Save substantially. Invest your savings wisely. The conventional wisdom holds that this is the way to accumulate a nest egg for your retirement, and the conventional wisdom is right on the money. However, you probably won’t always have earnings to invest. At some point, your work income is likely to cease or drop sharply in retirement, and you’ll need to draw down prior savings. Yet, studies have found that very few people have considered how they’ll go from investing earned income to generating retirement income. The sooner you give this issue serious thought, the more likely you’ll be prepared with a realistic spending plan when the paychecks stop. Here are a few options to consider.
Spend income, not principal
Most people can rely upon Social Security benefits for some retirement income. Beyond Social Security, you probably will have to tap your own savings. The question, then, is how to go about drawing down the money you’ll spend. One method is to use only dividends and investment interest income for cash flow. Example 1: Suppose Ed and Nancy Parker will each receive $20,000 a year from Social Security, so their joint annual benefits will be $40,000 per year, indexed for inflation. The Parkers have a $600,000 portfolio, in this example, invested in high-quality stocks and bonds. If their interest income and dividends average 2.5%, the Parkers will receive another $15,000 a year (2.5% of $600,000). By spending that $15,000 but leaving their stocks and bonds intact, the Parkers’ retirement income will be $55,000 a year, including $40,000 from Social Security.
Cracking your nest egg
Dividends and investment interest yields are low today, and may remain a low in the future. The Parkers, in our previous example, may wish for greater retirement income than $55,000 a year. One alternate strategy is to follow the so-called 4% rule, which has been developed by financial advisors and academic researchers. Example 2: The Parkers withdraw 4% of their $600,000 investment portfolio ($24,000) in the first year after they stop working. Now they have $64,000 ($40,000 from Social Security plus $24,000 from their portfolio) to spend rather than $55,000. The 4% rule assumes that the Parkers increase their withdrawals each year to keep up with inflation. Going by historic investment results, research indicates a high probability that the Parkers’ portfolio will last at least 30 years, with this method. To get that $24,000 in the first year of retirement, the Parkers might spend their $15,000 of investment income, as explained, and sell $9,000 of their investments to raise the rest of their cash. Over time, they would gradually deplete their portfolio in this manner. The 4% rule likely will provide more retirement income than just spending interest and dividends. However, active management will be involved—deciding which assets will be sold each year to provide the cash flow. In addition, the Parkers run the risk that poor results in the stock or bond market will accelerate portfolio depletion.
Yet another approach is to put retirement funds in an immediate annuity, sometimes called an income or a payout annuity. You can give a lump sum to an insurance company and receive monthly income for the rest of your life. Joint annuities are available, so a married couple might get this payout as long as either spouse is alive. Example 3: The Parkers, both age 65, weigh putting all of their $600,000 into a joint annuity. By using an online annuity calculator, they learn that such an annuity might pay them $3,000 a month, or $36,000 a year. If one spouse dies, the survivor will continue to get that $36,000 a year. Now the Parkers will start retirement with $76,000 of income in the first year, with $36,000 from the annuity plus $40,000 from Social Security. The annuity will protect them from running short of money over a long retirement. They won’t have to make decisions about selling securities, and they’ll enjoy some tax benefits because most of their annuity payments will be treated as a tax-free return of principal for many years, if held in a taxable account. On the other hand, annuities typically provide a fixed payment. The $36,000 the Parkers receive in 2015 won’t buy as much in 2025 or 2035, assuming inflation drives prices higher. Depending on the terms of the contract, a joint annuity may not leave anything to their children, even if the Parkers both die in a few years. Buying an annuity today, while interest rates are at historic lows, also will lock in a relatively low return, which might be surpassed by stocks and bonds over the coming decades.
Mix and match
The bottom line is that no method is absolutely better than the others. Some advisors suggest putting some retirement funds into an immediate annuity, for dependable lifetime income, while continuing to manage other assets under a withdrawal plan, such as the 4% rule. Other sources of income also might be considered: an inheritance, selling your home, using a reverse mortgage, even doing some part-time work. By planning ahead you will have a better idea of how much cash you reasonably can expect to receive and where it will come from, so you can set your retirement expectations realistically.