By Scott M. Peterson, Guest Writer
The goal of this guest post is to introduce to you, and outline for you, a common sense way to manage your money during retirement. I will introduce a retirement income plan that few of you have seen before, but after you read this blog, you will be asking yourself, “Why doesn’t everybody manage their retirement income in this manner?” Before we jump into the creation of a retirement income plan, let me explain to you the retirement income challenge.
The Retirement Income Challenge
Most of us sacrifice and save for four decades in preparation for what we hope will be a comfortable retirement. We are laser-focused during our working years in accumulating as much as possible, and by the time we retire, many of us have refined the art of wealth accumulation in our IRAs, 401(k)s, and a variety of other investment accounts. We feel pretty confident in our retirement preparation, and then something happens that shatters our confidence . . . we retire. We quickly come to the realization that successfully investing and managing the distribution part of retirement takes a completely different skill set than accumulating money in retirement accounts.
I liken the accumulation and distribution of retirement funds to what a new skier experiences at a ski resort. Riding the chairlift up the mountain is the easy part of skiing. It takes no skill, and even the most inexperienced skier can ride the lift without difficulty. If skiers simply stay on the lift, they will eventually get to the top of the mountain.
In a like manner, the accumulation process is the easy part of preparing for retirement. Deposits are put on autopilot as pre-determined percentages of income, and matching contributions by employers are systematically deposited into pre-arranged investment portfolios.
Getting safely down the mountain can be extremely frustrating—and even dangerous—to the novice skier. Newbie skiers learn, within the first seconds of leaving the security of the ski lift, that descending the mountain has little in common with ascending the mountain and relying upon the security of the ski lift. So it is with the transition from accumulating to the distribution of retirement savings accounts. It takes a unique skill set to successfully manage money in retirement, and few people (including financial advisors) have developed the experience and skills necessary to successfully navigate this part of life.
There are a lot of questions that need to be answered as we retire and start distributing, questions that we never had to even think about while in the accumulation phase. Besides the universal question of how to invest in retirement, there are questions regarding distributions, taxes, risk, and keeping our income up with inflation that will all have to be addressed. All these questions bleed into the single, overarching question that every retiree needs to figure out:
How am I going to create an inflation-adjusted stream of income from my investments that will last for the rest of my life?
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The Need for a Retirement Plan
It is a monumental challenge to transition a career’s worth of accumulations into a stream of inflation-adjusted income that will last through retirement. There are so many variables to consider, and every retiree’s situation is unique. There is so much on the line, and mistakes made at the beginning of retirement are not forgiving. There are no do-overs.
The quality of the next 30 years of your life is dependent on the decisions that you make at retirement and the plan you put in place. A well-thought-out plan will provide discipline, order, safety, and peace of mind. A sound retirement income plan will allow you to focus on your retirement dreams and not to be obsessed with the daily movement of markets, interest rates, or how current events will impact your retirement.
A retirement income plan should be unique to you and your specific needs. Copying your retired neighbor’s retirement income plan won’t work. Following some generic “rule of thumb” withdrawal advice from your financial advisor won’t get it done. Buying an annuity that will never keep up with inflation over a long retirement will only serve to crush your future purchasing power. And finally, decades of investing have already taught you the futility of market timing and betting your future on guessing the direction of the stock market.
Now that I have shot down all the popular attempts to create retirement income streams and before I show you how a professional retirement income plan is created, let’s address what we need a retirement income plan to do.
A successful retirement income plan must address five objectives:
- It must be goal-specific
- It must create a framework for investing
- It must create a framework for distributing
- It must create a framework to reduce risk
- It must create a framework for reducing taxes
Goal-Specific Retirement Plan
A retirement income plan that is goal-driven provides detailed objectives. It is a date-specific, dollar-specific blueprint that will guide you throughout retirement. A date-specific, dollar-specific plan defines exactly how much income will be needed during retirement and when it will be needed. Its objective is to deliver future income to the retiree with the least amount of risk after all risks have been considered. A properly structured retirement income plan matches your current investment strategy with your future income needs. Like any goal-driven program, the performance toward reaching the goal must be monitored to maintain discipline and to allow for adjustments if the goal is to be realized.
Create a Framework for Investing During Retirement
Retirees have to find the proper investment mix of both low-volatility fixed-income investments and higher-yielding, more volatile equities.
Fixed-income investments, such as bank deposits and certain types of bonds, can provide a haven to draw income from when the stock market takes its occasional dive. As valuable as these types of investments can be in the short term, they are a long-term liability that will never keep up with inflation.
On the flip side, retirees need to own some equities in their portfolios. Owning equities is a logical way to keep ahead of inflation over the long run. But we all know that short-term volatility and unpredictability afflict all who own equities. Creating a retirement income plan that takes advantage of the opposing nature of fixed-income and equities is an essential component in creating a long-lasting retirement income plan.
Why wouldn’t we invest the money we’ll need in the short term into fixed-income type investments and invest the money we don’t think we will need for a while into stock-related investments?
This isn’t rocket science here, folks. Of course, that’s how we should invest; it’s just common sense. But most retirees and their advisors don’t invest this way. Unfortunately, the failed practices of chasing last year’s returns and making investment decisions based on guessing the future direction of the stock market continue to be the prevalent methods used to determine investment allocations, even though these methods have proven to be extremely unreliable.
Following a plan that allocates retirement savings by determining short vs. long-term income needs liberates the retiree from having to time the markets or outperform the stock market average by superior investment selection. With a date-specific, dollar-specific investment plan that matches current investments with future income needs, the retiree only needs to concentrate on maintaining the discipline to follow the plan.
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Create a Framework for Distributing Income During Retirement
When it comes to withdrawals from investments at retirement, I have noticed two types of personalities. The first trait is manifested in individuals I will call the “entitled spenders” who think to themselves, “I have been saving all my life for retirement, and I am now retired, so I am going to spend whatever I want.” The second type I will call the “paranoid savers.” These people are those who think, “I may have a lot of money, but it has to last a long time. And who knows what the future might bring?” These types of individuals are often afraid of spending any of their retirement funds at all.
Spenders ruin their own retirement by spending too much too early, and they run out of money. The savers harm their retirement by living below their privilege by denying themselves many of the simple pleasures and opportunities of retirement. Both the spenders and the savers would greatly benefit from the same date-specific, dollar-specific retirement income plan, a plan that outlines how much money can and should be withdrawn from investment accounts and when.
The question is, “How much can/should I withdraw from my investments each year?” You must answer this question if you’re going to have a sustainable income stream throughout retirement and if you’re going to enjoy your retirement experience to the fullest.
A sustainable withdrawal rate can be created by determining the answers to three important questions:
- How much income will I need to pull from my investments to sustain my retirement lifestyle?
- When will retirement savings need to be converted into retirement income?
- How should retirement accounts be invested until they are needed to be converted into income?
Again, having a retirement income plan that includes date-and-dollar specifics should drive your withdrawal decisions. Adjustments in either the timing of withdrawals, the withdrawal amounts, or how retirement funds are invested between now and the future income date will impact your future income stream.
Create a Framework to Reduce Risk
A viable retirement income plan must recognize and minimize risks where possible. Retirees are particularly susceptible to three kinds of risks:
- Inflation risk
- Stock market risk
- Behavioral risk
The retirement income plan I will lay out for you will help you to decrease risk during retirement in all three of these areas.
When it comes to inflation, you must ask yourself the following: “How do I invest to maintain my purchasing power and stay ahead of inflation but not lose money during stock market downturns?”
Inflation is the gradual but lethal loss of purchasing power. We are going through a period of high inflation currently, but historically, the long-term inflation rate has averaged 3%. At just a 3% inflation rate, $1 will only purchase 41 cents worth of goods and services at the end of a 30-year retirement. Unless you are willing to reduce your lifestyle and spending habits by about 60% during your retirement, inflation must be dealt with. Fortunately, the risk of inflation can be mitigated by how we invest—through inflation-beating equities. The retirement income plan I will show you helps by deliberately designating a portion of a portfolio toward long-term inflation protection.
Stock Market Risk
How do I maintain investment discipline throughout retirement and not make major mistakes during periods of market volatility? Market corrections are part of the investment cycle, and you should plan for them. Successful investors follow plans and are patient, while unsuccessful investors follow the breaking news and daily movements of the stock market and are prone to panic. Informed investors manage stock market risk by being diversified and patient because they know every market decline is followed by an eventual new record stock market high. Having a plan in place is the antidote to panic. Knowing what you own and why you own it goes a long way toward helping you stay the course during periods of market turbulence.
Two related questions come to mind when considering the behavioral aspects of a retirement income plan:
- How do I protect myself from my older self when my financial judgment is clouded by age?
- How do I provide the less financially savvy spouse with a plan to follow that will provide for their financial needs after my death?
Retirement is not a time for investment experimentation. It’s not a time to be tossed about by every headline on the nightly news or by every story on the internet. It isn’t a time to change your investments based on irrational exuberance or equally irrational fear. A goal-specific income plan goes a long way toward helping to navigate the emotional rollercoaster of investment management now and as you age, and it can be a valuable tool to provide guidance to a spouse upon your death. A date-specific, dollar-specific retirement income plan helps protect your future from perhaps its greatest threat: you.
Create a Framework for Reducing Taxes During Retirement
From which accounts—or combination of accounts—should I withdraw retirement income to give myself the most tax-efficient income stream? Should I withdraw from my IRA, my Roth IRA, or my non-retirement accounts? How do I go about managing my Required Minimum Distributions?
Tax-saving opportunities rarely happen by accident. Rather, they come about through careful planning. This is especially true with retirees. Keeping retirees in lower tax brackets throughout retirement can be done by managing withdrawals from pre-tax vs. after-tax investment accounts. In other words, the retiree can take income from IRA accounts until they reach the top of a tax bracket and then take the balance of their needed income for the year from an after-tax account. This is an easy concept to visualize but a little more difficult to implement. What adds to the complexity is that implementing this plan has to integrate with the framework for investing and the framework for distribution sections that I just mentioned. At this point, it might sound daunting to bring all of this together. As we create the income plan in the next section, you will see how all these components can integrate with each other.
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Retirement Income Plan Creation Example
Now that I have explained the retirement income challenge and what your retirement income plan must address, let’s now create a plan where a family matches their current investments with their future income needs. The plan we will build will be goal-based and will include date-specific, dollar-specific details to guide the retiree. Our plan will create the frameworks for investing, distributing, reducing risk, and reducing taxation.
Allow me to introduce the Lee family, for whom we will build a retirement income plan. Tony and Kathy Lee are both 67 and are ready to retire. They have accumulated $1 million in their 401(k) and their after-tax brokerage accounts. They want to know how they should invest the million dollars and how much income they should expect to receive from that sum of money. They feel a retirement income plan spanning 25 years should be sufficient, and they would like to pass the full $1 million to their children upon their deaths, if possible.
When it comes to making investment decisions, the most important consideration is an investment’s time horizon. In other words, how long will the money be invested? We are going to match the Lee’s current investment portfolio with their future income needs by dividing their money into various investments that have different objectives based upon when a particular segment of their money will be called upon to provide future income. Therefore, we will divide the $1 million they have accumulated for retirement into six different accounts.
The first five of these accounts are responsible for creating retirement income for five different five-year periods of the Lee family’s retirement. I will refer to the accounts that cover the five-year period of income as segments. Segment 1 is responsible for providing the income for the first five years of retirement, Segment 2 for years 6-10 of retirement, Segment 3 for years 11-15 of retirement, and so on until 25 years of retirement are covered.
The sixth segment, or Legacy Segment, is designed to create a fund that will replace the original investment of $1 million to the Lee family at the end of 25 years. This provides money for their heirs, or it can serve as an insurance policy should they live longer than 25 years or experience large end-of-life expenses, like nursing home costs. The accompanying chart shows the retirement income plan being built for the Lee family. I will walk you through it to make sure it all makes sense.
Retirement Income Plan Walk-Through
The money that the Lees are depending on to provide income in the short term is invested in conservative investments that provide safety from volatile markets. The money that won’t be needed to create income for a prolonged period is invested into more aggressive investments that keep up with inflation. This is the underlying principle that guides the investment decisions of a time-segmented retirement income plan. Segment 1 will provide income for the first five years of retirement. It will be invested into a conservative account that will systematically distribute $4,329 monthly to the Lee’s checking account.
Segment 1’s primary responsibility is the safety of principal because it’s sending out a monthly payment immediately; so, this segment is the most conservatively invested. We assume only a 1% rate of return on the money invested in Segment 1. In today’s environment, retirees certainly can, and should, expect a higher return than 1% on their conservative money. We also expect to outperform the conservative assumptions for the other segments as well. By choosing to underestimate performance, we avoid creating a false sense of security and unrealistic income expectations. Obviously, if this retirement income plan works with the conservative assumptions we are using, it will work even better if investment performance exceeds these assumptions.
Segment 2 will take over the role of providing monthly income to the Lees once Segment 1 runs out of money at the end of the fifth year. Since the money from Segment 2 will not be needed for at least five years, it can be more aggressively invested than Segment 1. But it can’t be significantly more aggressive. A prolonged bear market could last longer than five years, so the bulk of this money should also avoid volatile investments. That’s why only a 3% return is assumed during the five years it’s invested before being turned into income in year 6.
Segment 3 will be invested for 10 years before it will be called upon to create income for years 11-15. Because the money in this segment won’t be used for 10 years, Segment 3 is moderately invested in a 50% stock/50% bond portfolio. A conservative 5% return is assumed for this segment.
You can see from the chart that Segments 4 and 5 and the Legacy Segment assume higher rates of returns because these segments are more aggressively invested. Investments that will not be needed for 15 years and beyond must invest in a diversified portfolio of equities to keep up with inflation. History has shown us that, in the long run, equities have always beaten inflation and have given us superior returns. It’s understood these inflation-fighting segments will experience occasional bouts of volatility that the stock market imposes with regularity. But given the long-term nature of these segments, short-term volatility is inconsequential. The key to making the stock market work for you is to follow the time-segmentation plan, maintain discipline, and stay invested during periods of volatility.
At first glance, this retirement income plan appears to become more aggressively invested as the retiree ages and gets into the latter segments of the plan. Having 80-year-old retirees with all their money invested in long-term, aggressive equity portfolios doesn’t make any sense. Fortunately, this is not how this retirement income plan works when the income model is properly managed and “harvested.” In financial terms, the process of harvesting is transferring riskier, more volatile investments into a conservative and less volatile portfolio once the target or goal of each segment is realized. The target or growth goal of each segment is the number found in the dark green box associated with each segment.
For an example of harvesting, let’s look at Segment 4, where the initial investment is $127,476. We know that if this initial investment grows by the assumed growth rate of 7%, it will reach its target amount by the projected 15th year. Segment 4 is invested in a moderate growth portfolio (70% stocks, 30% bonds). According to a study done by Vanguard, the historical return of a moderate growth portfolio has averaged an annualized return of 9.4% since 1926. It would be plausible that if history simply repeated itself, the investment portfolio in Segment 4 would reach its goal of $363,172 before year 15 (at a 9% growth rate, the segment reaches its target in 12 years). Once the target is reached, no matter what year that happens, the investment needs to be harvested and preserved. That means the equities in the segment that have reached their target goal must be moved into more stable and conservative investments.
The key to successful outcomes is to begin with conservative growth assumptions and then maintain the discipline to harvest portfolios in the segments when they reach their targets. I recommend using conservative growth assumptions within the retirement income plan in hopes that the target for each segment is reached prior to the date it’s needed to provide income.
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5 Insights to Point Out
- Notice the account balance stays roughly the same throughout retirement (see the far-right column of the chart). People often assume that, as segments are liquidated, the overall portfolio balance is going down. But that’s not the case. Recall that as the early segments are being liquidated, the later segments are invested and growing.
- Notice that the retirement income plan is projected to automatically increase the Lee’s income every fifth year by an annualized 2.6% rate to help offset the effects of inflation.
- For tax-planning purposes, projected Social Security, pension, and other sources of taxable income should be incorporated into the retirement income stream projections. Once the income stream is created by adding all sources of income, thoughtful consideration should be made to determine which type of account (IRA, Roth IRA, or after-tax account) should be located into the various segments for maximum tax efficiency.
- Assumed growth rates are purposefully overly conservative. Historically, the S&P 500 has averaged more than 10%, and the largest assumed growth rate used in the most aggressive segment is only 8%. If you feel that these assumed growth rates are not realistic, you can always adjust the income plan to run at lower or higher growth assumptions.
- Please look at the bottom line of the chart. Based upon these conservative assumptions, the Lee family will receive $1,674,433 of income during their 25-year retirement and leave $1 million to their heirs.
I end with the question that all new retirees and those approaching retirement need to ask themselves: “Will I outlive my money, or will my money outlive me?” Without knowing anything about your finances, I can tell you that you will be much more likely to have your money outlast you if you follow a plan. Your retirement income plan should be goal-based and should serve as a guide to your financial decision-making for the rest of your life. It should drive your investments and withdrawals and even influence your spending and gifting decisions.
Organizing and then carefully following this retirement income plan appeals to those seeking a logical, goal-based roadmap for investment management during retirement. The economy and stock market will continue to have ups and downs, but for those with a plan, short-term events and what the stock market is doing day-to-day become irrelevant.
The objective of this retirement income plan is to reduce the retirees’ need to be anchored to the daily movements of the stock market which, in turn, will make them less susceptible to making the irrecoverable investment mistakes that so many retirees make.
Retirees that follow this retirement income plan understand why they are invested, when they will need a specific portion of their investments to provide future income, how much they can safely withdraw, and how their dollars will need to be invested to accomplish their goals. They will also realize a greater discipline, a safer and more tax-friendly way to navigate retirement. This retirement income plan is designed to provide a secure stream of income in the short term while providing an inflation-adjusted stream of income for the retiree’s future.
Hopefully, you can now see that there is so much more to planning retirement income streams than buying an annuity—and more to consider than following generic and overly simplistic rule-of-thumb guidelines to manage your finances during retirement. My hope is that I have opened your eyes to a better way to invest during retirement and that you can incorporate some of these ideas so you might face your financial future with confidence and have the peace of mind to free you to pursue your retirement dreams.
Are there any changes you would make to the Lee’s retirement plan? Have you come up with your plan for spending in retirement? Comment below!
[Editor’s Note: As a pioneer in retirement income planning, Scott M. Peterson, ChFC®, is the founder of Peterson Wealth Advisors where he helps retirees nationwide achieve retirement success. This article was submitted and approved according to our Guest Post Policy. We have no financial relationship.]