Planning for retirement can never begin too soon, but whether you are 25 or 65, basic principles apply that should guide your decision-making.
The goal for investors should be this: Generate enough consistent and sustainable retirement income to cover basic living expenses after paying any federal, state or local taxes and allowing for any gifting for estate or charitable purposes.
How do you do that? Start by making sure you understand the language of investment and the meaning of retirement.
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For our purposes, “retirement” is the start of the period when the money you earn from a job (household salaries, wages and bonuses, etc.) does not cover basic living expenses. One or both spouses might be working still full- or part-time, but for most investors, the way you manage your finances changes when a gap between earned income and expenses first appears.
So what’s “retirement income”? It’s income that’s required to fill the gap now and in the future. The most basic definition of income is an amount received by the individual without any other financial effect. It is clearly different from withdrawals of principal, which have the potential to run out someday.
Let me give you my list of the different types of retirement income generated from your savings and investments, exclusive of salary, wages and bonuses from employment. This latter form of income depends on your interest in and willingness to work, plus your continued good health.
Guaranteed and Lifetime Income
Here are three sources of retirement income that are (1) not dependent on market performance, (2) personal management or effort, and (3) won’t change in the future simply because you receive them. Payouts may either be fixed or, in some cases, adjusted to increase based on the consumer price index.
- Social Security Payments — Since it is lifetime income that is adjusted for inflation, Social Security is the best source of income. Certain reforms of the system may be required to maintain the current level of benefits, though. Possible reforms might be in extending the normal retirement age or changing the formula for inflation adjustment, both of which might result in a small reduction in payouts.
- Pension Plan Payments — Typically they are lifetime, but only a few provide inflation protection. Corporate pensions are supported by the Pension Benefit Guarantee Corp., however there are limits. The PBGC caps the amount it guarantees, releasing its figures for 2018 in October. Government pensions, of course, are guaranteed by the government, but because government financial stability has ups and downs, these pensions require continuous monitoring and review of political decisions that might affect payments.
- Income Annuity Payments — Unlike Social Security and pension plans, an individual can customize the form of annuity. While some may be paid for a temporary period, most are paid for the lifetime of the recipient. Relatively few individuals elect inflation protection. Income annuities are supported by insurance company reserves. In addition, they are protected by state guarantee funds.
Investment-Driven Income
Some sources of retirement income that retirees typically count on depend on market performance and, therefore, payments will fluctuate.
- Interest Payments on Bonds and Savings Accounts — Interest rates may fluctuate and cause these payments to rise and fall. In today’s low-interest rate market, you need a lot of savings to generate any serious amount of income. For example, in order to generate an annual income of $20,000, at today’s bond rates a person would have to have a nest egg of about $500,000 – even more if the bonds are U.S. Treasuries or municipal bonds. The values of these bonds may fluctuate, but except in the rare case of default, they will be worth their face amount if held to maturity.
- Dividends on a Portfolio of Stocks — The amount of your payments will be affected by the dividend payout rates set by the corporations that issue the stock. Also, the value of the stocks in your portfolio will fluctuate.
- Income on Rental Property — This income can be highly variable unless the portfolio is widely diversified. If you own only a couple of units and your tenants move out, you are left without income and probably will face maintenance costs.
Withdrawals Often Get Lumped in with Retirement Income
Here is a list of withdrawals, often mischaracterized as retirement income, that decrease the amount of money available to you in the future. Market performance also will affect your potential for future withdrawals. Importantly, retirement income is paid to you, while withdrawals typically need to be requested by you.
- Distributions from 401(k), Rollover IRA — Any amounts you withdraw will impact future distributions, just as market performance will.
- Withdrawals from Other Investment Accounts — Any amounts you withdraw will affect future distributions, just as will market performance, no matter what the withdrawal formula.
- Withdrawals from Fixed, Indexed and Variable Annuities — Any amounts you withdraw may affect future distributions. Make sure you understand what any Living Benefit Guarantee provides.
As you can see, you have plenty of options when planning for retirement, but understanding the differences between income and withdrawals is essential. I have been advising people that guaranteed and lifetime income should be part of every retirement portfolio. Income annuities can provide a safety net of income for life, customizable to your personal circumstance and independent of the vagaries of markets and politicians.
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