3 Retirement Distribution Pitfalls (and How to Work Around Them)

These mistakes trip up many retired investors, but you can avoid them with a bit of planning.

Christine Benz 29.11.2013
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Much of the financial media is concerned with making money in the market, and for good reason: Accumulation is a key facet of financial success.

However, you tend to see far less about portfolio drawdown, or decumulation--the logistics of managing a portfolio from which you're simultaneously extracting living expenses during retirement.

Managing a portfolio during the decumulation phase deserves more attention because it's also far more complicated than accumulating assets, in my view. Not only do you have to figure out whether you've saved enough to actually retire--which can be pretty nerve-wracking because you don't know how long you'll need your money to last--but you also have to figure out how to balance long-term growth with your near-term income needs.

One of the keys to successful decumulation, as is the case with many financial-planning tasks, is avoiding the big mistakes. Overspending and holding too aggressive a portfolio are two obvious retirement-portfolio flubs, but below is a short list of some additional, less obvious pitfalls as well as ways to avoid them.

Distribution Pitfall 1: Not allowing for some variability in your withdrawals, based on need.
Many retirees use the 4% rule, which holds that you withdraw a specific dollar amount in year 1 of retirement, then simply adjust that dollar amount upward each year to account for inflation. Even though the rule can provide a good starting point for retirement planning, it's unrealistic to expect that you'll stick with a fixed withdrawal amount every year. You may have years when you need to spend more, such as for a new car, new roof, child's wedding, or a special vacation, and years when you can get by with less.

Workaround: When sketching out your expected income needs during retirement, be sure to pad your anticipated expenses a bit to account for extras and unanticipated expenditures--don't just plan for bare-bones expenses such as food, shelter, and one new pair of shoes a year. Retirees have told me they've gone so far as to anticipate some of those lumpy expenses while they were in the retirement-planning stage--for example, they've forecast when they would need to replace cars, take big trips, and repair roofs, as well as how much those items would cost. Use those padded expenses when determining whether your withdrawal rate is sustainable.

Alternatively, you could simply manage your distributions with the expectations that they will in fact not be static from year to year--for example, paying for unanticipated expenses on an as-needed basis with the expectation that you'll have to tighten your belt in subsequent years.

Distribution Pitfall 2: Not adjusting distributions to account for market fluctuations.
So-called sequencing risk--the chance that you'll encounter a harsh bear market early in the life of your withdrawal program--can have a big effect on your portfolio's longevity. Taking fixed distributions from a shrinking pool means your plan could suffer losses from which it never recovers.

Workaround: Maintaining a well-diversified asset mix is a retiree's best weapon for ensuring that a bear market doesn't doom his portfolio plans. Holding assets in high-quality bonds and cash would allow a retiree to meet his desired living expenses without having to withdraw from equity holdings during market weaknesses.

That said, the smartest retirement-distribution plans also make adjustments during times of market duress, reducing withdrawals or, at a minimum, forgoing upward inflation adjustments during such periods. Withdrawing a static percentage per year automatically solves for this issue, too, though such an approach may result in an uncomfortable reduction in a retiree's standard of living during periods of market weakness and therefore isn't for everyone.

Distribution Pitfall 3: Relying strictly on income-producing securities to meet income needs.
There's nothing wrong with using dividend and bond income to meet your income needs during retirement, but sticking exclusively with income distributions can leave you beholden to the current interest-rate environment. We've seen that problem in sharp relief during the past several years, as income-oriented investors have been forced into risky areas, such as junk bonds and emerging-markets bonds, to scare up the income they need.

Workaround: I've been evangelizing about the bucket approach to retirement income for a while now; it's essentially a total-return approach that relies on regular rebalancing to provide income for living expenses. Using such a structure, a retiree would own bonds and dividend-paying stocks but would also own other stock types, including those that don't pay dividends. Such a strategy ensures a better-diversified portfolio than the income-only approach provides and also allows a retiree to enjoy a fairly stable standard of living.


Christine Benz is Morningstar's director of personal finance.

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Christine Benz  Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

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