Are you ready for retirement?

Every transition in life is difficult. Humans are creatures of habit and we tend to find change challenging. Going from a regular paycheck to funding life from a portfolio is a night and day experience for many investors. The shift changes the strategy and approach we take. To ensure you are ready for this transition, the following four steps should be undertaken: Create a budget, review your investment strategy, plan for contingencies, and consider end-of-life scenarios.

Create a budget

Nobody likes to set a budget, but there aren't many people that like to run out of money in retirement either. During retirement, there is no scrimping until the next paycheck. This might be the time to overcome any aversion to budgeting. There are two general approaches that can be taken with a retirement budget. The first is a proactive approach, which involves figuring out the amount of money needed to support a desired retirement outcome and putting together a plan to achieve it. The second approach is to focus on the amount a portfolio can support on an annual basis, which is more suited for those already approaching retirement.

This second approach can be done in two ways: using a safe withdrawal rate or living off the income generated from a portfolio. A safe withdrawal rate is the amount that can be withdrawn from a portfolio on an annual basis until death without running out of money. It's based on factors like the future returns of a portfolio, the sequence of those returns, the level of future inflation, and time until death. All these factors are based on an unknowable future, and it pays to be conservative. The other approach is living off the income generated from a portfolio, which requires looking at the current yield and accounting for the natural variability of income as dividends and interest rates fluctuate. Regardless of the method, any budget should incorporate the natural shift in spending that occurs during retirement, where many retirees spend more at the beginning when they are healthier and more active, and spending tends to reduce as they age.

Review and refine your investment strategy

Every investor needs a plan that connects their goals with the investing strategy they will use to achieve those goals. An investor approaching retirement should review their plan to determine if any changes should be made to their goals, asset allocation, and security selection criteria. Traditionally, retirees have allocated a larger percentage of their portfolio to defensive assets to lower volatility. This makes sense to a point. However, getting too conservative can lower the length of time a portfolio can last that is supporting regular withdrawals. If a retiree has other sources of assets and income, such as an aged pension or an annuity, they may choose to retain a larger allocation to growth assets. The proportion of wants versus needs in a budget may also play a role, with a lower percentage of needs allowing for a larger allocation to growth assets.

Plan for contingencies

The biggest risk most investors face is not achieving their goals. The two most common risks that pre-retirees and retirees face are not meeting the milestone of retirement and running out of money before death. As retirement becomes imminent, the biggest risk is being forced to start selling in a down market. In an ideal scenario, everyone would retire when markets are going up. However, in reality, many people have little choice on the timing of their retirement. Retiring in a down market means that investors need to sell assets when they have fallen in value, leaving a smaller portfolio to take advantage of the market recovery. A plan should address this scenario and spell out the approach an investor will take if markets start to meaningfully fall as retirement approaches. One way to address this is to delay retirement if possible. Another is to build up a cash cushion to fund living expenses while waiting for a market recovery.

Consider end-of-life scenarios

There is no blueprint for the end of life, so it is best to be prepared for whatever scenario life has in store. This includes establishing or reviewing a will to ensure that post-death wishes are documented. For many self-directed investors, there comes a time when health may prevent the active involvement in the day-to-day management of a portfolio. Addressing this scenario in advance can involve simplifying investments or finding a financial adviser to provide assistance. Planning for these scenarios will remove one source of stress from the process of retirement.

Source: Morningstar Australia. Are you ready for retirement? by Mark LaMonica, CFA, 1 October 2024.

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The information on this website is intended to be general in nature and is not personal financial product advice. It does not take into account your objectives, financial situation or needs. Before acting on any information, you should consider the appropriateness of the information provided and the nature of the relevant financial product having regard to your objectives, financial situation and needs. In particular, you should seek independent financial advice and read the relevant product disclosure statement (PDS) or other offer document prior to making an investment decision in relation to a financial product.