Don't Wait Until It's Too Late to Decumulate

I focus a lot on saving, investing and saving some more for retirement. This week I do a 180 and talk about the opposite: What to do when you have reached retirement and need to tap into your retirement to pay your living expenses.

Names and personal information are excluded to protect privacy. NOTE: Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.

Q: It's finally time for me to retire and people tell me I need a "decumulation strategy." What is that and how do I do it?

A: Let’s first define the term, decumulation. Simply, it’s the antithesis of one’s wealth accumulation phase; it is a thoughtful plan/strategy on how best to draw down (spend) accumulated wealth/investments during retirement.

Often folks facing retirement give too little thought to the shift from wealth accumulation to wealth decumulation, which involves an important shift in investment strategy as investors transition to retirement. A necessary starting point includes the development of a retirement budget to better assess which assets might first be exhausted and which should remain invested. This, of course, involves an analysis of how your assets are currently invested and how you might best withdraw funds from those various sources. Don’t feel alone in this “chasing your tail” exercise.

How you decide to decumulate your assets is the most important decision you’ll make as retirement approaches. Specifically, when deciding how to decumulate your assets in retirement, consider taking these three important steps:

1. Do a risk analysis of your investments. By definition, so-called “safe” investments are less risky, but they offer lower returns. On the other hand, riskier investments should produce higher returns, but offer less protection for your capital. With this in mind, you’ll want to consider what assets you should access in the early years of retirement and what should remain untouched for the longer haul.

2. Based on your risk analysis, decide how you should you make withdrawals from your various accounts. One common approach is systematic where you develop a set dollar or percentage amount of withdrawals from your portfolio on a monthly or annual basis. If you have a non-Roth 401(k) or IRA , Uncle Sam – to get his piece of the action – will impose a methodology called required minimum distributions (RMDs) on you based on a table of life expectancies… whether you need the money or not. RMDs force you to consider which portfolio investments to liquidate in order to fund Uncle Sam’s requirements. This involves a bit of speculation on your part as to how changing market conditions might impact your month-to-month liquidation plan.

3. Delineate your guaranteed income sources and liquid assets. An optimal retirement portfolio includes both. If Social Security and existing pension benefits are insufficient to cover recurring basic expenses, you might consider covering the gap by converting some assets into a steady retirement paycheck that continues for life (e.g., an income annuity). This involves a tradeoff between near-term liquidity and the certainty of income you won’t outlive.

To summarize, a decumulating investment strategy requires a sound strategy involving the sale of certain assets to fund recurring retirement expenses as well as determining which assets to keep for purposes of continuing to grow one’s investment portfolio without exposing it to inordinate risk and volatility. Each individual’s asset base is different, thus requiring different approaches. Expert third-party input is always advised and can be downright helpful.

Q: What are your thoughts about financial planning in advance of becoming a loved one's in-home caregiver/financial guardian?

A: According to the AARP and the National Alliance for Caregiving, the average duration of time spent by caregivers providing care for a parent or parents is 4.5 years. So, planning is paramount whether you’re a caregiver or being cared for. The planning categories can be reduced to four: Income and Budgets, Estate Planning, Taxes, and Remodeling. Let’s start at the top.

Income & Budgets: There are two components to this finance issue, which demands knowledge of the state of financial affairs of a parent coming aboard – an often touchy subject but it must be addressed. Is he, she (or they) of modest or comfortable means? If financially comfortable, that implies he/she will be able to contribute to now higher household expenses. If a parent is of modest means, this implies more household expenses due, perhaps, to higher utility and grocery bills, and more trips to primary care physicians and specialists resulting in unplanned prescription and uncovered doctor bills. In more extreme cases, a working caregiver might have to reduce hours spent on the job to provide care for an invalid parent. Handled poorly, this can impact the budgets of all involved. Uncovering your parent’s financial condition up front helps plan for and avoid future financial surprises.

Estate Planning: It's vital to have an updated version of your parent’s last will and testament (and related documents). It’s also a good time to discuss other financial and guardianship matters… a time when, inevitably, a caregiver will need to assume financial and other responsibilities previously handled by the parent. Because rumors circulate about adult children taking advantage of elderly parents, a clear understanding of who will assume what roles and when is particularly important. Even discussions about an ultimate move to a nursing home, if affordable, should be discussed at the appropriate time. Old folks worry about losing control of their finances and future. They need assurances that caregivers have their best interests at heart.

Taxes: Research whether tax deductions or credits are available to you based on the significant contributions you will make to your parent’s care. This can help ease the financial burden on all parties involved. Discussions with a tax expert might be in order. But begin your own research by studying IRS Publication No. 501, “Dependents, Standard Deduction and Filing Information”, and IRS Form 2441, “Child and Dependent Care Expenses”. Always ensure that your parent’s federal tax return is promptly and accurately filed.

Remodeling: Because of the lengthy time period a parent might spend in a caregiver’s home, the stay often leads to remodeling efforts to accommodate the aging process… improved lighting, grab bars in bathrooms, changing handles on doors and faucets, relocating upstairs bedrooms to avoid stairs, door widening to accommodate wheelchairs, and even an additional bedroom or bathroom, or both. Some families even find it necessary to move to a larger home. In any event, this can result in significant unexpected outlays, so be prepared.

Obviously, there can be some major financial and physical issues involved in becoming caretakers of elderly parents… or becoming an elderly parent. And regardless of which position you occupy (probably both at different stages of life) it’s wise to plan ahead.

Q: What is the advantage of buying mutual funds versus individual stocks?

A: The primary advantage is automatic diversification… to varying degrees. For example, buying the S&P Index Fund gives you ownership in 500 of the country’s largest companies, by valuation… the best and the less good. Alternatively, if you should buy Vanguard’s Healthcare Fund you would be highly diversified in that particular sector of the market but not in other sectors.

There are companies that exist to assess the quality of mutual funds, which saves investors the trouble depending on how much they trust the evaluators. Morningstar, for example, rates funds based entirely on the numbers. It assigns one to five stars based on a given fund's past risk-adjusted results, taking into account sales charges the fund levies in calculating performance. The best (in Morningstar’s opinion) receive five stars; the bottom-dwellers receive one star.

A disadvantage of owning mutual funds is that investors have no control over the kinds of dividends to pursue, nor when to sell given stocks. Mutual fund managers make those decisions. With the advent of index funds and ETF’s, management fees approaching zero have become a very enticing feature of unmanaged funds and have helped to reduce the operating cost of managed funds as well.