look at the percentage of Social Security recipients who start prior to their full retirement age, maybe even take it when they’re first eligible to take Social Security at age 62, you take a major haircut on your lifetime benefit to do so.

In some cases, we talked about that may be the right answer, but in many cases delaying that receipt date can be very, very impactful. So I think that that’s one of the key pieces of advice that I would impart. If you possibly can, delay. If you think you have longevity on your side, do it because you’ll be glad about that higher lifetime payout.

Amy Chain: Alright, well, Christine, thank you. Maria, thank you. And thank all of you for watching. From all of us here at Vanguard and Morningstar, we’d like to say thank you for joining us this evening and we’ll see you next time.

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