Building a Retirement Income Stream

Maintaining Retirement income is the top priority of more and more retirees. As retirement nears their investment focus shifts from increasing the value of a portfolio to replacing their income stream. With baby boomers entering their retirement years, interest in managing retirement income is, well, booming. The potential for significant capital gains doesn’t interest investors who are more concerned with keeping what they’ve accumulated and using it to establish income.

Retirement income management is the weak link in financial planning. The financial services industry still is focused on gathering assets, not helping investors withdraw them, though that slowly is changing. The key fact for retirees and pre-retirees to remember is there is no magic bullet for retirement income. You need to take full advantage of the range of tools available for establishing retirement income, increasing income, preserving capital, and helping the income keep pace with inflation.

Social Security may seem a boring topic, but the program is the foundation of retirement income for most Americans. It provides over half the income for 64% of households with a member age 65 or older. Most importantly, it is inflation-adjusted income.

The lower your lifetime income, the more income Social Security replaces. Even for middle-income recipients, Social Security replaces 47% of average annual earnings, and for those with earnings of $106,000 in 2010 dollars, the program still replaces 26% of lifetime annual income.

You can boost Social Security income by carefully planning when to receive benefits. Delaying receiving retirement benefits until age 70 is a good deal for many people. The benefits increase by 8% each year you wait, and they are inflation indexed. Waiting to receive benefits is a very inexpensive way to buy an inflation-indexed annuity.

Married couples have more creative ways to increase Social Security benefits. For example, a spouse may be able to delay drawing his or her own retirement benefits until age 70 but begin drawing a lower spousal benefit, based on the other spouse’s earned benefits. Later, a switch to his or her own earned benefits can be made.

Another strategy, that works at the moment, is to begin drawing retirement benefits before age 70. Later, the benefits received can be paid back (without interest) and higher benefits based on your current age can begin. There are reports that Social Security is planning to eliminate or restrict this option, which we discussed in the October 2010 issue.

We discussed these Social Security strategies in past visits, and details are in the Archive on the members’ web site as well as my report, Secrets of Boosting Social Security, which is available on the web site under the Bob’s Library tab.

Annuities provide a lifetime stream of income, when you buy an immediate annuity and not a deferred annuity. An immediate annuity provides fixed payments of income for the joint life of you and your spouse (if that is the payout option you select). You don’t have to manage the investment, and its value doesn’t fluctuate with the markets. According to a Government Accountability Office study, a $100,000 annuity purchased in April 2010 would provide $6,480 per year for the joint life of the purchaser and spouse. This annual amount is 25 percent greater than the $5,200 of income that would be available from a highly rated $100,000 30-year corporate bond at the time.

There are disadvantages to the annuity. Part of each payout is principal. Purchasing a bond instead means after 30 years the principal of the bond is available to the owner or survivors, though the value could be greatly diminished by inflation. The annuity principal often can’t be tapped to pay unexpected expenses or be left to survivors, and the income is diminished by inflation. You can avoid the inflation problem by purchasing an inflation-indexed annuity, though the initial payout will be about 30% less than for a fixed annuity.

The biggest disadvantage of immediate annuities now is you’d be locking in today’s low interest rates. You might avoid this by waiting a few years or by establishing an annuity ladder. Decide how much you want to invest in immediate annuities and make equal purchases over five years or so.

You probably don’t want to put an entire portfolio in immediate annuities unless the annuities will cover your spending needs plus inflation. For most people, 20% to 50% of their portfolios will provide a solid income stream and make the entire portfolio last longer. Be sure to shop around before purchasing an annuity. Payouts differ among insurers by 20% and more. Also, don’t focus exclusively on the payout. Evaluate the financial safety of an insurer.

With the demise of traditional pension plans, many people depend on their investment portfolios for a substantial amount of retirement income. Because of extended life expectancies and low interest rates, most people can’t afford to invest the entire portfolio for income or buy annuities with it. There needs to be some growth to offset inflation. You also need access to cash for unexpected expenses.

Many people don’t invest this part of their retirement assets properly. Some are too aggressive, investing primarily for growth as they did earlier in their working years. They know stocks have the highest long-term returns, so they’ll invest primarily in stocks and take money out as they need it. In a long-term bear market this strategy doesn’t work well. Others are too conservative, investing for income as retirees did a few decades ago when life expectancies were shorter. They don’t want to take any risk. They invest primarily in treasury bonds, certificates of deposit and money market funds. The yields on these investments are too low unless you have a lot of money.

Those who want to invest primarily for income and safety should consider a mix of income assets that also have the potential for growth. That’s the approach we take in the Retirement Paycheck portfolio. We shoot for a 6% yield plus capital gains potential. It’s not a fixed portfolio. We make changes as the markets change. The portfolio also has more volatility than a conservative income strategy, but that is necessary to earn the yield and growth potential.

There are other investment strategies that will work for retirement income.

One is to establish a fully diversified buy-and-hold portfolio, such as our hedge fund portfolio. The portfolio is set up so different parts do well in different economic environments, and overall it returns more than stock indexes with less risk.

Another approach is to avoid the buy-and-hold strategy. Use risk management to change your portfolio based on current valuations, market trends, and the economic outlook. We do that in our recommended Sector, Balanced, and Income Growth portfolios each month and generate higher returns than stock indexes over time, especially when adjusted for risk.

Another way to increase retirement income is to manage your distributions and withdrawals. Most people determine their distributions based on planned and desired spending. They consider the distribution needs fixed, whether they are a percentage of the portfolio or a fixed amount adjusted for inflation. Studies show you can safely withdraw about 4% of a typical diversified portfolio each year. But there’s still a chance of running out of money in retirement, especially when you invest early in a bear market or long-term flat market.

It’s better to adjust your withdrawals based on changes in markets and the economy. Don’t withdraw a fixed amount or percentage of the portfolio each year. Instead, after the first year of retirement adjust the distributions based on portfolio performance. When the portfolio does well, you increase distributions; when markets decline, so do distributions. One way to do this is by using a version of the Yale Endowment Fund policy, as discussed in my book The New Rules of Retirement.

Another way to adjust distributions is to establish different portfolio buckets for different types of retirement expenses. Have a conservative fund that holds enough to cover two to five years of expenses. A long-term investment fund can be established for medical expenses, since the bulk of medical expenses usually are incurred late in life. A diversified or managed portfolio can be established to hold the bulk of your assets and add to the spending fund when it needs to be replenished.