Author Geoff Considine
The last several years have been hard for many people. There are unique challenges for different segments of the population. In this article, I am going to focus on the issues specific to people who are approaching retirement and will soon be living on investment income and other forms of non-wage income such as pensions, social security, etc.
The top five financial issues, as I see them, are:
1. Creating sustainable income
2. Managing inflation
3. Managing taxes
4. Managing risk
5. Coping with low accumulated wealth
Let’s go through them one at a time.
1. Creating sustainable income
If you are near retirement or in it already, the issue of how to convert your financial assets into long-term income is paramount. If all of your financial assets are in a traditional pension plan, you can ignore this item and go straight to the next one. For most Americans, this, however, is not the case.
Social security is a major part of most American’s retirement income and is a very reliable source of income for people who are currently in or near retirement. The only concern with regard to this source of income is whether the cost-of-living adjustments to your social security income will actually keep up with inflation (see also “Social Security and Retirement: The Reality“).
Many Americans will also pay for most (or all) of their retirement with investments accumulated over their working lifetimes in 401(k) plans, IRAs and regular taxable investment accounts. Converting these assets into a long-term stream of income can be a real challenge. There are three main approaches to converting assets:
First, you can use some or all of your savings to purchase an annuity. This will provide a specific stream of income for the rest of your life. The annuity solution has the principal benefit that you cannot outlive your money and you can remove all investment risk (in the case of a fixed annuity). These are big advantages. The negatives associated with annuities are that (1) they can be costly, (2) there is no inheritance left for heirs (although some annuities do provide a death benefit) and (3) the promise of future income is only as good as the company that sells the annuity. However, if the company goes bankrupt, you have a problem. There are insurance programs in each state that protect annuity holders, but the protection is limited. Purchasing a cost effective annuity bears consideration as one way to convert exiting assets into retirement income.
The second major approach to creating an income stream from your savings is to build a portfolio specifically designed to maximize income and to avoid income generating assets with a meaningful probability of not being able to sustain paying and even grow the income over the long term. Fixed-income assets usually form the core of income portfolios, supplemented by dividend-paying stocks and other asset classes such as REITs and MLPs. If you can simply live off of the income generated by your investments, you will have lifetime income and you can leave the entire principal balance to your heirs. The potential downside to this approach, is that you remain exposed to various forms of market risk and there are no guarantees that the income is sustainable: Companies can (and do) cut their dividends, go bankrupt and default on their bonds. Default is not a major concern if you buy U.S. Treasury bonds but these, too, carry meaningful risk. The principal risk in treasury bonds is interest rates. With current yields on 10-year treasury bonds at just above 2%, there is a real risk of a loss of purchasing power through time due to inflation.
The third common strategy for generating income from your assets is to create a structured withdrawal plan. In this approach, you build a portfolio for total return (yield plus price appreciation). Each month, you take any income generated by your portfolio and then sell some portion of your portfolio to provide the balance of the income that you need each month. This approach is the most widely accepted approach to creating an income stream for retirement. The dominance of total-return investing (as opposed to income investing) is primarily a result of academic research on market efficiency.
A variant of the structured withdrawal plan is what is referred to as a bucket strategy. Your most conservative investments go into a sub-portfolio (a bucket) that you will draw from for the first years of your retirement, your most aggressive assets go into a portfolio you won’t draw from for ten years, and you hold a moderate portfolio for the middle years. The idea here is that you will not be relying for income on volatile investments but that you can still hold volatile assets for their long term growth potential.
The major risk any form of structured withdrawal plan is that you are exposed to market risk. If you rely on selling assets for your income and the market suffers a large drop, you can end up selling a larger-than-planned percentage of your portfolio to generate your desired income. This, in turn, means that you run the risk of entirely depleting your assets during your lifetime.
A combination of these asset conversion approaches will be the best solution for some investors while others will decide to employ only one.
2. Managing inflation.
One of the largest challenges in long term planning is dealing with inflation and its effect on your long term income needs. Social Security payments are indexed to keep up with inflation. Even these payments are not necessarily immune to the effects of inflation, however, because the annual increases in social security are calculated based on the CPI index, which may (or may not) resemble the impact of inflation on any specific individual’s budget. Your personal inflation rate depends on what you actually spend money on. To the extent that food and energy are a large portion of your monthly expenses, the recent months will have shown substantial inflationary effects on your budget. If you live in a warm climate and don’t drive much, the impacts of inflation may be smaller. Costs like pharmaceuticals or out-of-pocket healthcare can also have a major impact on your personal rate of inflation. Similarly, your housing costs may or may not increase through time as a result of inflation. If you own your home, you will have minimal housing cost inflation.
In addition, your investments may or may not provide much protection from inflation. While stocks have historically outpaced inflation, they are not really an inflation hedge. This means that stocks may not provide income that keeps up with inflation over periods measured in years. There are certain classes of investments that trend to do better in tracking inflation. Real estate, commodities, and precious metals tend to do best in inflationary periods. Alternatively, buying put options on a long term government bond ETF can also provide excellent protection against inflation.
3. Managing taxes
Taxes are always a concern, but they are perhaps of greatest concern to people at our near retirement. Any changes to the way that dividends are taxed, for example, could have serious repercussions for an income investor. Converting existing retirement accounts to Roth IRAs from traditional IRAs is also worth analysis. I am not an authority on taxes, so I am not going to write much here beyond the obvious suggestion to hire a good tax planner.
4. Managing risk
The various types of investing strategies described here have different types of risks. There are performance related risks, and there are risks associated with matching your investments to your liabilities. Annuities may be less suitable for someone who may need to access a substantial lump sum of cash. Not having access to your capital when you need it is referred to as liquidity risk. A total-return structured withdrawal plan may be too risky for someone who cannot live with any variability in income. If you plan to travel in retirement, currency risk may be something you need to plan for. Another source of risk is income risk in the years approaching your planned retirement date. Many people put off detailed planning with the rationale that they will just work longer if they dont have enough money saved. But what if you are laid off and don’t have the option to keep working? During the real estate boom, many individuals started to think of their homes as a source of retirement income. If you were counting on being able to sell your home to fund your retirement, the recent years decline in housing values will have negatively impacted what you can expect to receive.
It is well worth thinking about the risks associated with your financial strategy in conjunction with your personal situation. If any situations look especially dangerous to your financial well being, it makes sense to explore how specific risks can be managed.
5. Coping with low accumulated wealth
It is clear that many Americans have not accumulated nearly enough wealth to be able to retire at age 65 and maintain anything like the lifestyle that they currently have. When I refer to ‘ low’ accumulated wealth, this is what I am talking about. If you have one million dollars in assets, but your retirement lifestyle requires eighty thousand dollars per year, you do not have sufficient savings. The simplest solution, of course is to work longer. Another solution that looks increasingly attractive is to work part-time for some period of time in a transition between full-time work and total retirement, possibly varying your hours from year to year to offset variability in your investment portfolio. Once you qualify for Medicare, working part time can look even more attractive because you no longer need private health insurance.
Looking at The Big Picture
While the transition from full-time work to a retirement-focused life is complex, focusing on the five big-picture issues outlined above should help in the planning process. Financial literacy and the commitment to take control of the key aspects of retirement planning are crucial. This is not an easy process, not least because many people have never obtained any kind of education in financial planning. Good advisors can play a crucial role, but every person needs to take responsibility for understanding the key components of financial health in the same way that we all need to take an active role in planning for our physical health.