As a TV sports reporter would say, “Let’s go to the videotape!” When the talking is done, it’s always good to look again at the results to find out who won the race, and why.
Unfortunately, most “experts” often watch the wrong race. In the case of your retirement, many advisers will tell you that in this race against time you win when you hit a magic savings number. When we go to the videotape (or in our case an Excel spreadsheet), we realize that isn’t the correct focus. Instead, we should be asking, “Do I have enough income to retire?”
In Part I of this series on asset allocation, we examined the difference between asset allocation (having diversified investments to maximize and protect your assets) and income allocation (having different sources of income that will be reliable and lasting in retirement). And I shared with you my personal income allocation plan as well as the thinking behind it.
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In this part, I will share my ideas about how to build an income allocation strategy. We’ll start with the largest part of your personal balance sheet, and address what you should do with the savings in your rollover IRA and personal investment accounts. In Part III, we’ll quantify the advantages of following this strategy.
What you hear vs. what you need
When working with a financial adviser who concentrates on helping you grow and then spend your savings, you will hear about positive steps to take, such as contributing the maximum to your 401(k), diversifying your investments and seeking low fees. All are good things to do.
Most advisers also talk about asset allocation, probabilities and market averages. They encourage saving but don’t discuss the best ways to convert those savings to steady income. Instead, when advisers give guidance on spending down your savings, they usually mention investing more in fixed income investments (like bonds), and possibly downsizing your budget to make your savings last longer.
With this spend-down strategy, you are taking 100% of the risk, whether from market volatility or from longevity.
Instead, ask your adviser about strategies that incorporate the most obvious “income” vehicle that reduce your risk and your taxes, the income annuity. It’s like a customized pension that you purchase with your own money. Your adviser may not bring it up first. Why? It’s not in their business model. But it should be in yours, as you will see below.
The first word in retirement is income
When I think about retirement planning for Boomers, I have a laser focus on income. This seems like common sense to me, because the universal retirement goals include:
- Maximizing Social Security income
- Minimizing taxes on income
- Allocating a portion of savings to lifetime income
- Reducing or eliminating income volatility
- Generating predictable income to cover essential expenses
- Generating secure income to cover late-in-retirement expenses
The first three steps in income planning
Income allocation has as its goals to both increase the amount of after-tax income (spendable) and to reduce income volatility (dependable). Here are three steps to improve your retirement income:
Step 1: Consider income annuities
Include income annuities as a new asset class in your portfolio. The three main asset classes are equities, or stocks; fixed income, or bonds; and cash equivalents, or money market instruments. It sounds reasonable to add income annuities to that list, considering they are an investment that pays you a monthly income, is guaranteed by an insurance company rated "A" or better, starts at a date you select and continues to you and your spouse for life. I’ve written blogs on the benefits of including income annuities in a retirement portfolio (“Create a plan for pension-like retirement income” and “A strategy for income as Boomers age and taxes loom”).
Step 2: Line up investments with tax treatment of savings
Treat your rollover IRAs differently than your personal (after-tax) savings. The tax treatment of each account is so different that it’s almost negligent if your adviser recommends the same allocation for both. For example, capital gains and dividends are taxed as ordinary income when you make withdrawals from a rollover IRA, yet they receive favorable treatment in your personal savings accounts. In Part III we’ll examine the adoption of very different equity portfolios in the two types of accounts.
Step 3: Have a plan for IRA withdrawals
Manage withdrawals from your rollover IRA savings rather than simply taking the IRS-mandated required minimum distributions. By manage, I mean adopt an investment strategy/withdrawal formula that reduces your risk and integrates with the income annuity cash flow. For example, if you purchase a QLAC providing income at age 85, your rollover IRA withdrawals ought to provide a bridge to the QLAC income. Remember, the IRS is just trying to collect some tax dollars, not creating a retirement plan for you.
Crunch the numbers
With these three pieces of income allocation in place, investors will need to research how much and what type of income annuities should be included, what tactics to employ on the investment side, and how to determine the need for income, both early and late in retirement.
While the numerical analysis will be important, the most important benefit may be an asset that's not recorded on your balance sheet: Peace of mind.
In Part III, we will evaluate one specific tactical approach to implementing the strategy, reporting not only the results of a soon-to-be-released study but also with a look at one investor’s choices that helped maximize retirement income.
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