Vanguard s Principles for Financing Retirement

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1 Vanguard s Principles for Financing Retirement At Vanguard, years of experience have taught us that our clients focus changes fundamentally as they approach and enter retirement. After years of accumulating assets, retirees have the challenge of withdrawing money from their portfolios in such a way that their assets will last a lifetime. Although each investor entering or in retirement faces a different set of circumstances, certain principles should govern how investors in general approach their retirement. These principles together with Vanguard s overall investment principles are the basis for the advice, products, and services that we provide to clients in or near retirement. You can use these principles to help guide your approach to financing a more secure retirement. Vanguard believes that Financial security in retirement means generating adequate cash flow, conserving sufficient resources to address changing circumstances, and, if desired, providing for survivors or an estate. 2. Five major types of risk market risk, inflation risk, longevity risk, health-cost risk, and spending risk can prevent retirees from achieving financial security. 3. Early and careful planning and disciplined follow-through can identify and reduce exposure to the five major types of risk. 4. Effective income planning requires a focus on the total cash flow that a portfolio can support, not just on the income that the portfolio produces. 5. The risks to financial security that exist in retirement can t be eliminated, so it s prudent to maintain a targeted level of assets as a cushion throughout retirement. 6. Retirement planning should reflect realistic assumptions regarding life spans and the potential length of retirement. 7. Maintaining broad investment diversification and minimizing costs are as important during retirement as they are before retirement. 8. Taxes may be the largest controllable investment-related expense during retirement, so tax-efficient spending, investing, and estate planning are critical aspects of a retirement plan. Connect with Vanguard >

2 Financial security in retirement means generating adequate cash flow, conserving sufficient resources to address changing circumstances, and, if desired, providing for survivors or an estate. Everyone views retirement differently. You may look forward to a completely new lifestyle once you leave the workplace. Or you may make the transition gradually, with work playing a more limited role in your life over time. Either way, your approach to achieving the goals mentioned on the front page will affect your financial security, and you ll need to decide how much of your portfolio to devote to each one. Generating adequate cash flow. The dividing line between retirement and nonretirement is securing a source of adequate, reliable cash flow that is independent of income from work. The money can come from a variety of sources, such as Social Security benefits and employer pension plans, as well as from a prudent liquidation of investment assets. Conserving sufficient resources to address changing circumstances. A portion of assets should be readily available to meet unexpected needs or a change in your situation including, but not limited to, any emergency needs. Providing for survivors or an estate. Planning is critical to ensure that a surviving spouse or other dependents, if any, are adequately provided for when you die. And if you want to leave an estate, it s important to make the proper arrangements to transfer that wealth as efficiently as possible. We provide advice and offer retirement products that are comprehensive and address each of these three distinct needs. Begin by assessing how important each of the three goals is to your financial security. Five major types of risk market risk, inflation risk, longevity risk, health-cost risk, and spending risk can prevent retirees from achieving financial security. A complete financial strategy in retirement must take into account the following risks. Ignoring even one of them could jeopardize your financial security. Market risk. Every type of investment has an uncertain future value and rate of return. This risk includes variability in the value of assets that you may not have considered, such as a house. Inflation risk. You can t predict how much your expenses will increase in the future because of rising prices. You may have limited ways to offset the impact of rising prices. Longevity risk. You don t know how long you are going to live. Your life span may be longer or shorter than the life-expectancy averages. Health-cost risk. Uninsured medical expenses and long-term care can be costly and subject to public policy changes. Spending risk. Along with spending more than you can afford, this includes the possibility that you will be overly cautious and spend too little thus missing out on the kind of life you want or have earned. We offer a variety of financial solutions to help you assess and mitigate the risks you face. We highlight the risks of all investments and provide tools and information to help you gauge and control the level of risk that you face. Determine your risks as explicitly as possible, using the best information possible, and make sure you are aware of all the methods that are available to help you manage these risks. 2 > Vanguard Investment Counseling & Research

3 Early and careful planning and disciplined follow-through can identify and reduce exposure to the five major types of risk. Planning and discipline are critical to achieving any financial objective, including retirement security. Early and careful planning can help you evaluate your exposure to risks before you need to address them and allows you time to develop strategies for coping with them. This increases the chance that you ll be able to afford the retirement you ve envisioned and reduces the likelihood that you ll need to radically adjust your lifestyle in retirement. The earlier you begin planning, the better. But it s never too late to start. Having a detailed plan helps provide you with the discipline to counteract overconfidence and other psychological and behavioral biases, such as relying too much on recent personal experiences or anecdotal information to infer broad principles. We offer a comprehensive range of planning services, from Web-based tools and information, to personal financial planning, to total wealth management. Make sure you have a detailed retirement plan, whether or not you use the services we offer. Effective income planning requires a focus on the total cash flow that a portfolio can support, not just on the income that the portfolio produces. As you near retirement, you need to focus on the amount and variability of the cash flow that your investments can provide. Just as when you are accumulating assets, your household s spending during retirement will vary from year to year so you must consider how much variability you re willing to bear. Choosing investments solely on the basis of how much income they provide places severe restrictions on a portfolio, and won t necessarily generate stable cash flow. Because the income that assets produce may vary over time, you need to be prepared to cushion this variability by prudently spending some of your portfolio s underlying principal as well as the income that the portfolio generates. We provide information and services that allow you to easily determine how your investment and financial strategies will affect the level of, and variability in, your spending. We help you determine spending targets and illustrate for you how investment decisions will affect variation in spending around that target over time. Adopt investment strategies that are carefully designed to manage the variability in your portfolio in retirement, thus enabling you to maintain a close match between your chosen investment strategy and your risk tolerance over time. Focus on managing overall cash flow, including the planned and judicious liquidation of assets. Don t focus solely on the amount of income your investments can produce. Vanguard Investment Counseling & Research > 3

4 The risks to financial security that exist in retirement can t be eliminated, so it s prudent to maintain a targeted level of assets as a cushion throughout retirement. Even the best-laid plans may go awry, and nothing about retirement finances is guaranteed. How much money you need to maintain as a reserve to feel financially secure is a personal decision. This cushion could be significantly larger than the amount of money you set aside to deal with emergencies. But it s crucial to target an explicit amount and to be comfortable with the notion of prudently spending the rest. After all, being able to spend is why you were saving in the first place. We offer a wide range of investment vehicles that are appropriate for maintaining assets for precautionary reasons. We only do business with partners that have the highest ratings for financial strength. Set an explicit target for how much liquid wealth you need to conserve to feel secure, and plan to prudently spend the rest as part of your plan to generate adequate cash flow in retirement. Retirement planning should reflect realistic assumptions regarding life spans and the potential length of retirement. An increasing number of Americans remain healthy and active well into their nineties. This means your retirement could span 30 years or more. Solid retirement plans must take into account the possibility that you will live much longer than average. If the chance of living too long poses a serious threat to your plans, objectively and carefully consider purchasing an income annuity or electing the lifetime income option from a company pension plan, if available. The decision to use annuity options requires extremely careful evaluation, because converting a portion of your assets into annuity income is generally irreversible, means giving up the option to use those assets in any other way, and can reduce the size of your estate. In addition, tax implications, insurance and investment costs, and the financial strength of the provider are critical factors. We provide tools and services to help you better understand how longevity risk can affect your financial plans. We administer income annuities with an eye toward keeping costs low and emphasizing the financial strength of the underlying insurers. Always consider planning horizons that substantially exceed average life-expectancy estimates. As part of your planning, understand and carefully weigh the pros and cons of receiving lifetime benefits from traditional company pensions or purchasing an income-generating annuity. 4 > Vanguard Investment Counseling & Research

5 Maintaining broad investment diversification and minimizing costs are as important during retirement as they are before retirement. As a retiree, you may be unable to generate income from work to offset investment losses, and therefore you may not want to accept as much risk as you did before retirement. Proper diversification of the portfolio is the most cost-effective way to reduce risk without sacrificing expected return. Financial services and solutions carry different prices and provide different benefits. Retirees should always bear in mind that costs not paid to investment managers or service providers directly translate into greater spending power for retirees. We focus on minimizing the cost of mutual funds, annuities, and other financial solutions. We offer investment services and solutions that make diversification easy. Maintain investment portfolios broadly diversified across all sectors of a securities market. Always be aware of all costs and fees. Taxes may be the largest controllable investment-related expense during retirement, so tax-efficient spending, investing, and estate planning are critical aspects of a retirement plan. Careful attention to tax rules can enhance returns over time. Simple strategies, such as tapping investment accounts in the most tax-efficient manner, can save money in taxes over the long run. While the most efficient tax-planning strategy for you depends heavily on your individual goals and financial situations, it is generally best to defer taxes for as long as possible. We provide information, tools, and services to help raise your awareness of taxes in your planning. We offer an array of tax-free, tax-deferred, and tax-efficient investments. Plan on spending your money in the most taxefficient manner when deciding which assets to use in retirement. You should generally spend taxable assets first, then tax-deferred assets, 1 and, last, assets in tax-free Roth IRAs. Consult a tax or financial advisor about your individual situation. 1 Do be sure to keep the rules in mind. If you take withdrawals from a tax-deferred plan before age 59 1 / 2, you may have to pay ordinary income tax plus a 10% federal penalty tax on the withdrawals. Vanguard Investment Counseling & Research > 5

6 P.O. Box 2600 Valley Forge, PA Connect with Vanguard > For more information about Vanguard funds, visit or call , to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing. Connect with Vanguard, Vanguard, and the ship logo are trademarks of The Vanguard Group, Inc. All other marks are the exclusive property of their respective owners. Vanguard Investment Counseling & Research Ellen Rinaldi, J.D., LL.M./Principal/Department Head Joseph H. Davis, Ph.D./Principal Francis M. Kinniry Jr., CFA/Principal Daniel W. Wallick/Principal Nelson W. Wicas, Ph.D./Principal Frank J. Ambrosio, CFA John Ameriks, Ph.D. Donald G. Bennyhoff Scott J. Donaldson, CFA, CFP Michael Hess Julian Jackson Colleen M. Jaconetti, CFP, CPA Kushal Kshirsagar, Ph.D. Christopher B. Philips Glenn Sheay, CFA Kimberly A. Stockton Yesim Tokat, Ph.D. David J. Walker, CFA 2006 The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor. FLGFR 0406