Retirement is seen by many as one of the most exciting times in their life. It’s a time when people can finally relax and enjoy the fruits of their hard work and savings, where they can do as much or as little as they wish. However, this is also the time when they need to make some potentially lifelong commitments. They need to determine a plan on how to take income from their retirement
accounts to meet their income and legacy goals.
Now starts the process that can lead to one of the most daunting decisions a retiree will have to make. Part of the problem is that everyone’s situation is just a little bit different, so a one-size-fits-
all solution is impossible. The factors that go into this decision can range from how much you have saved, to how much you need to live on, from what your concerns are for passing assets to loved ones or charity, to what your overall comfort with risk is. Wouldn’t it be great if all of these factors could be added into a formula and out pops the program to make you happy and comfortable for the rest of your life? Unfortunately, life is not so easy. In fact, even most professionals don’t agree on a single “best” strategy and there are a half a dozen rules of thumb to make things even more complicated. So which strategy is really best for you? The simple answer
is: it depends. Different options work best for different people, depending on specific circumstances. We have developed this Retirement Income Options overview to go over the four most popular strategies for generating retirement income. We will discuss an overview of each strategy, how the process works and what the pros and cons are.
The four most utilized retirement income strategies are:
The Systematic Withdrawal:
This strategy involves the least amount of change for the new retiree. This strategy simply creates a mix of investments or asset allocation to your risk comfort and then makes monthly withdrawals out of each investment proportionately to the amount desired for income.
The Dividend/Interest Strategy:
This is a strategy that is often referred to the “eat what you earn” strategy. The idea behind this process is to buy investments that make regular dividend or interest payments. This regular distribution then becomes the source of your retirement income.
The Annuity Living Benefit:
This strategy has only been available for the last 10-15 years. It is a twist on the traditional income annuity, by allowing the retiree to guarantee a lifetime monthly income without having to give up access and control of their original investment.
The Bucket Strategy:
This strategy is perhaps the newest and fastest growing income strategy. This strategy comes in various forms and each advisor that uses it calls it by a different name, but the premise is the same. The idea is that you divide your retirement into several accounts (i.e. buckets). Each bucket is matched with a period of time it will be responsible for generating income in the future (for example during years 1-5 or years 11 through 20) and then invested in investments to meet the appropriate risk and benchmarks that are required.
This isn’t an all inclusive list - there are an infinite number and twist to each strategy, but what you will discover is that most retirement income strategies are variations of these four concepts.
The Systematic Withdrawal Strategy:
The systematic withdrawal strategy is possibly the most common strategy used by financial advisors. This strategy is popular because it isn’t a significant change what most individuals understand and feel comfortable with. It involves investing in a portfolio of investments, typically in mutual funds, but can also include life insurance or deferred annuity policies. The process begins with the determination of the optimal combination of stock and bond portfolios which will maximize total return while minimizing the amount of risk. This combination of investments is called the asset allocation. In most instances that optimal allocation tends to be between 50%-70% stocks (both US and Foreign) and the remaining 50%-30% in fixed income investment (bonds, REITs and money market funds).
Each month a set withdrawal is taken proportionately, regardless of the growth or loss in each investment. The idea is that over time the portfolio will outperform the set withdrawal allowing the retiree to adjust their income up for inflation and build a larger portfolio for future generations.
The next decision in this strategy is to determine how big of a withdrawal to take and whether to take that as a fixed amount each year or as a fixed percentage, so as to not overstress the portfolio in down years.
When it comes to the percentage, most advisors recommend between 4% and 5%, with some utilizing a withdrawal as high as 6% for clients that have smaller savings. The College of Financial Planning recommends a 4% withdrawal based on various studies <See Chart here> (a retiree with savings of $500,000 would receive $20,000 annually with a 4% withdrawal); other advisors say that you can take as much as 5% if you hold back on increases in years that the portfolio is down (a $500,000 portfolio would generate $25,000 annually with a 5% withdrawal).
A question to be addressed is: do you set the withdrawal as a fixed amount year over year, or do you take a fixed percentage of the portfolio each year? For example, a fixed amount assuming 5% withdrawal for our earlier scenario would generate $25,000 each year until it is manually increased, regardless of the performance of the portfolio. Say that the $500,000 portfolio grew to $550,000 after income at the end of the first year. In year two you will again take $25,000 in income as well. The same would be true if the portfolio finished the year with a value of $450,000.
If you were taking a fixed percentage withdrawal, the income amount would represent 5% of the previous year end value. Therefore, you would start with the same $25,000 in year one, but at the beginning of year 2 you would adjust your income to $27,500 (5% of $550,000) if the account increased in value or to $22,500 (5% of $450,000) in the event the account dropped in value. This approach is favored by some, because it allows for pressure to be taken off of the portfolio in down markets. However, many retirees dislike it because their income from year to year is unpredictable.
The Pros and Cons:
The benefit of the systematic withdrawal strategy is its simplicity. Most retirees don’t have to make significant changes to how they have invested pre-retirement, so keeping things similar helps to minimize uncertainty. It also tends to be lower in cost and most retirees can look over the shoulder of their advisor or even manage the investment strategy themselves with minimal guidance depending on their level of knowledge.
The downside to the systematic withdrawal strategy is the obvious: in a period of back-to-back bad markets or if you take too large of a withdrawal and can’t outperform it, then the risk of running out of money becomes a real possibility. The only way to mitigate that risk is to start with a lower withdrawal amount or utilize the more uncertain percentage of account value method.
The Dividend/Interest Strategy:
This strategy is the most traditional method and the most popular by do-it-yourself investors. This strategy is popular because it is definitely the easiest and tends to leave more of the original principal intact. There are a couple of variations of this strategy. There is a high-dividend stock strategy, used by retirees that want income and some growth; or a fixed income coupon strategy, used by retirees that want a more predicable payment over growth.
This strategy selects investments with regular dividends like 1) large company, blue chip stocks or preferred stocks or 2) regular coupon payments like a bond or bank certificate of deposit (note that in recent years REIT income payments have sometimes been substituted for bonds.) Then the retiree uses only the dividend or coupon payment for income, leaving their original investment untouched even in a poor performing market.
The pros and cons of equity dividend:
The benefit of the equity dividend strategy is that companies tend to protect as much as possible their dividend payments to shareholders. It is likely that during strong economic conditions companies look to grow their dividends, which will help this strategy generate an income that would keep up with inflation. The negative to the equity dividend strategy is that the dividend is not guaranteed, although most companies reduce or stop it as a last resort. The recession of 2008 showed many investors that their income could vanish and the end result is both their income vanishes and their original investment drops. This has led to an increase in the popularity of preferred stocks. Preferred stocks dividends are guaranteed like that of a bond; however, like a bond’s coupon, they do not increase over time. This decreases the investor’s chances of keeping up with inflation. Additionally, preferred stocks do not appreciate like common stock shares can,
so there is even less of a chance for growth.It is this unpredictability that tends to make this strategy least popular with professional advisors.
The pros and cons of fixed income strategy:
Professionals that use the dividend/interest strategy, tend to use this version. It is best suited for retirees that are concerned more about stability than growth. The benefits of this strategy are that it offers a known income stream, one that is backed by the assets of the underlying company, or in the case of a CD it offers FDIC protection on the principal. The downside to this strategy is the fact that it is a fixed amount. There is no method to increase the amount of income for inflation. Most important (and many can attest to it in this low interest rate environment), there is no guarantee that interest rates will remain comparable or be higher when that bond or CD matures. Many retirees that selected this method in previous years have realized that it is even possible for your income to decrease over your retirement if interest rates don’t cooperate.
The Annuity Living Benefit:
The income annuity contract has been a popular income option for several years, because of its ability to generate guaranteed income, backed by the claims paying ability of an insurance company. The living benefit rider has redefined the deferred annuity into a popular tool among financial advisors and insurance agents. The living benefit can come in a variety of types and no two companies seem to work the same way, so it is an option that requires you to do some homework to make sure that you invest with a company that offers you the best solution for your situation. The Guaranteed Lifetime Withdrawal Benefit (GLWB) has become the most popular of the living benefit riders that can be added on to both Variable Annuities and Fixed Index Annuities.
The benefit of the GLWB rider is that it allows you to maintain your investment in stock and bond portfolios, while locking in a minimum income for the rest of your life, regardless of investment performance. Generally speaking, the GLWB works like this: the investor invests in a portfolio of stocks and bonds and when they decide to take income they are guaranteed to receive a lifetime payment equal to 5% of the amount invested. If at the next anniversary the invested amount is greater, then the new amount is locked in and the payments are based off of the new, higher locked-in amount for the remainder of your life. If the investment amount is lower, then the previous “locked-in” value is maintained. The two scenarios below illustrate how this works.
$100,000 is invested at the beginning of year 1; the investor starts their $5,000 annual withdrawal. At the end of year 5, the account value has grown to $120,000. The withdrawal base is now adjusted up to $120,000 and the investor is now guaranteed to receive $6,000 annually for life.
$100,000 is invested at the beginning of year 1 and due to catastrophic losses in the stock market and previous withdrawals at the end of year 5 the investment account is depleted. Then under this guarantee the payments of $5,000 annually will continue for as long as you live, and guaranteed by the insurance company.
Pros and cons:
The benefits of the annuity living benefit is that it allows individuals to have the “best of both worlds” in that it gives a retiree the peace of mind that comes with having a pension-like income stream while having complete control of his investment dollars and benefiting from long-term growth of the underlying investments.
The negatives to the annuity living benefit is cost. Just simply investing in a variable annuity can add 1.0% to 1.75% annually to the cost of managing your investments. Then adding a living benefit to it would increase that cost by 1.0% on average, bringing your total added expense to 2.0% to 2.75%. Within a fixed indexed annuity, this expense shows up in the form of an actual charge against the account or as a reduction in the stated rates. For example, if an indexed annuity has a maximum upside of 6% annually, then adding the living benefit would lower that “cap” to 5% annually.
In final consideration, the annuity living benefit option is best suited for the individual that is uncomfortable with investing and the risk therein, but understands the importance of needing long-term growth of retirement assets and is willing to trade maximum upside for peace of mind.
The Bucket Strategy:
The bucket strategy is a twist on the systematic withdrawal strategy, and involves dividing your retirement assets into groups or “buckets”, with each bucket designated to generate income for a specific period of time. The premise is that every investment has an ideal time horizon for that investment or, stated another way every length of time has an investment that is best suited to maximize portfolio performance.
For money that is needed within the next five years, then short-term fixed income investments are an optimal solution. For 6-10 year time frames, longer-term fixed income or high-dividend paying stocks are best suited. Finally, for time frames from 11 years and longer, growth stocks are most appropriate. The purpose of these buckets is to attach a time horizon to when each income payment is needed.
You start by forecasting you income needs including occasional increases to allow for inflation. Then you divide your investments based on when those payments will be needed. Generally, the payments needed during the next 5 years are placed in investment will earn between 1%-3%; the payments that will come in years six to ten are placed in investments that will average between 3%-5%; checks that you will not need for over a decade you can take on a little more risk by investing in growth investments that should earn between 6%-10%. Then it is important to do a one-way rebalancing annually, if available. In years when your riskier investments do well you replenish the nearer term bucket. The 6-10 year bucket refills the 1-5 year bucket and the 11+ years bucket refills the 6-10 year bucket. In years where there are losses in the riskier buckets, you defer making refills until the riskier investments rebound.
In the following example three buckets are used but the actual number of buckets varies according to personal preference and available investment options.
A retiree implements the bucket strategy with her $1 million IRA, and needs 5% or $50,000 per year for income.
She divides her investments into 3 buckets and plans to adjust for inflation every 5 years. Bucket 1 will be money for income needed within the next 5 years and will consist of $250,000 invested in a low maturity government bond fund, currently yielding 1.5%. This is the bucket from which the withdrawals will be taken from, and the interest and growth in this account will be used to make inflation adjustments. Bucket 2 will also contain $250,000 and be invested in a strategic income bond fund, leaving Bucket 3 to contain $500,000 and be invested in a balanced equity portfolio consisting of US and foreign stocks. At the end of the year she reviews her portfolio and if buckets 2 and 3 have made money, she will replenish the funds that were removed from bucket 1 and if buckets 2 and 3 have lost money, she does nothing and allows these buckets time rebound and ride out any volatility.
Pros and Cons:
The benefits of this strategy are that, if properly adjusted and implemented, it is the only strategy that is designed around a retiree’s actual income and timing needs. As well, this is the only strategy that has built-in or planned inflation adjustments. When properly designed and implemented, this strategy can generate a predictable, inflation-adjusted income that will help protect the core of your investments for your beneficiaries.
The cons are that this strategy can be complicated. It is better implemented by a knowledgeable professional. The impact of blending multiple investments is that it requires more frequent review and adjustment, which many individuals can find difficult.
Regardless of the strategy you select, it is important to start with a written plan and then stick to it. It is this carefully thought out plan, and then regular review of your plan and adjusting your strategy accordingly that will allow you to enjoy more of the benefits of retirement instead of more of the worries of retirement.