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Retiree Pitfalls to Avoid in a Lofty Market

Here are some tips for navigating withdrawal rates, risk capacity, and charitable giving.

Susan Dziubinski: Hi, I'm Susan Dziubinski for Morningstar. The year 2021 is shaping up to be yet another very strong year for the equity market. Joining me to discuss some of the pitfalls that retirees can fall into in very strong microenvironments is Christine Benz. She is director of personal finance and retirement planning for Morningstar.

Hi, Christine. Thanks for being here.

Christine Benz: Hi, Susan. Great to see you.

Dziubinski: You say one of the first pitfalls that new retirees can fall into is that they take too high of a withdrawal rate when they're first entering and starting out in retirement. And that may seem counterintuitive to someone who is a new retiree because they'll think, "Well, this has been a bull market, why can't I take a larger percentage for withdrawals than I might otherwise?" Let's talk a little bit about that.

Benz: It's very counterintuitive. But the key issue is that when we've seen the market go up and up and up, that tends to mean that the raw materials for good returns in the future are a little bit less. And that's what we have today where we have very low fixed-income yields, we have fairly high equity valuations, especially with certain parts of the market. And so, that argues for setting a conservative withdrawal rate as your starting withdrawal. But remember, this is a percentage of your portfolio. What really matters is how much in dollars you can take out and spend. And the good news is, your portfolio balance is very likely enlarged. If you've been enjoying the strong equity market gains, you may need to take a smaller percentage, and, in fact, our recent research would argue that rather than sort of the 4% guideline, maybe like low-3s is a better place to start. The good news is, it's from an enlarged portfolio. And so, your take-home withdrawal may be just as high as it would have been a couple of years ago when a higher withdrawal rate was supported.

Dziubinski: How can retirees know whether the withdrawal system that they've set up might be too aggressive? What should they be thinking about?

Benz: I think they should be thinking about their portfolio, what it looks like. So, if you have a balanced portfolio, that will tend to support a higher withdrawal rate than if you have one that's super conservative. It's rare that retirees would have very conservative portfolios today because fixed income and cash are just so low-yielding and unattractive. But nonetheless, you wouldn't want to be too conservative. You want to be thinking about your withdrawal period. Our research looked at a 25- to 30-year period. If you have a shorter time horizon, say, you're a 75-year-old retiring, you can arguably use a higher withdrawal rate because your time horizon in retirement, your anticipated time horizon, is lower. So, factor in some of those considerations as well.

Dziubinski: Now, pivoting over to the portfolio, you say another pitfall that retirees can fall into is this idea of confusing their risk tolerance with their risk capacity. Let's walk through what the difference is and why it matters.

Benz: Right. I think some people might hear this and think it's sophistry, like, why are we talking about this. But the reason it matters is, risk tolerance is how you feel about losing money. So, people often take these risk-tolerance questionnaires about, well, if the market dropped 10%, would you have a sleepless night and so forth? That's how you feel. Risk capacity is how much risk you can take and afford to continue on with your goals. Will big losses disrupt your plan is the fundamental question.

And the real issue for retirees is that oftentimes they have really high risk tolerance. They're battle-tested, right? They've been through a lot of market downturns. They know that stocks recover. They are sort of in the position where they say, 90% equity weighting, sign me up, I've done that, I know that that's the place to be. The issue is that their risk capacity, because they're going to be spending from their portfolios soon, is diminished, at least for those near-term portfolio withdrawals. So, you need to derisk that portion of your portfolio that you expect to spend. I would say in fewer than 10 years you need to derisk that portion of your portfolio. So, there, you're thinking about cash, you're thinking about high-quality bonds, maybe a complement of dividend-paying stocks but not all stocks. You really want to reduce the risk potential in that portion of your portfolio. Then for withdrawals for 10 years and beyond, have at it with stocks, go ahead and be aggressive, but those near-term expenditures are what you want to lock down and keep safe, and that will really help ensure peace of mind in retirement.

Dziubinski: Related to that, there are some retirees that would, of course, look at this rising stock market and be like, "Oh, I need to get more conservative right now." Talk a little bit about how conservative is too conservative. How should you be thinking about that?

Benz: It's a good question, and I could see retirees sort of looking ahead hearing this conversation and thinking, "I'll go all cash, I'll go all bonds." The real risk of that--well, a few risks--one is longevity, which is that many people embarking on retirement today may be retired for 25 or 30 years or more. So, you can't afford to sort of sit down in the very low-risk securities and not have much of a return on your portfolio. You need the risk that accompany stocks. And then, another issue is that inflation is on the move. Inflation is not this benign nonissue that it was for so many years. It's a real issue right now. So, the opportunity cost of having too much in safe investments is arguably greater than it's been in a couple of decades. So, I wouldn't derisk a portfolio entirely. I think you need to have a balance, and I think you need to be prepared potentially for some volatility over the next few years.

Dziubinski: And then, lastly, Christine, another pitfall is more of a personal one for retirees, and it's the whole idea of giving, whether it's charitable or you're giving to family members. How can retirees make sure that they don't forget about having enough for themselves, frankly, before donating and helping out other people?

Benz: This is such an issue, Susan, anecdotally, and speaking with older adults, they have such a desire to help their adult children, they want to help grandchildren, they want to help charities. But I do think that some older adults do have a propensity to over-give. And so, the key is to really look at your own assets, look at whether your assets can tide you through your retirement comfortably, get some help from a financial advisor. You're looking for enough to get yourself by, but also a comfortable cushion, and that's especially important if you have uninsured long-term-care expenditures where you haven't insured against that risk and it's a risk factor for you.

I like the idea of setting aside--I hate to introduce another bucket--but even thinking about a giving bucket where you've determined, well, this is money that I can afford to give away whether it's to my loved ones or to charity. And the beauty of that is that lifetime gifts are so much better than gifts after death. You get to see the fruits of your gifts. You get to see people enjoy them and use the funds. So, I like the idea of really doing some work on the front end to decide how much you can give and then potentially segregating those assets. You may even use--if you're giving to charity, you may even use a donor-advised fund. If you plan to give to family members, you might have some sort of separate account. But segregating those assets from your spendable assets, I think, will provide peace of mind.

Dziubinski: Christine, thank you for your time today and for these workarounds and solutions to some of these pitfalls that retirees commonly fall into. We appreciate your time.

Benz: Thank you so much, Susan.

Dziubinski: I'm Susan Dziubinski. Thanks for tuning in.