Other highlights from this webcast
- Principles for extending the life of your savings
- Asset allocation in retirement
- Health savings accounts
- Required minimum distributions
- Tax efficient order of withdrawals
Akweli Parker: Hello, I’m Akweli Parker, and welcome to our live webcast on spending in retirement. Now tonight we’re going to cover how to determine how much you can spend in retirement, how to make the most of your assets in a low-return environment, how to figure out the role of pensions, Social Security, and annuities in your retirement portfolio, and how to plan the most tax-efficient order of withdrawal. I know that sounds like a lot to cover, but, fortunately, we have on hand two of Vanguard’s premier retirement experts to walk us through.
Joining us are Colleen Jaconetti, who is a senior investment analyst with Vanguard Investment Strategy Group, and also we have Kevin Miller, and Kevin is a Certified Financial Planner professional (a CFP) with Vanguard Personal Advisor Services. Kevin and Colleen, welcome, and thanks for being here.
Colleen Jaconetti: Thank you.
Kevin Miller: Thanks.
Colleen Jaconetti: Happy to be here.
Akweli Parker: Now those of you who’ve joined us on previous webcasts know that we’re going to spend most of our time today answering your questions. Now those are questions that we received when you registered, so you sent them in to us in advance, as well as those that you can submit live during our broadcast. So we really appreciate all of your questions, and we encourage you to send your questions in live to us tonight.
Now before we get to that Q&A portion, there are a couple items that I’d like to point out really quick. So we’ve got these icons at the bottom of your screen—we call them widgets. If you need technical help, just access the blue widget on the left of your screen. Further, if you’d like to read some of Vanguard’s thought leadership material that relates to today’s topic, or if you want to view replays of our past webcasts, just click on the green Resource List widget on the far right of the player.
So, what do you say, experts, you ready to rock and roll with some of these retirement tips?
Kevin Miller: Yes.
Colleen Jaconetti: Definitely.
Akweli Parker: All right, fantastic. So before we start peppering the two of you with our audience questions, we want to turn it around and ask our audience a question. So we’ve got our first audience poll of the evening. On your screen now you should see our first poll question, which is “Do you have a plan for spending in retirement?” Now your options are, “yes, no, or no, but I do realize that I need one.” So please just take a quick second now to respond, and we’re going to share your answers in just a few minutes.
All right, so, Colleen, while we’re waiting for those results to be tabulated, how about if you start us off with just talking about what are some of the key principles for extending the life of one’s retirement savings?
Colleen Jaconetti: Sure. There are actually 3 key principles for extending the life of retirement savings. The first one is to develop a prudent spending rule that balances current spending with preserving the portfolio for future spending or requests. The second one would be to construct a broadly diversified low-cost portfolio that you can stick to in the best and worst of markets. And the third one would be to implement a tax-efficient withdrawal strategy. So following these three principles, you could really meaningfully extend the life of your retirement savings.
Akweli Parker: Fantastic. Well thanks for that overview.
Let’s take a moment to see how our audience responded to our first poll question. So the question was, “Do you have a plan for spending in retirement?” And it looks as if about 55% of you responded yes, about 11% said no, and a little over a third, 35% said no, but I do realize that I need one. So Kevin, Colleen, what do you make of those results?
Kevin Miller: I would say that that’s pretty typical from what I hear from clients. That’s really at the heart of what I do on a daily basis. It’s really for that maybe third that doesn’t have a plan but realizes that they should, you know, looking at the goals that they have, what it is that they’re trying to accomplish, and then seeing how well they’re doing versus those goals.
Akweli Parker: Excellent, excellent. Thanks for that analysis.
So we do have our second poll ready for you, so let’s ask another poll question. So that one is, “Will guaranteed income—and that’s things such as Social Security, pensions, annuities—will those be a source of retirement spending for you?” And your options there are pretty simple, yes or no. So, once again, if you could just take a second to respond, and we will return with your answers in just a few minutes.
So while we’re waiting for those results to be tabulated, Kevin, I want to turn to you; and this is a really good question that comes to us from Teddy in Glendale, California. Teddy asks for us to please explain required minimum distributions (RMDs) for IRAs. So the notorious RMD, Kevin. What’s the deal with that?
Kevin Miller: Yes, so the IRS mandates that in the year someone turns 70½, you have to start taking, as the name suggests, a required minimum distribution every year from a tax-deferred account, so they would be traditional IRAs, 401(k)s, those types of accounts. And it’s based on the balance in the account and how old you’ll be. The good news though, when it comes to the calculation, Vanguard can help you out with that and making it real easy. We can tell you exactly what it is that you need to spend every year when you get to that point.
Akweli Parker: Fantastic, so I know that we have another RMD question, so hold that thought.
We do have results back from our second poll, so let’s take a look. So the question, once again, was “Will guaranteed income be a source of retirement spending for you?” And, resoundingly, you replied yes, 97.6%, 98% said yes; and about 2.5% said no. So that seems pretty obvious folks, but what can we read into that.
Colleen Jaconetti: Yes, I mean, I think, really, it’s just most people probably responded about Social Security; but, obviously, some people may or may not have pensions or they may or may not decide on an annuity. So I think our discussion tonight will help people decide whether they would like to have those strategies in their plan.
Akweli Parker: Excellent, excellent. So let’s take another presubmitted question from our viewers, and this one comes from Patricia from parts unknown, but it’s a really good question. She asked, “What should a person do with the money from those RMDs, required minimum distributions, if they don’t need to live off of it?” So our good friends at the IRS say that you have to take it, but what if it’s really not necessary for you?
Kevin Miller: Absolutely. So, if you don’t need to spend the money, a lot of times we would tell you to move it to a taxable account and get it invested. What you would want to do then is match the investment to the goal that you have. So if it’s money that you may not need to spend right away but maybe in six months or a year, you’d want to invest it in something that’s a little less risky versus if this is money that you could invest for five or ten years, maybe something that gives you more growth potential but is also a little riskier. So, you know, just making sure that you take it out and then invest it in a tax-efficient way that matches the goal that you have.
Akweli Parker: So you’re complying with the IRS rules and potentially expanding the length of your retirement savings as well by reinvesting.
Kevin Miller: Exactly.
Akweli Parker: Excellent, excellent. So our next question comes from Sally in Annapolis, Maryland, and she asks, “How often should you take a distribution?” So monthly, quarterly, yearly?” So what should the cadence be? Kevin, I’m going to pass this one to you as well because I’m sure your clients probably ask this one a lot.
Kevin Miller: Sure. And when it comes to the distribution schedule, there are no hard and fast rules. I usually tell clients to match it to the particular needs. So for someone, let’s say, that’s taking a required minimum distribution that needs monthly income, they’ll typically take it monthly. For someone that maybe doesn’t need the money or has it set up where they have a year’s worth of expenses already in a cash position, maybe they’ll take it in a lump sum towards the end of the year.
So the IRS doesn’t really care when you take it out throughout the year. They just want to make sure that it’s out by year-end, and then you can just match it based on whatever it is that works for you.
Akweli Parker: Okay, so it’s really just a matter of personal need, right?
Kevin Miller: Exactly.
Akweli Parker: Right, right. Okay, so this RMD subject seems to be pretty popular. We have a live question on it, and Doug asks, “RMDs start when you reach age 70, is that correct?”
Kevin Miller: It’s the year that you turn 70½.
Akweli Parker: Okay. All right, so let’s go to one of our presubmitted questions once again. This one comes from Mark in Charlotte, North Carolina; and Mark asks, “What is the most tax-efficient method of withdrawing from retirement accounts?” So, Colleen, you’ve written research papers, you’ve written lots of blog posts on this, can you answer Mark’s question?
Colleen Jaconetti: Sure. It really depends. If a client is looking to maximize spending during their lifetime, we would suggest starting with RMDs, as Kevin just discussed. They’re required by law, right, so they’re the first portfolio monies to be used toward spending. After that, we would say spend the cash flows on assets held in taxable accounts—so that includes dividends, interest, and capital gains distributions. And the reason these are next is because they are taxed to you whether you spend them or reinvest them. So if you reinvest them and then sell them in the near term or even longer term later, you could be incurring additional taxes. If you still need money in excess of those two, we would then say start spending from your taxable portfolio in a way that minimizes taxes. So start with assets at a loss, and then assets at no gain or loss, and then sell to assets at gains.
And then the final way we would do it, say your tax-advantaged accounts, you have to make a choice. Right, you have tax-deferred accounts, 401(k)s, traditional IRAs, or tax-free accounts such as Roth IRA. And, really, the goal here is to spend from your tax-deferred account when you think your tax rate will be the lowest. So if you think your tax rate is lowest when you retire, you would want to spend from your tax-deferred account then. A lot of people may have part-time income when they retire or they may have rental income or things like that. So when they retire, they may actually be in a higher tax rate, in which case we would say spend from your tax-free assets—your Roth assets—upon retirement; and then spend from your tax-deferred assets later when your tax rate’s lower.
Akweli Parker: Excellent. So I just do want to remind our viewers that whenever you hear us talking about tax strategies, just make sure that you talk with your qualified tax professional to make sure that these strategies apply to you, because everyone’s situation is different, right, so your mileage may vary. All right, excellent. And, Mark, thanks for that question. I hope that we answered it for you.
Our next question comes from Steele in Argyle, Texas, and it’s really a follow-up to the one you just answered, Colleen. Steele asks, “Are there exceptions to the most tax-efficient order of withdrawal?” So is there ever an instance where you would do the opposite of what you just explained?
Colleen Jaconetti: Yes, absolutely. So, well the withdrawal order that I went through was if you want to maximize spending during your lifetime, so that’s not everybody’s goal in retirement. Some people may have goals to leave money to their children or to charities and things like that.
So, again, it comes out a little bit about tax planning as far as if your children end up, say if you have a traditional IRA, your children are in a lower tax bracket than you, you may not want to spend from the traditional IRA during your lifetime, pass it on to them, and then the withdrawals could come out at their lower tax rate. Obviously, it can get very complicated with the tax and estate planning, so it’s certainly a place where you would want to speak to an advisor.
Kevin Miller: And I would add in, in addition to sort of those longer-term strategies, you can also have it in a one-off situation where let’s say in a particular year you have a lot of income. Maybe you’ve realized capital gains from rebalancing or something like that, and someone would choose to spend from say a Roth IRA if they needed money but didn’t want to incur any additional tax. So that could be something that you do for maybe just that one year and then revert to taking from a traditional IRA in subsequent years.
Akweli Parker: That’s a really great point and one that could potentially save someone a lot of money, right?
Kevin Miller: Yes.
Akweli Parker: Right? Okay, so we do have another live question, and thanks, once again, for sending in those questions. Just keep them rolling on in.
This one comes from Harvey, and Harvey asks, “Any thoughts on converting a traditional IRA to a Roth IRA?” So a couple ideas packed in there. Maybe you can start off by talking about the difference between the two and then your thoughts on the actual conversion.
Colleen Jaconetti: Sure. I mean a traditional IRA, obviously, is funded with tax-deferred dollars, right, so you do not pay tax on the way in, but you’re going to have to pay tax on the way out. A Roth IRA is funded with after-tax dollars, so you already paid tax on that money, so all the growth and the withdrawals from that are tax-free. So the decision to convert or not convert really probably comes down to tax rates. It’s kind of looking at what is your current tax rate and what is your future tax rate expectation. If you are in what you think is a lower tax rate, it can make sense to convert your traditional IRA to a Roth IRA; and it can also give you more flexibility when managing RMDs down the road. If you are in a position where you think you’re in the highest tax bracket of your life, then that might not be the right time to consider doing a Roth conversion.
Akweli Parker: All right, thanks for that answer; and thank you, Harvey, for sending in that question.
We have a question from Rich in Naples, Florida, and I knew we were going to get to this at some point. Rich asks about the 4% rule, I guess. His question is, “Is 4% still the spending number in retirement?” So, Colleen, I know that you’ve written extensively on that, so maybe you can tell us. Start off by talking about what is the 4% rule and if it still has applicability today.
Colleen Jaconetti: Right, yes, so the 4% rule states that an investor who has a balanced portfolio—so balanced between stocks and bonds—with a 30-year time horizon, can take 4% of their portfolio out upon retirement. So just for round numbers, we’ll say a million dollars, they would take out $40,000 at retirement and inflate that number each year by inflation and that this would have a high probability of lasting for 30 years.
So the 4% is actually a very good rule of thumb. Right, it’s still applicable for people who meet those specific criteria. So if you’re just starting out, you have a balanced portfolio, a 30-year time horizon, it’s still applicable.
The biggest drawback to the 4% rule is really that it’s indifferent to the performance of the markets. So every year you’re going to take that $40,000 and grow it for inflation, whether the market goes up or down. And what could end up happening is if you have a period of poorly performing years early in retirement, you could be spending a larger proportion of your portfolio. You could possibly run out of money prematurely before the time horizon.
In addition, on the upside, if you had a lot of positive performance in the beginning years of retirement, you may actually be able to spend a little bit more and you could end up having a large surplus at the end of your life and maybe have forgone some things that you wanted to do in retirement. So the real drawback is just it doesn’t take market performance into account.
Akweli Parker: Okay, and I think we’re going to talk a little bit later on about some alternatives to that rule. Okay, so we’ll wait till we get to that.
We do have another live question, so thank you again, actually, a few live questions. Let’s see, so the question is, it comes from Gerald, and Gerald asks, “I always hear about reinvesting dividends. I never hear about a strategy on using them as a source of income. It almost seems taboo to actually take them when they pay out. I’d like to use my dividends as a source of bridge income before I take Social Security.” So Gerald really wants to know, “Is that not a wise decision?”
So, Kevin, I’m going to pass that one to you. He’s really wondering about using these dividends as a source of income. What are your thoughts on that?
Kevin Miller: Sure, yes, if it’s in a taxable account, you could certainly take them as a stream of income because, as Colleen had mentioned before, you’re taxed on those regardless. So some people would use that as a source of income first. Another school of thought is if, let’s say they’re coming from a stock investment, maybe if you’re reinvesting hoping that you’re going to get growth on those dividends and they compound over time, maybe that’s preferential. But there’s certainly nothing wrong with taking the dividends if they’re going to meet your particular spending need, which is sometimes based on what it is that people need to spend. The dividends may not be, in and of themselves, enough to meet that goal, so they have to supplement it somewhere else. But they could certainly take them.
Akweli Parker: Got it. Thank you, Gerald, for sending in that question.
All right, let’s take another live question. This one comes from Douglas who asks, “Can I contribute to my Roth while unemployed?” And in parentheses it says “retired.” Is that something that someone can do? Is it allowed to contribute to your Roth while unemployed?
Kevin Miller: So, the key for making any type of IRA contribution is you need to have earned income, and so typically that would be W2-type income. So things like Social Security, pensions don’t necessarily qualify. And I always tell clients, if you’re unsure about it, it’s always good to check with your qualified tax advisor to make sure that in your situation any income that you do have would qualify.
The other one would be too, if you’re not working but you have a spouse that’s working, you can also do what’s known as a spousal contribution where if you don’t have it but they’re working, they have the earned income, you can make the contribution.
Akweli Parker: Really helpful response. Thanks, thanks.
Okay, we’ve got another live question. This one is from Shirley, and Shirley asks us, “What is the best way to develop a spending strategy in retirement?” And just as a parenthetical, she adds that, “We’re about ten years out.” So she’s ten years away from retirement. Colleen, you want to take that one?
Colleen Jaconetti: So I guess there’s different components to a spending strategy, so it’s really how much to spend, and it’s also which account to spend from. And it’s also how to allocate your portfolio.
So the how much to spend, generally speaking, we would say spend about 3½% to 5½% of your portfolio balance upon retirement would be a prudent initial withdrawal rate. How to allocate your portfolio, obviously, you need to select an asset allocation that you’re comfortable with, really, what we try to tell people is to pick what you can stick with in the best and worst of markets, right? So don’t be so aggressive that if something happens in the market you’re bailing out and that could actually really hurt your plan because maybe you wouldn’t be able to recover from doing something like that.
But, obviously, you need to take some equity exposure because you could be living in retirement for 30 or more years. And then figuring out which assets you’re going to spend from. Right, so kind of looking through your portfolio, do you have RMDs or not, do you have taxable cash flows or not, and then just planning out in a way that minimizes taxes, which accounts to spend from.
Akweli Parker: Excellent, excellent. And you mentioned asset allocation. I know that we’ve got some questions on that coming up, so hold that thought.
Let’s take another live question, and this one comes to us from Steve. And Steve asks, “What do you think of the three-bucket approach to spending during retirement?” First bucket is in short-term cash for about three years. The second is about seven years’ horizon; and the third bucket is for longer-term, more aggressive investments. So that’s one bucket approach. Colleen, I know that you’ve spoken about this a bit. You want to take that one as well?
Colleen Jaconetti: Sure. When it comes to the bucket approach, really the difference there is sometimes you might be overweighting income. So certainly having a short-term reserve bucket for near-term needs, one to three years, makes perfect sense. And then it’s really kind of how you want to allocate the middle bucket and the final bucket is based on what shelf space do you have. So, really, for us it goes to are you giving up returns based on asset location? So if you have say, bonds in that middle bucket—which may be a more conservative approach which you’re trying to spend on that next seven years—that might not be the most tax-efficient place to hold your bonds. So, generally, we would say in your taxable account, hold tax-efficient equities so each year you would not be generating a lot of taxes. We would want to actually shelter the bond income, so we would say bonds should go in tax-advantaged accounts.
So when you follow the bucket approach, it’s certainly very prudent and lines up with people as far as like meeting their goals. And the only thing you just need to be aware of, if that is helpful for people, is that there could be an asset location give-up, meaning you could pay additional taxes on those monies if you’re not holding them in the most tax-appropriate way.
Akweli Parker: Excellent, excellent.
So we have another live question, and I think this one might be for you, Kevin. It comes to us from Richard, and he asks, “If you have an excellent defined pension, should you delay taking Social Security or take it at 62?” So defined benefit pensions, it’s something that we’re seeing less and less of. But if you can get it, it’s good to have, right? So what do you say to Richard’s question? Should you delay taking Social Security?
Kevin Miller: Yes, I mean it really depends. In a lot of cases, when you look at the analysis, clients are better off when they delay it because the more you delay it, the more it’s going to increase your benefit not only now but then any cost of living adjustments that you get later on are based off that higher number to begin with.
A lot of times when I talk to clients, they can look at the numbers and say, “Okay, what I end up more with, if I have sort of an average or a longer life expectancy,” but sometimes they just have more of an emotional connection to it where they figure, “I paid into Social Security for 40 years, and I have a preference to spend the government’s money before I spend my own.” So even though the numbers may not work out in that way, they choose to take it early because they want to keep their investments growing for them, and so they do that versus waiting it out and supplementing any pension that they may have from their investments.
Akweli Parker: So let me ask you, Kevin, what are some practical reasons why someone might actually want to take Social Security early?
Kevin Miller: Probably the biggest one would be just based on you as an individual, like if you have let’s say a health issue or not a history of longevity in your family where you don’t expect to collect Social Security for 30 years, you may say, “I want to start taking it now,” so I’d try to maximize the benefit.
The other one would just be the need aspect for someone that maybe doesn’t have a lot of retirement savings or doesn’t have a pension and they need that source of income, they may choose to take Social Security because they may not have a lot of other good options.
Akweli Parker: Excellent, thank you. Let’s go to some of our presubmitted questions once again, and this one comes from David in Culver City, CA, and asks, “How does one calculate how much they will need to save before retiring?” So pretty foundational question, right, Kevin? I’m sure you get this one all the time. What’s your response to that?
Kevin Miller: Yes, the way that we look at it is sort of in two components. So one is knowing what do you think retirement looks like for you because that’ll play a huge role in it. So for someone that wants to retire and maybe stay local, retire and volunteer in their community, maybe that doesn’t cost very much versus someone that wants to travel the world, and that’s pretty expensive, that level of spending will dictate a lot. And then also on top of that, how much will they have in guaranteed income sources, so do they have a pension, do they have Social Security? How much of their annual spending need will come from sources other than their retirement savings? So if you’re someone that’s not spending a lot and you have a pension, you could get away with not having a whole lot in savings and still be fine for the long term versus someone that wants to spend a lot and you don’t have a pension or maybe not expecting to get a lot in Social Security, then you’ll probably need a much more substantial nest egg when it comes to retirement.
Akweli Parker: Yes, so as with a lot of things we’ve been talking about, it really depends on your individual circumstances, right?
Kevin Miller: It does.
Akweli Parker: Okay, let’s take another live question; and thank you, once again, for sending those in. This one comes from Louis, and Louis asks, “What is a tax-advantage account?” So, Colleen, we’ve been talking about that all night, but maybe we should just go back a few steps and explain what that is.
Colleen Jaconetti: Sure. It’s like an account that actually gets a preferential treatment from taxes in one way or another. So there’s really two types. A tax-deferred account is when you do not pay taxes up front, so you actually, so if you contribute to a 401(k), you actually get a reduced income right now so you do not pay taxes up-front. And then later when you take the monies out, all taxes and income will be taxed at your ordinary income tax rate.
The other type is a tax-free account, a Roth account, and what happens is you’re taxed up-front. So before the money gets contributed to that type of account, you pay income tax on it; then all the contributions and growth on that account would generally be tax free.
Akweli Parker: So it’s something that people definitely want to be mindful of, which type of account they’re contributing to, depending on the needs.
Colleen Jaconetti: Absolutely.
Akweli Parker: Okay, great. We continue to get more live questions, so thank you for continuing to send those in. Our next one comes from Lee, and Lee writes, “The conventional wisdom is to split your portfolio with the stock percentage being equal to your age. But if you have sizeable fixed income, for instance, a pension, does it make sense to keep a larger stock position as a hedge against inflation?” So, Kevin, what do you make of that?
Kevin Miller: Yes, I mean we definitely recommend stocks as a way to get growth in excess of inflation. I don’t know as much about doing that as an offset if you have a pension. You would typically, when we construct a portfolio, we want to try to match it to the goals that you have as an investor, your time horizon, and then your risk tolerance because, ultimately, you want something that you’re going to be able to stick with long term. So, you know, if you have say too much of a stock allocation, if you consider a pension more of a fixed income-type component, and the market drops significantly and you’re not able to stick to that, it’s probably not the best thing for you long term.
Colleen Jaconetti: Right, and I find sometimes that people don’t necessarily always think of their pension or Social Security as a bond. If you actually have pension and Social Security covering your basic living expenses, you might actually decide to become more conservative. Right, you may say, “I don’t need to take risk in this portfolio,” so I think a lot of times people do ask that question of is my Social Security or pension considered part of my bond allocation? And I really would say, it totally depends, as Kevin said, on someone’s circumstances. Someone could easily say, “I want this for other goals down the road. I want this for heirs or legacy purposes, so I’m going to be more aggressive.” Or some people might say, “I might need this for healthcare reasons down the road, and I don’t want to take any risk with it.” So I don’t think for every situation that it goes in the same direction.
Akweli Parker: So now that we’re talking about allocation and risk management, I want to go to this question from Holly in Saratoga Springs, New York. And she asks, “Should I change my asset allocation at retirement?” So, Kevin, I’m sure this is one you get pretty often as well. What is your advice to people?
Kevin Miller: Absolutely. So when we manage assets for clients—the sort of fancy investment term is called the glide path—which is just a systematic reduction in the amount of stock exposure that you have as you get closer and closer to retirement. Usually for us we do it every few years, and so it’s not, sometimes people use more of, I would call it, a cliff approach where you’re a lot riskier; and then when you maybe get to retirement, you see a dramatic reduction. Typically what we’ll do is it’s more gradual over time because what you want to try to do is, let’s say there’s a big market downturn right before you get to retirement and now maybe that impacts whether or not you’re able to retire, so we think you should be in sort of your longer-term asset allocation a few years before you actually get to retirement.
Akweli Parker: So, in other words, not an abrupt change in allocation but more gradual.
Kevin Miller: Exactly.
Akweli Parker: All right, fantastic. Thank you.
Our next question was submitted in advance from Brian in Naperville, Illinois, and Brian asks, “Do you have any advice on how to determine the proper proportion of assets invested in traditional IRAs versus Roth IRAs?” So, Colleen, you explained the difference for us earlier. Now how do you divide your assets between the two?
Colleen Jaconetti: So it really comes down to what are you eligible to contribute to. So, and a lot of times when people are working, they actually contribute to a 401(k) instead of a traditional IRA. And it really comes down to when you think your tax rate will be the lowest. So it is really an individual decision of if you think your tax rate is lower now, then you might want to consider investing in a Roth IRA. So maybe younger investors who are thinking of their wage earnings will go up throughout their lifetime, they may want to invest in a Roth today. Some people who are maybe closer to retirement, may be at the highest tax rate of their lifetime, so they may not want to currently be contributing to a Roth. They may consider contributing to a traditional IRA so that in the future when their tax rate is lower, then they could actually be taking those monies out at a lower tax rate.
Kevin Miller: And I would say too that when we were talking before about it, it doesn’t always have to be the same thing year after year. You could have a situation where maybe you’re someone that’s done a Roth IRA historically, and this year something happens in your tax situation and maybe you would benefit from making the traditional IRA contribution because it helps you on your taxes; and then in subsequent years you go back to doing a Roth IRA contribution, assuming that you’re eligible for both. So it doesn’t always have to be like once you start with one that you have to continue it forever.
Akweli Parker: All right, excellent.
I want to go to this live question from Linda, and it’s a really good one. We know that people are living longer, life expectancies keep growing and growing, Linda asks, “What percentage of your portfolio should be held in reserve for potential long-term care costs?” And that’s something that people really need to think about, right? Who wants to take that one?
Colleen Jaconetti: Yes, again, this is a highly individualized question, only because it really depends on what your health is now, what your family health history is, how long you anticipate you’re going to live. Right, so some people could end up possibly being in a long-term care facility for one to three years, whereas other people may never be there. So, on average, I think you kind of have to take inventory of your own health situation combined with family factors that go into it to kind of figure out are you likely to be one of the people who may end up in one of those facilities. And if you are, obviously, in your state, look up how much does it traditionally cost and try to put monies away towards that or even look into buying long-term care insurance.
Akweli Parker: Thanks for that and thank you, Linda, for asking that question.
Let’s take another live question from Phillippe who asks, “Do mutual funds have an advantage over individual stocks?” Age old question, thoughts?
Kevin Miller: Yes, typically what we would recommend for clients are mutual funds because of the broad diversification. You’re getting the management—either if it’s in an index fund where you’re capturing broad parts of the market or in an actively managed where you’re paying a professional fund manager for the ongoing management of those securities. And doing it in a way, that for the average person, how many individual stocks that they could buy? First, you would typically need a pretty large asset base in order to go out and acquire a significant number of stocks to get diversification. And even with that, it doesn’t come anywhere close to probably what you would end up with by holding a mutual fund. So sometimes in clients that we’ll manage portfolios, they’ll dabble in a few stocks here or there; but the core of the portfolio’s held in mutual funds.
Akweli Parker: Just as a reminder, why is that broad diversification important?
Kevin Miller: Sure. So you don’t want to be too concentrated in any one area. You have the stock that, you know, we can think of some examples from the dot-com bubble and some other ones where people thought that they could only go up; and it turned out not to be that way.
Akweli Parker: But that wasn’t the case, was it?
Kevin Miller: That’s right. And so you want to spread out risk, not only across companies but also across sectors. So sometimes people will hold a number of different stocks, but maybe they’re in all tech companies or all in financials; and they may not move in lockstep with the broader market.
Akweli Parker: All right, well thanks for that.
We have another live question, and let’s take this one from John. He asks, “Is there any good reason to delay receiving Social Security benefits beyond age 62?”
Colleen Jaconetti: I guess we’ll start with this going over what the claiming strategies are available to people. So anyone from the age of 62 to 70 is eligible to claim their Social Security benefits, and you can get 100% of your benefit at your full retirement age. So, currently, that’s either 66 or 67, depending on the year you were born.
So, obviously, if you take your Social Security, you claim your Social Security benefits closer to 62, for every month you claim early, you get a reduction in benefits. So if you take it at 62, you would only get 75% of your full retirement age benefit. If you actually delay and claim it closer to 70, every month you delay past your full retirement age, you actually get an 8% inflation-adjusted increase in your benefit amount. So there’s definitely benefits to at least trying to get to your full retirement age so you get your full benefit and even going beyond to 70 as Kevin had mentioned before.
Akweli Parker: Excellent. One more live question. This one comes from Richard, and he asks, “In a time like now where interest rates are expected to rise, and if you need to rebalance from equity investment increases in recent years, what is the best way to invest in bonds while protecting yourself from rising interest rates?” So there’s a bunch of questions packed in there, but I guess the main thing is we’ve seen the Fed has shown interest in raising rates over the next year, so how does that affect your bond investment strategy?
Kevin Miller: Sure, so I would say from what we do on a daily basis, it hasn’t changed the role that we think bonds play in the portfolio by providing diversification, helping people weather those ups and downs in the marketplace. For someone that was really concerned about a rising interest rate environment, you can skew potentially more towards short- and intermediate-term bonds versus long-term where maybe you’d see a little less in terms of a pullback in bond pricing when bonds go up in the future.
I would also say though that if someone’s invested in bonds for the long term, which we think they should be, rising interest rates are actually good. You may see a pullback in pricing initially, but over time they would make it up through increased yields because as the bonds turn over, they’re going to get replaced by bonds that are now yielding a little bit more. And historically most of the return that you get in a bond fund comes from the income that gets produced; and so for someone that’s maybe more income-focused, rising interest rates would be a welcome thing. So it’s not always bad when we see rates going up.
Akweli Parker: A really great point.
Okay, so let’s go back to our presubmitted questions, and this one comes from Dorothy in Champaign, Illinois, and this is a really good one. Dorothy asks, “What are your thoughts on managing my retirement portfolio in a low-return environment?” So Vanguard’s own economic outlook, we talk about how not to get excited about equities performing as well as they have in recent years, right? So, Colleen, what are your thoughts on that?
Colleen Jaconetti: So, yes, we actually get this question a lot now because of the reasons you mentioned. So, I guess, the first important thing to do is try to minimize costs and taxes. Right, going forward, every dollar you pay and any costs or taxes is a dollar less you have to spend. And if returns are lower, that actually becomes a larger portion of your returns.
The second thing to do is really build flexibility into your spending plan. So to help you with this, we actually developed what we call a dynamic spending strategy; and this helps people to weather the ups and downs in the market by altering their spending accordingly.
So what we would say to people is, the dynamic spending strategy is a hybrid strategy between the dollar plus inflation strategy (which is really the 4% rule) and the percent of portfolio strategy, two pretty common strategies that retirees use. And as we mentioned with the 4% rule, the dollar plus inflation strategy does provide stable inflation-adjusted spending from year to year which many retirees like. But given the fact that it ignores market performance, but you could end up with large surpluses or shortfalls that really are not what people would prefer.
On the other spectrum, then people could say, “Well, I’ll spend a percent of the portfolio every year.” And the biggest issue is this does provide people with fluctuations in spending with the market. So it’s highly sensitive to market performance. So while you can’t run out of money technically, because we’ve been a percent of a dollar, it is something to spend, your spending amount can vary greatly from year to year. So many retirees maybe can’t handle a 10%, 15% adjustment in their spending downwards.
So what we developed was this hybrid strategy called dynamic spending, so you do spend a percent of the portfolio each year; but what happens is we actually put a ceiling and a floor around that amount to try to keep the amount of spending stable from year to year.
Akweli Parker: All right, excellent answer. I just want to point out to our viewers that you can do a much deeper dive into that topic if you just click on the green Resource List widget. There’s a research paper called, Retirement Income in the Lower Return World. So go ahead and check that out, and there are lots of other goodies in there too.
So we’re getting a lot of questions. Colleen, I’m hearing about tax-efficient withdrawals. So you talked about that earlier. Could you maybe dive a little bit deeper on some of the methodology behind that?
Colleen Jaconetti: Sure. So I guess the reasoning why we do the RMDs first and then the taxable cash flows and things like that, kind of run through it again?
Akweli Parker: Yes, sure.
Colleen Jaconetti: Okay, sure. So, obviously, we say spend from required minimum distributions first. They’re required by law as Kevin went through for anyone over 70½. So, obviously, you’re being taxed on them. Definitely spend them first.
Akweli Parker: Right.
Colleen Jaconetti: All right, and then we would say interest, dividends, and capital gains distribution on assets held in taxable accounts. So those monies are taxed to you, whether you spend them or reinvest them. So you already had to pay tax on this year, so you might as well spend those. If you reinvest them and sell them six months or a year from now, you might incur short- or long-term capital gains taxes to spend those monies. And then the next thing I would say is if you have taxable assets, try to spend from them in the most tax-efficient way. So spend assets that are a loss, then assets that no gain or loss, then assets at a gain, until your taxable portfolio has been depleted. We say spend from taxable prior to tax-advantaged because as the name suggests, there is an advantage to not spending from your tax-advantaged accounts first.
And I should go back and, I guess, qualify this. This is for people who want to maximize spending during their lifetime. We went through that. This is definitely not appropriate for everybody. This is for people who are looking to maximize their spending.
Then when we get into, okay, your taxable account is depleted, you can choose from—in your tax-advantaged accounts—you have tax-deferred or tax-free. So the goal is to spend from your tax-deferred account, which is traditional IRA, 401(k), things like that when your tax rate will be the lowest. Right, so those monies will be taxed at ordinary income tax rates, whereas your tax-free assets, your Roth assets, will not be taxed if you meet eligibility requirements, will not be taxed on the way out. So, really, what you’re trying to do is manage that tax bill by spending from your tax-deferred accounts when you think your tax rate will be the lowest.
Akweli Parker: Excellent. Thanks for reviewing that, and to our viewers, if you still have questions about that, once again, I remind you to check out the Resource List widget. There are several research papers that talk about tax-efficient withdrawal strategies.
So let’s go back to our live questions, and I want to take this question from Joe who asks, “How do target-date funds work?” Kevin, I’m going to pass this one to you because I’m sure you hear a little bit about this yourself in your clients.
Kevin Miller: Absolutely. Target-date funds, when we were talking before about the glide path, they were really designed around that concept. So what a target-date fund is, it was really designed to be a portfolio unto itself. The ones at Vanguard bundle a few Vanguard funds together, typically broad market index funds, so you’re getting exposure to not only stocks, U.S. and international, but also U.S. and international bonds. And then based on the target year, the further away someone is from retirement, the more aggressive the fund would be, the closer the more conservative.
And what happens is it’s really designed to do all the heavy lifting for you, so you could theoretically invest in the fund when you begin working and then gradually over time the fund does all the work of becoming more conservative, so it changes as you get closer and closer to retirement. So they can be a great option for someone that’s investing, let’s say, have a large IRA that they’re trying to, or even someone that’s starting out and doesn’t really know about portfolio construction, just wants something that’s well-diversified.
Akweli Parker: I’m going to keep you on the hook here for a little bit, Kevin. We actually are getting several questions about the group that you work for, Personal Advisor Services®. So could you please just explain how Vanguard PAS works?
Kevin Miller: Yes, absolutely. So I have a group of about 200 clients that I work with on an ongoing basis. So typically what the process would look like is we’ll talk to them about their needs. What is it that they’re trying to accomplish with their money? Obviously for a lot of investors, it’s around retirement; but it could also be, in addition to retirement, it could be college planning. It could be “I want to purchase a house. I’ve a wedding to plan for,” and figuring out exactly what it is that they want to accomplish and then building a plan around that to help them meet that particular goal. And then once it’s set up, helping them along the way. So for someone that’s maybe ten years from retirement, we were talking before about gradually getting more conservative. So making sure that we’re taking care of that for them, and we basically would take on the management of the assets and making sure that they’re doing things like rebalancing and things like that, making sure that they’re properly diversified.
And the biggest value that we think is in this service long term, is providing someone as sort of a circuit breaker or the emotional coaching aspect of it in times which we saw recently with a lot of volatility in the market, getting calls from clients, and some of the clients that I’ve worked with from a while ago would call up and say, “I know what you’re going to tell me, that we just need to stay the course, but I need to hear you say it.”
Akweli Parker: Yes, sometimes if you’re actively watching that portfolio and you see those numbers slide, it’s hard to resist pressing that “Sell” button, right? But you guys are there to help people avoid that.
Kevin Miller: Yes.
Akweli Parker: Fantastic. I just want to remind viewers that if you’re interested, there is a link to Vanguard’s Personal Advisor Services® in your Resource List widget, so please do avail yourself of that.
So let’s take another live question and, Colleen, I’m going to pitch this one to you; and it comes from David who asks, “You’ve spent your entire life working and saving for retirement. Now that you’re retired, there’s some anxiety over switching from being a saver to a spender. So how does one cope with that?” And, Colleen, I know that you’ve written about that, just that emotional thing that you have to overcome of spending this money down.
Colleen Jaconetti: Right. A lot of people actually get very concerned about spending on their principal, right, so that seems to be the big thing. And I think what people need to realize is if you set up a prudent spending plan with a proper asset allocation—you can actually feel comfortable working with an advisor or something like that—you can feel comfortable spending from your portfolio each year; and it’s something that you should be revisiting each year. So if you start out with 3½% to 5-½% spending, which is certainly a prudent initial withdrawal rate, then you can work with someone each year if you’re very concerned about it to run the possibility of scenarios that could happen.
So I think being knowledgeable and educated and even maybe consulting with an advisor to help you realize that what are the implications of spending the money? What are the implications? They actually run through many scenarios—what if you did have poor returns in the first 10 years of retirement? The first 15 years of retirement? What does that look like to your daily spending? It can help you realize can I afford to take a vacation or not afford to take a vacation? Should I really not enjoy the beginning of retirement and be worrying about later or can they help me put a plan together where I can enjoy retirement and still make sure I have enough reserves for later.
So, I think a lot of times it’s just really either consulting an advisor or using some online tools—I know we have online tools as well—to help you realize what the implications are of different spending rates from the portfolio.
Akweli Parker: Excellent, excellent.
So let’s take another presubmitted question, and this one comes from Steve in Maple Falls, Washington. And he asks, “Are annuities a good idea for retirement investments?”
So, Kevin, I’m going to pass this one on to you, and maybe if you could just start off by explaining to us briefly what annuities are and where they fit in the whole retirement spending picture.
Kevin Miller: Sure, absolutely. So at their very simplest, an annuity is a type of insurance contract that you would have. There’s different types of annuities that you can get. The ones that we hear about as they relate to retirement and retirement spending would be ones where you basically turn over a lump sum of cash, and they agree to pay you a certain amount of income per month for the rest of your life.
And the answer, like a lot of things we talked about, is really, “It depends.” So it depends on how much are you going to receive and if you feel like you’re being compensated for the amount of the lump sum that you’re giving up, as well as looking at the long-term goals that you have for that money. So, especially for someone that is maybe looking to do some legacy planning, so passing money along to children or grandchildren, are they philanthropic-intent, when you give up that lump sum, it’s irreversible at that point, and there won’t be anything left over for that money that you would then pass on to someone else. So you would need to weigh the benefit of having that guaranteed income versus giving up that lump sum of cash.
And then, obviously, you’d want to make sure that you always had some other money available for bigger purchases as well. You wouldn’t want to, even for someone that does end up purchasing an annuity, making sure that you have cash available if you need to replace the roof or buy a car, things like that.
Akweli Parker: So there’s definitely a tradeoff, but it’s guaranteed in a sense, right?
Kevin Miller: Yes.
Akweli Parker: You were about to add something to the comment?
Colleen Jaconetti: Well, sometimes we talk to people about maybe just trying to buy annuity to purchase basic living expenses. So, already, most people probably have a guaranteed income stream from Social Security, right? So to the extent that there’s a gap between the Social Security payments and what you need to spend, some people might say, “I would like to purchase an annuity to fill that gap.” So that would mean, obviously, if they had a savings goal in mind for retirement, they wouldn’t have to turn all of that money over to the insurance company. Right, so they could have a smaller amount, and that way they feel comfortable with that for the remainder of their life. Between Social Security and that annuity, they would be covered. And then all the extra money that they have, actually, sometimes we refer to as having freedom to spend. So then you could actually spend and enjoy the other money in the portfolio.
But the one caution is, I guess two cautions, I would liken annuities to insurance in that you buy it in case something happens, right? So you buy it in case you live longer than you planned for. So no different than homeowners insurance. If your roof falls of or blows off in a storm, you want to have homeowners insurance to pay for it. Right, insurance costs money. So if you want to have insurance against the fact that you may live longer than you plan for, be prepared that there is a cost to it. But for some people, that cost could be worth it for peace of mind.
Akweli Parker: Excellent. Thank you both for that.
Okay, so we do have some remaining live questions. Oh, I do want to take this one. It comes to us from Eiko who asks, “What do you think of HSAs as a retirement tool?” Now we’ve seen, HSAs have been in the news a lot. It’s this fantastic, not new thing, but people seem to be discovering their benefits. What are your thoughts on those healthcare spending accounts?
Kevin Miller: Yes, they can be in terms of, for someone that’s able to save in the account, get the growth, I would always caution some accounts here. They give you the ability to invest in things other than just a money market position. So you’d want to be careful if you think you’re going to need that money for expenses, not putting it in something that’s too risky. But, you know, the benefits of then using that money for healthcare costs in the future, yes, there can be some significant benefits there.
Akweli Parker: All right, let’s take one of our presubmitted questions, and this one is from Jeff in Eugene, Oregon. And Jeff asks, “Before retirement, I rebalanced my portfolio, primarily using additions to my investments. How should I rebalance in retirement trying to minimize taxes?” So another tax question.
Colleen Jaconetti: All right, so I guess really the place to start is try to rebalance in tax-advantaged accounts. So if you can rebalance in your tax-deferred or tax-free accounts, that would be ideal. Another way to think about rebalancing retirement is if you don’t need your required minimum distributions, so as we talked about before, we said reinvest them in a taxable account; and you could use those monies actually similar to how you did when you were in the accumulation phase of putting them to the most underweight asset class, right, so you can rebalance your portfolio with RMDs if you don’t need to spend them.
Kevin Miller: And I’d also add, given how much the market has moved, rebalancing is something that comes up with a lot of our clients. Not necessarily letting the tax impact impact what you’re doing from an allocation standpoint because even if you rebalance and you do end up paying some taxes, if you’re able to reduce the amount of risk that you’re taking on in the portfolio, you could end up costing yourself less if the market were to have a downturn then what it is that you would have paid out of pocket in tax costs. So that’s, just by paying taxes, it’s not necessarily a bad thing if your portfolio is properly allocated.
Akweli Parker: Excellent. So we’ve talked a lot about allocations between equities and fixed income, but our next live question asks about allocation to cash. This question from Michael. He asks, “When in retirement, how much cash should I keep in a bank savings account?” So that’s not money that’s achieving these great returns, but it’s sitting there in cash. What’s a prudent amount?
Colleen Jaconetti: Yes, I guess I would say for people, this, again, is an individualized situation; and it really depends on how comfortable are you. So normally we would say maybe 6 to 12 months of expenses. But if you are very much more concerned that the market could go down in the next few years, you could easily bump that up to two or three years if you felt comfortable knowing that, yes, you’re not earning returns on that. So there is a return giving up to do that. However, the peace of mind that some people may have given the outlook for lower returns going forward, that might be helpful.
Kevin Miller: And I would add too if you had anything in the short run—one-time expense wise—if you’re going to purchase a car or going to do renovations at home, those are instances where you could hold additional cash above and beyond your normal say 6 to 12 months in expenses.
Akweli Parker: Right, let’s take another live question; and this one is from William, and William writes, “I hear a commercial that says ‘Without the right plan that the IRS could be the greatest benefactor of your retirement savings.’” Comments?
Colleen Jaconetti: Yes, I mean I guess it kind of goes back to like our maximizing lifetime spending and order of withdrawals conversation. If you are not prudent about how you are withdrawing from your accounts, say you’re selling from your taxable accounts starting with things that have gains or you’re spending from your tax-deferred account prior to your taxable account, there are ways that you would accelerate payment of income taxes. So I think what that is trying to get at is the fact that if you don’t plan for taxes carefully, you can, obviously, be paying more to the government than you would want to.
Kevin Miller: Yes, and it can even come down to something as simple as if you have multiple account types. We talked a little bit about asset location before which is when you have different account types, certain types of funds or certain types of investments are better suited for different types of accounts. And it could be what seems like an arbitrary decision around, “I want to buy this fund and I can put it in my IRA or my taxable account,” and maybe the fund is really tax-inefficient so it historically has paid out a lot of what I would call involuntary capital gains that you don’t have any control over as the investor and maybe you elect to put that into your taxable account. Now every year as it pays out a distribution, you’re going to pay additional tax; whereas if you would have put it in your IRA, it can pay out distributions as much as it likes, and you won’t pay the tax on it until you actually take a distribution at some point in the future. So even something like that can really be important.
Akweli Parker: Excellent. Well, it seems like we have time for one more question, so let’s take a live one. How about we take this question from Brian who asks, “If you have moved out of equities into cash, what strategy would you recommend to get back into a fund, like a target-date fund?” So he wants to move that cash into something that’s going to earn a bit of a return. Talk to him how to do it.
Colleen Jaconetti: Yes, I mean there’s, obviously, multiple ways to do it. The lump sum means that you will start earning money right away in the market. And putting it in something like a target-date fund, which is broadly diversified globally with stocks and bonds could make perfect sense.
Some people might get a little worried that could the market go down, so they don’t want to buy it and then regret that the market went down a few weeks later. So certainly some people would advocate that they could do something like dollar-cost averaging, which is putting a set amount every month or every quarter. And really that just comes down to personal preference and comfort. If you put it in and the market went up, then you may have lost money. If you put it in and the market went down, you may be better off by having done dollar-cost averaging.
So it’s really kind of a personal tradeoff between how comfortable you are going all in in the market; and when you do so, doing it in such a broadly diversified fund as a target-date fund where you do have the global diversification, the split between stocks and bonds could be a good way to do it.
Kevin Miller: And I would also just quickly add in for someone that’s in cash, having an endpoint in mind, how long are you willing to go and let the money sit in cash waiting for the market to go down. So we’ve had a long string of positive market returns, and I talk to clients still on a daily basis that have been in cash for a long period of time waiting for the market to go down and they have and they’ve missed all those returns. So thinking about, okay, if the market hasn’t gone down by this point in the future, then that’s when I would start to invest. So that way, at least you have a plan for how you’re going to start to do this if, trying to benefit from a market decline doesn’t occur.
Akweli Parker: Excellent. Well I don’t know about you two, but I’ve been having a great time talking about spending in retirement. Unfortunately, we are out of time. But before we bid adieu to one another and to our viewers, what final takeaways do you have for the folks who are watching? Start with you, Colleen?
Colleen Jaconetti: Sure, thank you. I guess I would just say that you can meaningfully extend the life of your retirement savings if you develop a prudent spending strategy, invest wisely, and implement a tax-efficient withdrawal plan.
Akweli Parker: Okay.
Kevin Miller: And I would say having a plan and making sure that you’re on track for whatever goals you have can reduce a lot of anxiety and make sure you’re on the right track for investment success.
Akweli Parker: Excellent. I want to thank the both of you for your excellent insights, and I’d like to thank you, our viewers. We really appreciate you joining us and all of your fantastic questions.
Now if you’ve missed something or you wish that you could rewind to a specific section, don’t worry, we’ve got you covered, because in a few weeks we’re going to send you an email with the link to view highlights of today’s webcast, along with transcripts for your convenience.
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