By Peter Mastrantuono
Retirees face three profound unknowns in planning for sustainable income in retirement: their investment return, how long they will live and how much inflation will erode purchasing power. That’s why careful planning and expert assistance from an experienced financial advisor are essential.
Beware of Conventional Thinking
The general advice offered by personal finance publications and bloggers suggest dialing down equity exposure in favor of more fixed income (bond) investments as you age. They also remind readers of the 4% rule, which research suggests is the most optimal withdrawal rate to sustain retirement income for a lifetime.
All good advice, but the truth is that you’re not everyone, and everyone is different. That’s why each retirement income plan needs to be custom designed to reflect your individual circumstances, capacity for risk and the goals you’ve set for your retirement years.
Tailoring an Income Plan to Fit Your Retirement
One approach to constructing a retirement income plan is to align your investments so they reflect your essential spending, discretionary spending and legacy requirements.
For instance, assume that your essential spending (shelter, food, utilities, grandchildren gifts, etc.) is $60,000 per year. Since these expenses must met regardless of the stock market’s performance, you may want to create guaranteed income streams to equal your essential spending needs. Social Security is one form of guaranteed income. Any gap between your essential spending needs and Social Security (and a pension, if you have one) can be bridged with the purchase of an immediate annuity in an amount that fills the gap.
For discretionary spending (buying a new car, taking a vacation, etc.), investments in blue chip, dividend paying stocks may help fund spending that can be deferred in the event of a market downturn. This investment bucket is also useful for growing capital and income streams to keep pace with inflation.
Finally, the retirement assets you’ve targeted for legacy (e.g., paying grandchildren’s college or charitable bequests) can be in longer-term assets to maximize growth, such as small to mid size companies.
Protecting Against the Biggest Retirement Risk
Your biggest risk in retirement is “sequence of returns” risk. It’s a complicated way of saying that a falling stock market while taking retirement withdrawals can fatally shorten the life of your retirement savings.
You can mitigate this risk in three ways:
- Create a cash position before retiring so that you can pay for essential expenses for two to three years without having to sell investments.
- Purchase a five-year certain annuity to fund near-term income needs to avoid having to tap assets during down market cycles. Once the five years are up, buy another five-year term annuity.
- Build a bond ladder with each step of the ladder equal to your annual income needs so that as the bonds mature, they fund a new year of retirement spending.
Addressing Longevity Risk
The longer you live, the greater the risk that your savings run out. Here are three potential solutions.
- Purchase an immediate annuity, which guarantees you lifetime income.
- Buy a deferred annuity with the intention of annuitizing at, say, age 80 to lower the cost of mitigating longevity risk. Until then, you can live off your investment assets for the first 15 years of retirement.
- If your goal is to maximize wealth transfer to heirs, while retaining income security, you could consider purchasing a lifetime annuity, with an inflation rider, to fund your income goal and leave the remaining assets to grow for the next 20-30 years in retirement.
There are many ways to draw up a retirement plan that works for you, and it begins with contacting a financial advisor who can help guide you in this critical endeavor.
Peter Mastrantuono is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.