There are two phases to your investment life span, accumulation and distribution. Accumulation is the portion of your working life where you save and presumably invest as much as possible to fund activities and a lifestyle later on in life, most commonly retirement. We discuss this phase of life most often in this blog when we examine investing and the method of planning for this part of life is called Goals-Based Planning. This column is meant to focus on the distribution phase of life or living off of your investments. We refer to this as Cash-Flow Planning.

First off, there are tax implications when considering distributions from investment accounts that differ from investor to investor. So here are some simple rules of thumb: take distributions from “taxable” accounts (bank accounts and brokerage accounts) first and from tax-deferred accounts (IRA’s, 401(k)’s, annuities) last. Let the power of tax-deferred compounding help you for as long as possible. Most investors will pay capital gains tax rates of about 20% rather than higher income tax rates (or no taxes when investing in tax free bonds) on distributions from the former. You will then pay income tax rates on gains from tax-deferred accounts as you draw down on them. Most importantly, you should get professional advice from a Certified Financial Planner and a Certified Public Accountant long before considering retirement so that you have a distribution strategy ready when that day comes.

Broadly speaking, there are a few ways to look at how to best draw down your money from various investment accounts. Again, we are simplifying that process here for illustrative purposes. Your situation is specific to you and may differ. We will make certain assumptions here are that are equally as important as the title subject but are complex enough that they deserve their own column. Risk for example is again, unique to the investor and will in large part, dictate your investment outcome so we will assume that readers are of “moderate risk” for these examples.

Goal: generate income without materially dipping into principal.

The simplest approach: build a portfolio of high dividend paying stocks and high yielding bonds and live off the yield of those investments without ever touching the principal. This is an approach that might work in an environment with much higher interest rates and stock yields but it’s been decades since we’ve been in that situation. Attempting to do this now means investing in high yield or “junk” bonds and a limited number of stocks concentrated in a few industries. In the case of the former, higher yielding bonds means taking on higher risk, thus the term “junk” bonds. This doesn’t mean you should avoid high yield bonds altogether; just that you have a prudent amount of exposure to them if at all. In the case of high yielding or high dividend paying stocks, concentrating your stock holdings in fewer names and fewer industries also leads to higher risk, known as concentration risk.

Total Return approach: this refers to drawing down on your money in a tax aware manner from interest on bonds, stock dividends, and capital gains (profits from occasional sales of both). In a low interest rate environment, this has become the most sensible way to consider portfolio distributions. One approach is to set an acceptable rate of draw down like 3%-4% annually. If you’ve saved $1,000,000 over your lifetime, then 4% per year in simple terms (no adjustments for inflation) means taking $40,000 per year from your investments. 4% (or less) is probably a safe assumption that you won’t outlast your money. Of course, there are no guarantees and when you start your draw downs in the market cycle will impact your success. This is called sequence of return risk. Use your common sense here, if you start distributions and the market experiences negative returns for the next two years, you should revisit your financial plan to see how that impacts your assumptions. Likewise, if the market has two big up years, that gives you a nice cushion going forward.

Goal: making your money last as long as possible while living the life you want.

What’s the difference between this and the last goal? Most folks will have to dip into their principal to create the lifestyle they want in retirement. This can be daunting for many investors but it’s unavoidable due to their savings balances. The smart way to extend your income from your investments is to do one of three things:

  1. Work a few years longer than you originally expected.
  2. Pick up part time work in retirement.
  3. Lower your expenses in retirement.

Retirement is a phenomena of the second half of the 20th century. Those who retired in the ‘50’s – the ‘70’s became rather sedentary and life expectancies were quite a bit shorter than today. Now, retirees tend to stay active later in life and many take on part time or volunteer work and not always because they must, but because they desire to. The extra money from this is a huge benefit to any financial plan and those who stay active live longer. Another factor more recent in retirement living is retirees selling their primary home and renting rather than buying again. Couple that with moving to a less expensive part of the country and again, it has a large positive impact on your lifestyle.

Make sure to meet regularly with your planner to keep them apprised of your cash flow. The cash flow analysis a planner does at the outset of your engagement will need to be updated as you progress through life. Common life events that will impact your lifestyle and withdrawal rates are your health, amount of travel, helping out other family members in financial need, etc. The list goes on… These events will cause you and your planner to revisit distribution strategies from time to time.

The single most important thing you can do with your investments regardless of what stage you are at in life is to diversify them – across sizes of companies, industries, countries, styles (growth, value) etc. Diversification costs nothing and helps to manage risk no matter what type of investor you are.