Because retirees do not earn regular income, they need to save, usually over decades, enough money to cover their costs in old age. A key component of retirement planning calculates your decumulation, which is the rate at which you will draw down from savings to cover your retirement costs. Let’s take a look at how a safe decumulation strategy is calculated. A financial advisor can help you create a retirement plan for your needs and goals.
What Is Decumulation?
When planning for retirement, many people focus on the accumulation of assets through long-term savings and investments. But financial experts say that it is equally important to plan for the decumulation of those assets after you retire.
Decumulation is a multifaceted approach that determines how much you will draw down from your savings and investments to create an income stream for retirement.
The success of this strategy will largely depend on the way it aligns with your goals and needs.
How to Calculate a Decumulation Withdrawal Rate
When determining a decumulation withdrawal rate, the goal is to make sure you don’t deplete your savings too quickly. In general, a good rule of thumb is the 4% rule. If you stick to the 4% rule, studies suggest that your savings will last for 30 years or more.
But you can map out your own decumulation rate to ensure your funds last as long as you need them. Here’s a formula to find you find the appropriate withdrawal rate:
Safe withdrawal rate = Annual withdrawal amount / Total amount saved
For example, let’s say that you’ve saved $1,000,000 for retirement and you want to spend $40,000 per year in retirement. Here’s what the math would look like:
Safe withdrawal rate = $40,000/$1,000,000 = 0.04 or 4%
But you can adjust these numbers based on your retirement spending needs and risk tolerance. The lower your withdrawal rate, the less likely it is that you’ll run out of money.
An Example of Decumulation
Let’s say that you want to live on $50,000 per year in retirement. If you want to stick to the widely regarded safe withdrawal rate of 4%, you would use the above formula and solve for “Total amount saved” to see how much you would need in your nest egg. You divide the annual withdrawal amount by 0.04 (4%) to get $1.25 million. Keep in mind that there are two other factors at play that will affect your ability to spend during retirement: the inflation rate and the return on your investments. Given how those two critical variables fluctuate, you’ll need to regularly calculate this number to reflect the changing times and ensure you are not spending too much.
For example, $50,000 might be plenty to live on in your area right now. But in 30 years, that amount might not buy as much. Take some time to explore our inflation calculator to see how this economic factor could impact your retirement plans. If you anticipate spending more in retirement due to inflation, then you’ll also need to save more.
7 Things to Consider for Your Decumulation Strategy
Many retirement plans are based on a combination of income, savings and investments. Here are seven factors that will affect your retirement money and how you determine your decumulation strategy:
Ask yourself what an ideal retirement looks like. Ideally, you’ll start thinking about your decumulation strategy while saving and investing for retirement. To do this, you will need to consider what type of lifestyle you would like to maintain. Will you continue working part-time in retirement? What hobbies will you pursue? Do you want to travel? Are you willing to downsize housing costs? Your decumulation strategy will need to support your intended lifestyle.
Map out the sources of your guaranteed retirement income. In addition to savings and investments, financial experts recommend having guaranteed streams of income to pay for fixed retirement expenses like housing, utilities and food. Sources of guaranteed income include Social Security, pensions and annuities. Once you’ve mapped out how much income you will get on a monthly basis, you can calculate the decumulation strategy to cover the rest of your retirement expenses.
Review withdrawal options for your tax-advantaged accounts. Depending on your retirement account, you will need to adhere to specific rules to avoid paying a tax penalty. Here are the rules for three common accounts:
- 401(k): You must be 59.5 to access these funds.
- HSA: If under the age of 65, then you can only withdraw these funds for a qualified medical expense. If over the age of 65, then you can withdraw the funds for other expenses but you’ll have to pay tax on the withdrawal.
- IRAs: You must be over the age of 59.5 to withdraw funds from a traditional IRA without a penalty. Additionally, you must begin taking a required minimum distribution at age 70.5
You should take into consideration these minimum age requirements when planning your decumulation strategy.
Consider health care costs. Health care costs tend to rise in old age. So you should factor these costs into your decumulation strategy. While Medicare at age 65 will cover substantial parts of your health needs, you should note that long-term care, dental services, hearing services and international coverage are not included.
Take a look at other wealth alternatives. With rising home prices, many retirees are amassing significant equity in their homes. A reverse mortgage could help you turn this equity into an additional source of income for retirement. Though you should note that reverse mortgages could come with various costs and variable interest rates, and you can’t deduct interests paid on your tax returns.
Don’t forget about risk. It’s important to reevaluate your risk tolerance as your working years come to a close. You might rebalance your portfolio to minimize risk in old age. Though you should also take into account other retirement risks beyond your portfolio like longevity risk, inflation, and healthcare costs.
Plan your estate. In addition to your own retirement needs, you may also want to preserve parts of your estate for your family’s future. An estate plan will help you protect those assets. And this should also factor into your decumulation strategy, since you will most likely rely only on part of your estate for retirement, while the other part will focus on continued growth for your family.
Bottom Line
The success of your decumulation strategy depends on how well you are able to align it with your retirement needs and goals. You must have a clear idea of the retirement lifestyle that you will need to pay for, and map out different streams of income, as well as fixed and variable expenses to execute a decumulation strategy that will cover you in golden age.
Tips for Retirement Planning
- A financial advisor will help you put a financial plan into action for your retirement needs. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Use SmartAsset’s free retirement calculator to see how you’re doing preparing for retiring.
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