What’s a decumulation strategy?

For a considerable part of your working years, you have focused on earning an income and setting aside part of the income for retirement. The piece by piece contributions have accumulated into a sizeable nest egg, which will be one of your primary sources of income in retirement. Once you retire, you must decide how to decumulate your retirement savings.

A decumulation strategy refers to the drawing down of your retirement savings to provide income for your retirement years. Whether you have a 401(k), traditional IRA, or Roth IRA, decumulation represents a shift of focus from funding your retirement to using your retirement assets to generate income for your retirement. Decumulation is the opposite of accumulation.

Accumulation vs. Decumulation

Once you retire, you are allowed to start taking distributions from your 401(k) to meet your expenses in retirement. However, before you start drawing your savings, you should understand that your retirement savings are not unlimited, and you should plan how to use the retirement savings to last a lifetime.

Accumulation is a strategy that investors use to accumulate and build up investment assets over the long term. This strategy involves contributing money into your 401(k) or other retirement accounts so that you will have enough for your retirement. On the other hand, decumulation strategy involves drawing down your retirement assets and investments to earn an income that is enough to maintain the quality of life in retirement.

The decumulation phase represents a shift from an offensive strategy where investors invest in high-growth funds, to a defense strategy where you use your nest egg to fund your retirement expenses. However, a common problem that retirees face in the decumulation face is predicting how many years they will live and spreading distributions over that period.

Types of decumulation strategies

There are several types of decumulation strategies, and each strategy has a different impact on your retirement money. The key decumulation strategies include:

Total drawdown:

The total drawdown decumulation strategy involves planning to use the entire nest egg over your lifetime until the 401(k) balance is nil. This strategy may involve planning to draw your 401(k) by a certain age. However, using up all your retirement savings in your lifetime could jeopardize your retirement goals.

Partial drawdown:

A partial drawdown decumulation strategy involves planning to use part of your wealth in your lifetime and leaving the rest of the accumulated retirement savings to your designated beneficiaries. Since you do not plan to exhaust your retirement money, this strategy ensures you live a comfortable retirement life, regardless of the number of years you will live.

Preserving principal

If you have built an adequate nest egg, you can choose to live off the investment earnings from your retirement account. This means you will use the interest and dividend earnings from your retirement plans to maintain your quality of life in retirement while preserving the retirement contributions you made over your working years.

How to Transition from Accumulation to Decumulation

Switching from accumulation to decumulation is a gradual process. As you approach retirement, you can start by reducing the number of hours spent on your job, or retain a part-time job in the early years of your retirement.

Once you adopt a decumulation strategy, you may decide to maintain the quality of life in retirement, or opt to cut back on certain expenditures. Depending on how much you have saved in your 401(k), you must decide on a monthly income in retirement, and create a budget to break down how you will spend the money. The monthly income should be enough to meet your expenses in retirement and any expected emergencies.

Key Considerations When Planning for Decumulation

When moving from accumulation to decumulation phase, there are certain considerations you should consider. Here are things to watch out for:

Uncertain life expectancy

While you may peg your life expectancy on the national average, you cannot be sure how long you will live. Hence, you should plan how to use the nest egg to last a lifetime, and still leave the assets to your beneficiaries when you die.

Healthcare costs

As you grow older, your healthcare costs will increase. According to Fidelity Investments, an aged couple may require an average of $300,000 to cover healthcare costs in retirement. However, the amount you will need will depend on when you retire, your health, and your state.

You will need to switch to Medicare once you retire, but you will still incur additional costs like deductibles and copays out-of-pocket. You should budget for the additional healthcare costs in your retirement income.

Fixed income

Once you retire, you must plan how you will live off your fixed retirement income. The distributions you take from your 401(k) or IRA will be constant over the years, but the social security may be adjusted for inflation. As you plan your decumulation strategy, you must strike a balance between maintaining your quality of life and ensuring the nest egg lasts a lifetime.