Retirement Investments: Assessing Your Success

Planning for retirement is a multistep process that evolves over time. The fun part of retirement is what makes it important to pay attention to the serious and boring part: planning how you'll get there. The first step is to calculate the approximate amount you'll need each year. This is done by calculating your expenses and your expected income from other sources. The difference between these amounts is what you'll need to cover with your retirement savings.

The next step is to determine whether you can safely withdraw this amount. You'll want to make sure your savings can sustain your spending over the next few decades. This depends on your personal asset mix and time frame.

The third step is to decide which accounts to withdraw from first. By the time you retire, you'll likely have multiple accounts to withdraw from, along with sources of income like RMDs and fund distributions.

The fourth step is to understand your time horizon. The longer the time until retirement, the higher the level of risk that your portfolio can withstand. If you're young and have 30-plus years until retirement, you can have the majority of your assets in riskier investments, such as stocks.

The fifth step is to determine your retirement spending needs. Most people believe that after retirement, their annual spending will amount to only 70% to 80% of what they spent previously. However, this assumption is often proven unrealistic.

The sixth step is to calculate the after-tax rate of investment returns. The after-tax real rate of return must be calculated to assess the feasibility of the portfolio producing the needed income.

The seventh step is to assess your risk tolerance versus your investment goals. Proper portfolio allocation that balances the concerns of risk aversion and returns objectives is arguably the most important step in retirement planning.

Finally, stay on top of estate planning. Having a proper estate plan and life insurance coverage ensures that your assets are distributed according to your wishes and that your loved ones will not experience financial hardship following your death.

Understand your retirement account options

Understanding your retirement account options is a critical step in planning for retirement. There are several types of retirement accounts available, each with its own advantages and considerations. Here are the key options to consider:

Tax-Advantaged Accounts:

• 401(k) Plans: These are employer-sponsored defined-contribution plans where employees contribute a portion of their salary. They offer tax incentives, automatic savings, and sometimes matching contributions from the employer. The contribution limits for 2024 are $23,000, or $30,500 if you're 50 or older.
• Individual Retirement Accounts (IRAs): IRAs provide tax-deferred investing for retirement. Traditional IRAs may allow you to deduct contributions from your taxes, while Roth IRAs allow tax-free withdrawals in retirement. The contribution limits for 2024 are $7,000, or $8,000 if you're 50 or older.
• Roth 401(k)s and Roth IRAs: These are funded with after-tax dollars, meaning you can't deduct contributions. However, withdrawals in retirement are tax-free.

Taxable Accounts:

Most brokerage and bank accounts fall into this category. They are funded with after-tax dollars, and you pay taxes on any investment income or capital gains.

Defined-Benefit Plans:

Also known as pensions, these are funded by employers and guarantee a specific retirement benefit based on salary history and employment duration. However, they are becoming less common outside of the public sector.

Self-Employed or Small-Business Plans:

If you're self-employed or own a small business, you may consider options like SEP IRAs, SIMPLE IRAs, solo 401(k)s, or profit-sharing plans. These plans offer tax advantages and flexibility for the self-employed.

Annuities:

Annuities are insurance products that provide a steady income stream during retirement. They can be purchased from insurance companies and offer tax-deferred growth. However, it's important to consider the guarantees, liquidity, and potential penalties associated with annuities.

Diversified Bond Portfolios:

Bonds can be a source of fixed income in retirement. You can invest in various types of bonds, including U.S. Treasury securities, corporate debt securities, and government-offered bonds. Bond mutual funds offer a professionally managed and diversified approach.

Total Return Investment Approach:

This strategy involves investing in a diverse mix of stock and bond funds, adjusted for your risk tolerance. It focuses on generating interest, dividends, and capital gains over a longer period, aiming to meet or exceed your withdrawal rate.

Income-producing equities:

Some stocks pay dividends, providing a regular stream of income. While dividend-paying stocks may not offer the same exponential growth as other stocks, they can be a reliable source of income.

Remember, it's important to consider your financial goals, risk tolerance, and time horizon when evaluating these retirement account options. Consulting a financial professional can help you make informed decisions about which options are best suited to your needs.

Calculate your net worth

Net worth is a snapshot of your financial position at a given time. It is calculated by subtracting your liabilities from your assets.

Your assets are everything you own that has financial value. This includes the money in your bank accounts, investment accounts, and retirement plans; the value of your home and other real estate; the resale value of your car and valuable property like jewellery and furniture; and the market value of your small business.

Your liabilities are your outstanding debts. This includes credit card balances, mortgage, auto loans, student loans, and any other money you need to repay to others.

The formula for calculating net worth is:

Assets – Liabilities = Net Worth

For example, if you own a house with a market value of $200,000 and you have a mortgage of $150,000, you can add $50,000 to your net worth.

Net worth can be positive or negative. A positive net worth indicates that your assets exceed your liabilities, which is a sign of good financial health. A negative net worth indicates that your liabilities exceed your assets, which could be a cause for concern.

To improve your net worth, you can either reduce liabilities while keeping assets constant or increasing them, or increase assets while keeping liabilities constant or reducing them.

Net worth can be calculated for individuals, companies, sectors, and even countries. It is a useful metric to gauge the financial health of an entity and can be used to determine eligibility for certain investment strategies or financial products.

Decide which accounts to withdraw from first

When it comes to deciding which accounts to withdraw from first during retirement, a common strategy is to follow the order below:

• Taxable accounts: These include individual, joint, and revocable trust accounts, as well as checking and savings accounts, standard or joint brokerage accounts, and employer stock purchase plans. Withdrawing from these accounts first allows your tax-advantaged accounts more time to grow. Brokerage accounts are subject to taxes on dividends, interest, and capital gains, and they will not grow as quickly as tax-advantaged accounts.
• Tax-deferred accounts: This includes traditional IRAs, 401(k)s, 403(b)s, and similar accounts that allow pre-tax contributions. These accounts are tax-deferred, and you won't owe taxes until you make a withdrawal. However, once you reach a certain age (70 or older, depending on the account), you will be required to take Required Minimum Distributions (RMDs).
• Tax-free retirement accounts: Accounts like Roth IRAs and Roth 401(k)s are typically the last to be drawn from since they are funded with after-tax contributions and offer tax-free withdrawals. There are no RMDs for Roth IRA accounts, so you can let the money compound tax-free for as long as possible.

It's important to note that this is a general strategy and individual circumstances may vary. Consulting a financial advisor can help you devise a customized plan that takes into account your specific needs and goals during retirement.

Consider a total return approach

The total return approach is a strategy that can help you make the most of your retirement investments. It is a holistic way of managing your entire retirement portfolio. Instead of having different allocations for all your accounts, there is one main asset allocation that is implemented across all of your accounts.

The total return approach focuses on generating income through a wide range of sources to maximise return rates and preserve your principal. It is a strong method for measuring performance and is expressed as a percentage of the amount invested. It is calculated by factoring in both price appreciation and income generation over a set period, commonly one year.

The total return approach is ideal for those looking to maximise their long-term growth while also receiving a steady cash flow. It is particularly suitable for investors with a longer-term investment horizon. It is also a good strategy for retirees or anyone focused on regularly generating high income that can fund their living expenses.

The total return approach is more balanced than the yield approach, focusing on both asset growth and fixed-income investing. With the total return approach, you develop a diversified portfolio of growth and value stocks that you can draw down during retirement, while hedging your risk with "safer" fixed-income-generating assets that protect your principal.

The total return approach has several advantages over the yield approach. Firstly, your money continues to grow even in retirement, extending the life of your savings. Secondly, it gives you more control over taxation and risk. Thirdly, it allows for greater tax management by placing investments that produce more taxable income in taxable accounts, and investments that produce more capital gains in tax-deferred or tax-free accounts.

Assess your risk tolerance

When it comes to retirement investments, assessing your risk tolerance is crucial. Here are some detailed guidelines to help you evaluate your risk tolerance:

Understand the Concept of Risk Tolerance

Risk tolerance refers to an investor's ability to withstand potential losses in their investment portfolio. It is influenced by various factors, including age, financial circumstances, investment goals, and emotional comfort with risk. Those with a higher risk tolerance are generally willing to accept greater fluctuations in their portfolio value, expecting higher returns but also accepting the possibility of significant losses. On the other hand, those with a lower risk tolerance prefer more conservative investments, sacrificing potential gains for greater stability and peace of mind.

Evaluate Your Financial Circumstances

Your financial circumstances play a significant role in determining your risk tolerance. Consider your net worth, income, and savings rate. If you have a higher net worth, you may have more flexibility to take on riskier investments. Additionally, if your income is expected to grow considerably, you may be more comfortable with a higher-risk portfolio. However, if you anticipate more modest income growth, you might opt for a more conservative approach to ensure your financial stability.

Consider Your Investment Goals and Time Horizon

Your investment goals and time horizon until retirement will influence your risk tolerance. If you are planning to retire early, you may need to adopt a more conservative investment strategy to ensure your savings last throughout your retirement years. On the other hand, if you plan to work until a more traditional retirement age, you may have more time to recover from potential market downturns, allowing for a slightly higher-risk approach. Additionally, consider your desired lifestyle during retirement. If you wish to maintain a modest lifestyle with minimal expenses, you may be comfortable with a lower-risk strategy. However, if you aspire to a more luxurious retirement with extensive travel and higher costs, you might need to take on more risk to achieve those goals.

Assess Your Emotional Comfort with Risk

Different individuals have varying emotional responses to risk. Some people are comfortable with market volatility and the potential for significant gains or losses, while others prefer a more stable and predictable investment journey. It's essential to be honest with yourself about your emotional tolerance for risk. If the idea of seeing your portfolio value fluctuate significantly keeps you up at night, opting for a more conservative approach may be wise. However, if you are excited by the prospect of potentially higher returns and can handle the risk of losses, a higher-risk strategy might align better with your personality.

Seek Professional Advice

Assessing your risk tolerance can be complex, and it's easy to make emotional decisions that may not align with your long-term goals. Consider working with a financial advisor or planner who can provide objective guidance and help you understand your risk tolerance. They can assist in constructing a portfolio that aligns with your risk tolerance and investment objectives. Remember, risk tolerance is highly individualised, and there is no one-size-fits-all approach.

Frequently asked questions