What’s in a word?

Words are impactful; some flow off the tongue smoothly and others, not so much.  The word “decumulation” falls decidedly in the latter category: it’s a word you’ve likely never used in polite conversation.  Not using it in conversation is okay, but not understanding it is could have dire consequences to your financial health.  It’s the opposite of accumulation, of course, and some use it to describe the act of spending money.  But more accurately, in financial planning it’s the process by which assets are optimally converted into income and spent over retirement. Semantics aside, a properly structured decumulation process is critical to ensuring you don’t outlive your money; and yet, the process is often done with little thought or consideration. With apologies to Albert Einstein for attempting to shoehorn his quote about compound interest, “he who understands it, benefits from it; he who fails to understand it, pays for it”.   

Decumulation starts with accumulation.

You’ve spent 30-40 years thinking about, seeking advice on, and (hopefully) accomplishing accumulation – the process of growing your assets.  You’ve likely received lots of advice, some of it good and some not, along the way regarding accumulation: my favorite – a penny saved is a penny earned. (What exactly does that mean?)  But chances are you’ve received little advice on, and given even less thought to, how to decumulate.  Maybe you’ve heard conventional wisdom like: “don’t spend more than 4% of your principal or “buy bonds and spend the coupons.”.  In reality, decumulation is much more complex than how much you should spend in retirement; it also involves proper investment of your assets, how to set your initial spend rate, what to do if your initial assumptions prove inaccurate (and they will), and prioritizing which account to draw from first.  Despite the oddity of the word, decumulation is critically important to your financial well-being and worthy of discussion; so much so that you should consider reducing your plan to writing in a systematic withdrawal plan (SWP).

Current challenges require a proactive response.

We believe the current environment presents more challenges than ever to ensuring you don’t outlive your resources:  1) ever increasing life expectancies; 2) decline of traditional pension plans; 3) anticipated decline in Social Security benefits; and 4) lower projected investment returns, especially interest paid on bonds, CDs and cash. Now more than ever, it’s important that investors focus on their future retirement goals and anticipated expenses to maximize the income producing potential of hard-earned assets.  Assuming you are nearing the end of the accumulation phase – where the goal was simply to save as much as possible and take as much risk as you were comfortable to maximize your savings – and about to enter into the “decumulation zone” (bearing many similarities to the Twilight Zone), your question should be “what comes next?”.

First, you need to determine what your income needs will be in retirement; and no, it’s generally not advisable to rely on “rules of thumb” (e.g., “you’ll only spend 80% of previous expenses in retirement”}.  You need to employ a goal- oriented approach in determining your likely expenses, distinguishing among needs (e.g., food, housing, etc.), wants (e.g., a child’s wedding) and wishes (e.g., a new sports car).  Be sure to realistically take into account the stages of retirement:  the “go-go” phase, the “slow-go” second phase, and the final “no-go” phase.

Second, you should then assess whether your resources as currently invested will yield the necessary level of income.  And by income, I don’t mean just interest and dividends.  As one commentator put it, it is the mechanical challenge of how to actually generate “retirement paychecks” from investments that transitioning retirees are accustomed to receiving from their working years.  This is where the concept of sequence of return risk comes into play – that is, the risk associated with highly irregular and unpredictable stock market performance at any given time.  Using historical averages, most financial advisors can provide reasonable estimates of market performance over an extended period of time, but no one can confidently (well, maybe confidently but not accurately) tell you what the stock market it is going to do next year, next month or even next week. Experiencing an ill-time market downtown early in one’s retirement can be devasting, resulting in a portfolio that struggles to regain lost ground and its longevity declines faster than the retiree. Risk analysis involves assessing the level of risk that you need to take and are comfortable taking against the inherent risk in your investments to ensure they are aligned.

Third, having positioned your investments to take into account your income needs and risk tolerance, you should work with your financial, tax and legal advisors to devise a strategy to pull assets from the account(s) that minimize adverse tax consequences and maximize future appreciation – that is, pull the right assets and pull them rightly.  And revisit that plan annually, making course corrections as needed. 

Decumulation – probably still not a word you will find occasion to use in most social settings, but one you fail to fully understand at your peril.