Although we approach retirement with great expectations, one of the scariest days of a person’s life is the day they retire. This is the day when your paycheck stops. Imagine reaching into your purse or back pocket for your wallet, only to find it’s not there. How will you pay your bills now that you’re retired? What’s the best way to use your assets to produce an income stream that you won’t outlive?
Mom & Dad’s Retirement Plan – The Good Old Days
For the generation of people living in retirement before 2000, the typical retirement plan included a healthy dose of CDs and bonds which were used to generate needed income to cover basic living expenses. This was made possible by the relatively high interest rates these securities paid at the time.
Example: Client with $1,000,000 in assets needed $30,000 of income to supplement their other income sources. Bonds and CDs were yielding 6% (the good old days) at the time. The client could invest $500,000 in CDs or bonds to generate $30,000/year of income and invest the remaining assets for growth. The income portion of their portfolio never dwindled, assuming their were no bonds that defaulted.
In addition, many people working through the 1970’s and 1980’s worked for companies with traditional pension plans that would provide a monthly income stream at retirement that would last until you died. When pension income was combined with Social Security benefits and income from CDs, the older generation had very stable retirement income sources. The strong income sources allowed them to live and spend with confidence.
Current Situation – What’s Changed?
Interest rates have plummeted since the early 1980’s and have reached all-time lows in the last few years. That same $500,000 investment in CDs now generates approximately $5,000 of income; and the purchasing power of those dollars is far less than it was over 20 years ago.
Pension plans were not adopted by many of the new companies that started in the 1990’s and beyond. The old line companies that offered pension plans in the past began phasing them out. As a result, very few workers today have a guaranteed income source like their parents.
The purchasing power of Social Security benefits has been reduced over the years as incomes have risen faster and higher than the income limit used to calculate benefits. In addition, the inflation adjustment made each year for those receiving benefits has been kept artificially low as the government strives to keep the program solvent.
Healthcare costs as a percentage of retirement spending has risen exponentially and now encompasses a much greater wallet share relative to the older generations.
Retirement Income Planning in the 21st Century
Although our need for income hasn’t changed, the strategies we employ today must be different. The new income generating strategies focus less on guaranteed income sources and more on variable investments like equities. Rather than putting 50% or 100% of our assets in bonds or CDs in the hopes of generating needed income, we are incentivized to do the opposite.
The new Growth & Income approach secures a few years of your basic living expenses in conservative investments while it invests the majority of your assets in equities. As you need funds each month to pay your bills, we look into the portfolio and harvest portions of the securities that are doing well. If the equity securities are doing poorly at a given point of time, we then harvest portions of the conservative bond investments to provide your needed income. To implement this strategy effectively, careful attention must be paid to re-balance your portfolio from time to time. This ensures one asset class doesn’t grow or shrink too quickly relative to other aspects of your account.
Logistics: Assets to Income
From a logistic standpoint, we create a link between your investment accounts and your bank accounts. Each month we facilitate an automatic deposit into the bank account to pay your bills. We call this a ‘synthetic paycheck,’ as the deposit looks and feels like your typical paycheck from your an employer. This monthly payment has the second benefit of helping you live within your budget, although there is almost always more liquidity available within your portfolio if you have unexpectedly high expenses in a given month(s).
Although the retirement plan for the older generation seems better, it was relatively inflexible from a tax perspective. The guaranteed income sources came in each year and provided little flexibility if you wanted to deploy tax savings strategies.
The new era income replacement plan is far more flexible if done correctly. It’s not uncommon for clients to have different types of accounts, such as brokerage (taxable) assets, 401k and IRA (tax deferred) assets and roth IRA (tax free) assets. In this situation, we’re able to pick and choose which accounts to withdraw from based on your specific tax situation. In addition, 401ks and IRAs produce required minimum distributions (RMDs) at age 70 ½, which results in higher taxable income, and must be planned for. If left unattended, IRA and 401k RMDs can create an unpleasant tax surprise later in retirement.
Householding – Tax Efficiency
One solution to the tax issue above is the management of the different types of accounts in a fashion that is tax efficient. By deploying more income producing (tax inefficient) assets to tax deferred accounts, and growth oriented (tax efficient) assets to brokerage accounts, you begin to best control your tax destiny. In addition, utilizing specific securities such as exchange traded funds (ETFs), which by definition are more tax efficient than mutual funds, we’re able to minimize tax liability.
Implementing the above income replacement strategy, with a focus on minimizing taxes and rebalancing properly, was made possible with advancements in technology. There is now advanced trading software that helps facilitate these strategies and provides great value over time.
Though we may yearn for the ‘good old days’ of retirement income planning, the new age retirement income strategy has many advantages over the old system. It does require more work to implement and maintain; but if done properly can provide the same security as our parents’ or grandparents’ generation.