Planning for retirement involves the accumulation of assets and then spending the savings. Creating a twofold approach to retirement savings can give you a more accurate assessment of how much you will need, along with a long-term plan to address both sides of the equation.

One of the major challenges with retirement planning is the high level of uncertainty. You do not know how long you will live, how many years you will have good health, or how investments will perform.

To address these uncertainties, you can choose different withdrawal strategies. You want to employ a method that will stretch investments to last your lifetime while leaving enough money for the rising cost of care. This back-end game plan can lead your front end saving strategies.

There are four primary approaches used to steer investment decisions in retirement. They include the probability, safety-first, bucket, or weighing utility approaches.

Probability Approach

The probability approach evaluates past market performance to estimate the probability of success with a given portfolio. You choose a range of investments based on your assets and spending needs in retirement, and a computer program will review market performance, analyzes scenarios for future markets, and calculate the probability of success. You can then adjust spending levels early in retirement to reduce the probability of running out of money.

The strategy is popular among investors because it mirrors many pre-retirement investment strategies. Its strength is it alleviates the worst possible scenario. Its weakness is that it does not compensate for the fluctuation of your financial needs.

Safety First

The safety-first strategy focuses on establishing a safety net for essential expenses and then rates other costs in retirement by ranked needs. For example, a contingency fund will have a higher priority than hobbies or travel. The most recent advocate of this method is Professor Zvi Bodie author of Worry-Free Investing and Risk Less and Prosper.

The first step is to prioritize retirement goals, with the highest value given to basic needs, and a lower value given to luxuries. Then match risk characteristics to existing assets and goals. For effective implementation, you must maintain consistent spending patterns and avoid splurging on luxuries in early retirement to ensure you have enough assets to pay expenses in later years.

In most cases, you would fund your essential costs through a guaranteed income strategy such as social security, pensions, or a fixed immediate annuity, that guarantees payments for life, regardless of how long you live. An annuity can also include income for a couple, to provide enough money for you and your spouse’s lifetime, adjusted for inflation.

After meeting basic needs, you invest enough money in conservative investments to cover unexpected expenses, and then other investments earmarked for pleasure or luxury items. The safety-first strategy will not maximize annual returns or beat an investment benchmark. Instead, you chose investments based on spending needs.

The strength of the safety-first income strategy is you are less likely to run out of money because you establish guaranteed income for essential spending in retirement. The drawback is that you need more cash than other strategies because it is the most conservative of the four approaches.

Bucket Approach

The bucket approach establishes categories or buckets for retirement spending based on time. Much like you create a budget using spending categories, you set up timeframes for retirement to determine how you will invest funds in each bucket.

Harold Evensky, the financial planner who pioneered the bucket approach, focused on the basic principle that near-term living expenses should remain in cash, even with minimal yields. You can then invest assets not needed for several years, in a variety of long-term holdings, increasing gains. The cash cushion will provide peace of mind, while long-term holdings provide ongoing growth and the ability to withstand market downturns, without needing to sell investments at a loss due to income needs.

The first bucket, for immediate use, focuses on the safety of principle, rather than account growth. In some cases, returns may not keep up with inflation. To determine the amount, you need in the first bucket, analyze annual spending patterns. Subtract ongoing payments from Social Security, a pension, or an annuity, to determine the amount of deposit in cash investments.

Investments for short-term needs might include a money market for one year’s worth of living expenses, and short-term bond funds or dividend paying stocks for the remaining one to four years’ worth of expenses. You may also choose to include an emergency fund to cover any unexpected costs.

As funds deplete in the first bucket, you adjust the balances from other buckets to replace the money. The number of buckets and their investment goals will differ from person-to-person.

Longer term investments will fill the last bucket, which can withstand more market volatility because you do not need the funds in the near term. Stocks will be a major part of the long-term investment strategy, which could increase profits in the long run.

As the years in retirement progress, you can adjust spending based on the level of risk in your portfolio.

The strength of the bucket approach is the ability to capture higher returns on a significant portion of your investment portfolio in retirement, reducing the chances of running out of money, even with limited assets. The weakness is that you could incur higher costs as you move investments between buckets.

Weighing Utility

The weighing utility approach introduces satisfaction to the retirement income equation. You determine tradeoffs by weighing the value or utility of certain expenses. For example, you might need to decide whether to work an additional three years to increase your level of happiness in retirement or reduce your living costs as you age.

To calculate withdrawals, you determine the amount you need and want and put a weight on each expense. Then prioritize based on the weights. The strategy can help prioritize spending for discretionary items while ensuring you have enough to cover higher medical bills required as you age.

The strength of the weighing utility is that it considers the quality of life. The downside is that it can be hard to qualify the value of happiness.

Having an income distribution strategy in place can help you calculate the amount of money you will need in retirement. How you anticipate on living out retirement and your comfort with risk in investments will determine the best strategy for you.

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