One of the more difficult items to explain to retirees is how their paycheck will be created in retirement. Your entire adult life, and sometimes childhood, is spent working, spending, and saving ideally for life and retirement. However, many retirees have a difficult time conceptualizing how their income will actually come together. While there are many options to create income for retirees in retirement, here are a few of the strategies we have come across that individuals imagine or actually utilize.
Client Example: Individual person retiring at age 65 with $500,000 in an IRA, invested evenly with stocks and bonds. He or she has Social Security and Medicare but no other savings. For planning purposes, we are assuming the age of death is 90.
Option 1: Cash and Life Expectancy
The most simple way to create income in retirement is to simply convert savings at retirement into cash. In the example of our client retiring at 65 with $500,000 in an IRA, when he or she retires, they would sell all their investment holdings in the IRA and have their cash in the account. Assuming they live to age 90 means the money needs to be spread out over 25 years, which results in $20,000 of distributions per year for 25 years ($20,000 x 25 years = $500,000). The positive in this plan is the simplicity. All investment future returns have been removed resulting in knowing exactly how much income there will be from age 65 to age 90. However, this approach completely ignores how expenses tend to rise over time and the income received early on will not likely “go as far” in the future and could stress budgets in the later years of retirement. It also introduces the risk of ‘outliving your money” in a substantial way.
Option 2: Spend the “Interest”
The most common thoughts we hear from individuals planning for retirement is that they will “live off of the interest” of their portfolio in retirement. This may or may not actually work, and here’s why. First, you have to define what is principal and what is interest. For most individuals, they consider principal the value of the account when they retire, and interest to be the income stream from the portfolio from dividends and interest payments. The next step in this process is to decide how a client is invested and receives their interest income. For that, we’ll divide the option 2 out to 2A and 2B.
In 2A, the client above rebalances his or her portfolio from a 50% stock and bond mix to 100% bonds, represented by the security AGG (US Aggregate Bond Index Fund). AGG currently has a 30-day yield of 4.40% as of October 31, 2024. Hypothetically for this example, if that yield remained steady (in reality it can fluctuate for different reasons) a $500,000 portfolio could yield $22,000 annually. Here we can see the annual distributions would be more than Option 1 above, however, it does not guarantee the income stream. Yields could rise or fall. However, by only touching the income portion the principal value of the account can fluctuate somewhat.
In 2B, the client above keeps their 50% mix of stocks and bonds. If we assume AGG for bonds still and utilize VTI (the Vanguard Total Stock Market Index) for stocks, we would have annual income of about $14,500 per year. VTI has a 30-day yield of 1.22% as of October 31, 2024, and a weighted average yield of the portfolio would be about 2.81%, resulting in the $14,500 income stream. Compared to both option 1 and 2A, this provides less in terms of income. However, the principal balance could grow as the stock portion of the portfolio remains intact. Conversely, the principal balance could fluctuate more in volatile markets meaning not only will you have a lower income stream, but also more of your principal balance is at risk.
Option 3: Utilize a % Based Withdrawal Strategy
One of the most common ways a client creates income from their portfolio in retirement is to commit to withdrawing a certain percentage of the portfolio annually. Generally, a withdrawal rate of between 4-5% is considered normal, while below 4% is optimal for longevity of the portfolio, and a rate above 5% can become problematic. The reason behind this has to do with the return of the overall portfolio. If we use our client example of a 50% stock and bond portfolio of $500,000 we already know the income could be around 2.81%. If you chose a withdrawal rate of 5%, 2.81% would come from income and the remainder would need to come from capital appreciation or about 2.19%. As withdrawal rates increase, you can see that markets need to perform better, more consistently to maintain that withdrawal rate. Inevitably, when a downturn does occur, an unhealthy withdrawal rate could ravage the portfolio. However, Option 3, if managed correctly, could provide a higher annual distribution than other options and allow assets to grow in retirement protecting from a rising cost of living and reduce the risk of outliving your wealth.
In reality, there is not one strategy that is best for everyone. In our illustrations today, it’s important to note we didn’t discuss the impact of fees or taxes on the portfolio. We also didn’t attempt to match possible income streams to what actual expenses might be for each client. Additionally, some individuals prefer a dynamic withdrawal strategy that incorporates different amounts over different time frames to account for different stages in life. This is just an attempt to explain how portfolio income can be built. Even then, it’s not an exhaustive list. Annuities could play a role in the right situation for a client. The reality is that each individual or family’s income strategy in retirement is likely different and should be customized for their needs and wants.