What do you save and invest for?
Is it for freedom, more money, security…for fun?
Well whichever answer you come up with—the reality is that most of us are investing for our future retirement income. Ultimately, we all are investing so that we will have enough money to withdraw and live off of each year of our retirement—when we are no longer working full-time.
Sure, short term investing can sometimes be fun, and maybe we will take $10,000 out of an IRA for our first home purchase, or dip into a little bit of our investment winnings to remodel the house. However, this usually is not the primary reason we strive for higher returns and increased savings rates.
That main reason is for retirement income. So that we can secure our financial future—and be able to regularly withdraw the amount of money that we need when retirement time rolls around.
The core concept of a successful retirement is fairly simple: Accumulate a large enough retirement account to a point where the growth and earnings earned will generate enough income to support your lifestyle—without the need to work any longer. Once you reach that point—factoring in social security and other additional retirement income—you can afford to retire, financially speaking. From there, the choice is how much longer you would like to work.
Retirement is certainly a thought on the minds of many, from age 25 onward. Even millennials in my age range are considering what they need to be doing for retirement; since the likelihood of gathering social security income during our retirement years decreases as our nation’s debt and other obligations continue to rise.
And let’s also not forget that our life expectancy continues to rise with advances in medicine. When our parents and grandparents life expectancy was somewhere in the 60’s or 70’s—retirement planning was slightly more simple. Now—most of us reading this post have the very real possibility of living well into our 80’s, or 90’s—maybe even longer than that, depending on what sort of progress modern medicine will provide.
The point is…retirement planning is getting more complex as uncertainties arise. Especially when we are not sure if we should plan on 15, 20, or 30+ years in retirement. Not everyone is afforded the luxury of simply building a large retirement account then riding off into the sunset with enough money to last all of their retirement years. With all of this saving and investing, we want to rest assured that we will not outlive our money.
As a starting point in your retirement planning, let’s map out your financial journey and get an understanding of the two separate phases that we all go through in our financial lives. The decisions we make are highly impacted depending on the phase we’re in.
The First Financial Phase
Investing during our working years, while we are building up our retirement accounts to a number which we can then withdraw from each year during retirement—is called the accumulation phase of our financial lives. We are climbing up the retirement hill, working and (hopefully) accumulating assets over the years that are growing, compounding and otherwise accumulating their way up to the sort of numbers that we need in order to be able to retire comfortably.
This is the first phase of your financial life. It can be defined as your entire life up until the second financial phase—and for most of us, it’s usually the longer of the two phases. The longer—and more—you can continue to accumulate, the better off you will be in the second financial phase.
The accumulation phase is usually when you are earning more money than you are spending, and you are saving at least part of the excess earnings into your retirement accounts. We call it the accumulation phase with the idea that usually you are contributing more to your accounts each year, and you’re investing them in areas where your money will grow, and accumulate over time.
Your actions in this phase are what will ultimately determine what kind of lifestyle you will be able to sustain during the next financial phase in life.
For example, let’s consider Jane and John’s scenario.
At 60 years old, retirement is a lingering thought on their minds and in the actions they are taking with their investments; they are hoping to retire in six years. They collectively earn about $80,000 per year, and save around $8,000 each year into their retirement accounts—spread among their 401(k)s and IRAs. Adding their accounts up reveals they have just over $400,000 saved for retirement so far. They are a little nervous as to what this means for their retirement, and if they are doing the right things.
Since they are still working and building up their retirement accounts—they are in the accumulation phase of their financial life. Once they stop saving for retirement, and they begin to supplement their social security income with disbursements from their retirement accounts—they will begin the second phase of their financial lives.
The Second Financial Phase
After you have climbed up the accumulation hill and reached the peak, the second phase of your financial life kicks in. At this point, the ideal scenario is that you will be able to withdraw and live off:
- Social security income
- Employer-sponsored pension plans
- Disbursements from your retirement accounts (401(k), IRA, 403(b), etc.)
- Annuity income
- Additional wages or business income
This second phase in your financial life is called the withdrawal phase. This is when the accumulation phase might have ended, and you have started withdrawing money out of your retirement accounts, rather than contributing to them each year. Hence the name—withdrawal, meaning you are disbursing, or withdrawing funds from your retirement accounts. This phase most commonly begins at or near the time of retirement.
As a side note—there can by a hybrid stage, where you are still accumulating and saving money, yet forced to withdraw from a retirement account based on something like age. Being in one phase does not always necessarily mean you cannot also be in the other for a limited time. Continuing to accumulate even while making withdrawals would be a positive scenario.
This withdrawal phase is usually what we are all aiming to maximize when investing, and certainly when considering our retirement. The longer we can make this amount last from the top of the hill—the more financially secure we will be.
Entering the withdrawal phase does not necessarily mean that your account will not continue to grow. That is, as long as your withdrawal rate is less than your growth rate—which is the goal and reality for many.
A fairly typical withdrawal situation is illustrated in the chart above. It reflects that their withdrawal rate is greater than the earnings rate. In other words, they are withdrawing more than they are earning—which is why the orange, account size line is going down toward zero.
Keep in mind, however, that our goal is to get readers and clients to smooth and flatten out this withdrawal line as much as possible. We want to avoid this line going to zero. The smoother your withdrawal line is, the longer your money will last for you and your family. That’s done by shrinking the gap between rate of return and withdrawal rate.
For example, if you are withdrawing about 6% of your account balance each year, and you are only earning 4%, this line will drop—like you see in the chart above—since you would be withdrawing more than you are earning. If you can bump that earnings rate up to 8% or more, or lower your withdrawal rate to 4% or less, then that withdrawal line will flatten out or even rise.
If your withdrawal rate is exactly equal to your earnings rate, the withdrawal line will go straight across. If you can maintain a higher earnings rate than withdrawal rate, the line will continue to rise—rather than drop off.
This is the ultimate goal in retirement—an ever increasing withdrawal line that continues up and away from zero. Earn more on your account than you spend each year—and you will never run out of money. Of course, that is much easier said than done.
It just goes to show that withdrawal phases are different for everybody. The withdrawal phase does not have to mean your account value is dwindling—though in most cases it does. It can be a little intimidating to see that line drop rapidly and your account value drop quickly. This is what we want you to avoid. You avoid this by spending less/earning more, or increasing the rate of return.
Going back to our couple Jane and John, let’s fast forward six years, when they will retire, and begin their withdrawal phase.
At this point, they are 66, and will elect to take social security income—which will provide them with just over $33,000 each year. In addition to this, they have now built up their retirement accounts to a collective total of $695,000. Here’s the calculation for the final 6 years of their accumulation phase—solving for their future value.
Given their retirement inputs, and solving for “How much do you need to live on annually?” this $695,000 will provide them with an additional $47,397 per year, to withdraw from the accumulation of their retirement accounts.
This gives them $33,000 from social security, plus $47,000 from their retirement account withdrawals, for a grand total of $80,000 they are planning to live on each year during retirement. Now that their accumulation phase is complete, the withdrawal phase of their lives begins.
This amount they have available will allow them to maintain just about the same financial level they have grown accustomed to during their peak earnings years.
Now they have financial security, and they are confident that their hard work and savings will last them for the rest of their lifetime.
Of course, if they want even more financial and retirement security, they could lower their withdrawal rate each year by either spending less, or earning income elsewhere—thereby requiring lower disbursements from their accumulated amounts. They could also seek higher rates of return, which would allow their money to go further.
What Financial Phase Are You In?
No matter which financial phase you are currently in, we hope that you will take the necessary steps to secure your financial future.
If you still have a decent amount of time left in the accumulation phase, aim for the withdrawal phase where your account values continue to rise. This can be done by saving more, or increasing returns. This would provide an immense amount of financial freedom, and it can absolutely be done if your focus your sights on it as your major financial goal.
However, be sure to also manage your risk. Don’t seek out higher rates of return by taking immense amounts of risk. Learn how to invest in something like stocks or currency, or take advantage of low-valued real estate markets…something, or a combination of things, that will increase your chances of a higher rate of return—without increasing your risk substantially.
If you are already in the withdrawal phase, take steps now to either increase your return (and/or decrease fees), reduce spending, or earn additional income.
Talk to us if you would like some help calculating what you are on track for, and how much you will need in order to retire. We can also help you in coming up with some simple strategies to save money, cut management fees, increase income, or raise your rate of return.
Overall, remember what it is you are working and saving for, set your financial goals, and stay disciplined in your saving and investment strategies. This is the best way to maximize your future retirement income.
After all, it is what we are all ultimately investing for.