10 Ways to Generate Retirement Income
Each of these retirement income strategies has benefits and drawbacks. Here's what to consider to help you decide which ones might work for you.
When it comes to retirement planning, income planning is typically the first point of discussion. Can you afford to retire and enjoy the lifestyle you want with the resources you have? What seems like a straightforward question has become anything but.
The reality is that there is no such thing as a perfect investment, product or strategy. You cannot avoid risk. Even the guaranteed lifetime income stream from an insurance company has inflationary risk. If taxes were to go up, the net income you would get from your annuity income, assuming it was funded with pre-tax dollars, would go down. Those are two risks among many others that are associated with that one strategy. The point here is we are all subject to risk in one way or another.
In an attempt to bring balance to the retirement income conversation, I want to share 10 common income strategies you can consider when putting together your retirement plan.
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You do not need to go all in on one or two strategies. In many situations, it makes sense to blend multiple strategies. Just like you would diversify a portfolio to help lower your risk, you may want to consider diversifying your income strategies to help lower risks associated with your desired quality of life in retirement.
1. The encore career
If we define retirement as the ability to spend your time how you want, then you may consider taking a full-time or part-time job in retirement that gives you purpose. Instead of working for money, consider working for the cause.
Mike is the author of the book How to Retire on Time, creator of the Functional Wealth Protocol and the founder of Kedrec, which specializes in comprehensive wealth planning and management. He creates retirement plans designed to last longer than you™, without annuitized income streams or stock/bond portfolios. Mike is also a national coach to other financial advisers and frequently contributes to nationally recognized publications.
Benefits: Twenty-eight percent of retirees report they feel depressed. Whether you need the money or not, the encore career, also called a second act, may be able to help you emotionally transition into retirement. For those who may not have enough savings to retire, the encore career may be able to bridge the gap so you can spend your time doing work you enjoy.
Drawback: You’re working in retirement when you might prefer to relax, travel and spend more time with family, friends and hobbies.
2. Social Security benefits
Social Security is not intended to take care of all your needs in retirement. It is important to understand that when you file will affect more than just your income. It can also affect your taxes and estate. (For more about this, read my article Social Security Optimization If You Save More Than $250,000.)
Benefit: Social Security supplements your retirement savings. You can collect it if you’ve worked and paid Social Security taxes for at least 10 years (specifically, if you have earned at least 40 credits).
Drawbacks: Generally speaking, if you file for your benefit too early, your overall income could be hurting. However, if you file too late, you could hurt your overall estate.
Social Security optimization, in my opinion, should be treated as a holistic, or comprehensive, conversation and not an isolated strategy to try to get the most money back. You don’t want to jump over dimes to pick up pennies.
3. Pension
Pensions may be one of the lowest-risk retirement income strategies on this list, which is why many people who are offered a pension take it. However, a pension does have a few detriments. Since a pension is taxed as income, if taxes go up, your net-of-tax pension income would go down. Also, if inflation goes up, your pension may become less valuable over time.
Benefits: If you want a simple income strategy and are offered a pension, then taking the lifetime income may be right for you. If taxes or inflation are a concern, you may consider taking the lump-sum option, assuming it is being offered. The lump-sum option would allow you to be more proactive with your tax planning (e.g., IRA to Roth conversions, etc.). You would also have more control over your legacy intentions. The financial freedom the lump sum offers requires additional risk and responsibility.
Drawbacks: Those who take the pension option have tax and inflationary risks. Those who take the lump-sum option are subject to market risk, sequence of returns risk and more. Are you comfortable inheriting the additional responsibility and risks? (More about sequence of returns risk in No. 6 below.)
4. Lifetime income from annuities
The best definition I can give of an annuity, when used as a source of lifetime income, is the transference of longevity risk to an insurance company. If you live long enough, it may be financially worth it. However, the numbers are on the side of the insurance company. An annuity is not an investment. It is an insurance product. The annuity income stream is not intended to make you more wealthy.
Benefit: If you are more concerned about outliving your money and less concerned about your legacy planning, inflation risk and liquidity in case of expensive life events, annuities may be for you.
Drawback: If you are more concerned about maintaining flexibility while growing your assets, the annuity income strategy may not be right for you.
5. Real estate income
The three most common real estate investments I see are:
- Self-managed investment real estate
- Privately traded real estate investment trusts (REITs)
- Delaware statutory trusts (DSTs)
Publicly traded REITs don’t work for this group because they are structured and behave more like a mutual fund than a pure real estate investment, in my opinion.
Benefit: These three real estate investment options have the ability to offer cash flow while they can appreciate in value.
Drawback: It can be hard to sell a property, making liquidity a problem. Privately traded REITs can be redeemed only a few times a year, depending on the REIT, and even then, it may not go through. DSTs are illiquid, typically, for about six to 10 years.
6. The 4% rule
The 4% rule suggests that you can take about 4% from your portfolio each year and you should be fine. It is based on the idea that you can focus your portfolio on long-term growth and take the income you need from the growth.
Benefits: The 4% rule provides high growth potential overall and great flexibility. If you are focused on growing your wealth for legacy purposes, this may be for you.
Drawback: Sequence of returns risk is an issue. Basically, if you were to take income from your accounts during a time when they had lost money, you would amplify the loss, making it more difficult to recover. This is called sequence of returns risk. (For more about sequence of returns risk, read my article Many Retirees Don’t Know About This Major Market Risk: Do You?)
7. Dividends
The dividend portfolio is a traditional retirement income method that suggests you purchase positions that historically have offered competitive and consistent dividends. In this strategy, you hope to maintain the principal while living off of the dividends whenever they come in.
Benefits: The dividend strategy includes the potential growth of the position while it pays dividends. Also, when you pass, your positions could get a step-up in basis, potentially making your legacy planning more tax efficient. Lastly, if you put in enough time and research, you could probably put together a competitive dividend portfolio on your own and save yourself advisory fees.
Drawback: Dividends are not guaranteed. For example, during the COVID-19 pandemic, many companies known for dividends temporarily stopped paying them. That can put a lot of pressure on a retiree whose income strategy relies on dividends.
8. Option contracts
Selling option contracts (covered calls) can be an effective strategy to generate income in retirement, especially when markets are not moving.
Benefits: Selling calls against stocks you already own may help to provide income in retirement income while maintaining your overall portfolio positions.
Drawbacks: If the market moves too much in a certain direction, you could be forced to relinquish your shares and miss out on some of the growth potential. If you do not have experience in trading options, you may want to steer clear of this strategy altogether. I am writing about it here to acknowledge it, not to suggest it.
9. Limited partnerships
Limited partnerships can be an effective way to generate passive income in retirement if given the opportunity, and it makes sense from a risk/potential reward standpoint.
Benefit: Investing in a limited partnership makes you part-owner of a business venture without having to take on the day-to-day responsibilities of managing it.
Drawback: Be mindful of the health of the company/partnership and the risks you are taking before you invest.
10. The reservoir
I teach “the reservoir strategy” in my book, How to Retire on Time. This strategy is intended to complement any of the strategies listed above. Just like a city has a reservoir of water in case of a drought, I believe that any retirement portfolio should have a “reservoir” of assets that have growth potential and principal protection. That way, if the markets go down, dividends dry up or something else happens, you can keep income coming in without amplifying losses.
There are seven investments or products that I have found work well with this strategy: CDs, treasuries, fixed annuities, fixed indexed annuities, indexed universal life insurance, buffered ETFs with a 100% buffer and principal-protected (structured) notes. They each have their place within the reservoir strategy. When implemented correctly, you would typically see a blend of these products based on your liquidity needs and overall retirement plan.
Benefit: You may be able to focus more of your overall portfolio on long-term growth. When implemented correctly, you should be able to maintain your income, even when markets are down, without accentuating your losses. Basically, the reservoir can help you hedge against market crashes and flat-market cycles.
Drawback: In order to get growth and protection in any investment or product, you’ll have to give up liquidity for a certain period of time. Make sure you always maintain enough liquidity so you can keep your income coming in regardless of market conditions.
Conclusion
It can be tough to try to figure out which strategies are right for you. If you talk with someone who is licensed only in insurance, chances are they will make the annuity sound like it is the best solution. If you talk with someone licensed only in securities, you may get a biased guide trying to persuade you to follow the 4% rule or something similar.
Instead of getting “sold” a product or portfolio, consider taking the following steps:
- Put together your lifestyle and legacy plan. Find a way to articulate what you want before anything else.
- Consider all the potential pitfalls and inefficiencies you may be facing. You may want to take time earmarking certain tax minimization or other strategies focused on efficiencies that may be able to help you get more out of your hard-earned money.
- Design a portfolio that supports your lifestyle and legacy goals and is able to implement a blend of the income strategies discussed above.
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