A Floor with an Upside: The Best Strategy for Lifetime Income?

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Could you live off your investment portfolio indefinitely, if you had too? The answer to that question lies in the relationship among your total assets, your living expenses, your investing skill, the length of your retirement, market valuations when you retire, and market performance thereafter. That’s a lot of variables, only some of which you can control….

My investment results from the two decades before retiring gave me confidence that we could live off our portfolio for the rest of our lives through a variety of economic conditions. We held a conservative but diverse portfolio that had weathered both the 1990’s dot-com bust and the 2008-2009 Great Recession. I knew I owned at least one asset class that would perform well in any investment climate, and I had proven to myself under real-world conditions that I wouldn’t panic out of the others. What was there to fear?

Then I retired and had the time and inclination to dig deeper into the mechanics of generating retirement income. I also had motivation to reflect thoughtfully on what our future might hold, to look at how other family members had dealt with their advancing years and to ponder the similarities, and differences, between their situations and ours.

I uncovered some sobering statistics. I learned that the odds of depleting even a substantial portfolio were much higher than expected. Turns out that the math behind a distribution portfolio (one where you are making steady withdrawals as markets cycle) is much less forgiving than the math behind an accumulation portfolio, where you are saving. The issue in a nutshell is that when you withdraw money in a down market, even a small leg down, you are effectively "locking in" a loss forever, so that portion of your money never has the opportunity to grow again. The results are punishing over the long haul….

In his book Unveiling the Retirement Myth, CFP and professional engineer Jim Otar reports that, even at a low withdrawal rate of 3%, there is nearly a one in four chance that your portfolio will sustain a loss early in your retirement from which it will never recover. That doesn’t necessarily mean you will run out of money, but it does mean your net worth will be launched on a steady downward trajectory. I don’t know about you, but I don’t like those odds!

Thinking through your options for fallback income, you may realize, as I did, that the retirement years divide into two phases: (1) early retirement when you probably have the desire or at least the ability to work part-time and produce some income; and (2) later retirement when, due to health issues or physical limitations, work is simply no longer an option.

Many in early retirement will think, "If my investments begin to underperform, I can always go back to work." That may be true, but it’s wise to be realistic about your options for returning to the work force. A few could easily return to former careers; many couldn’t. In most cases, after a few years away from work, you’ll develop new interests and your original career skills and contacts will begin to atrophy. Even those who could resume their old career in some form, might have difficulty replicating their old salary. For me, even though I’ve always wanted to do some enjoyable, part-time work in retirement, returning to my previous fast-paced, high-tech, corporate environment is a rapidly diminishing option.

Everybody is different, and many boomers do expect to work longer. But, for me, I’m guessing the transition from "early" to "late" retirement happens somewhere around age 70, plus or minus a few years. It’s advisable to keep your own personal dividing line firmly in mind as you plan for retirement income, because it’s a "point of no return" for your investment assets.

And that brings me back to the question posed in the title: What is the best strategy for lifetime income?

In early retirement, you might choose to live off your portfolio in an ad-hoc manner. If the markets don’t cooperate, and your investments take a damaging hit early on, you can probably return to some form of work. Though, as noted above, don’t expect to bring back your old salary.

But what about later in retirement, when you are out of options for producing income and growing your assets. Then what? The choices are slim and grim: borrow from family, move in with children, take public assistance (SNAP aka "food stamps" requires you to spend down all but about $2,000-$3,000 in assets to qualify), live out of your vehicle. I’m serious! It’s not a bad idea to visualize yourself in some of these unpleasant scenarios, to build motivation for what I have to say next….

Once you add up all the factors around retirement income, I’ve come to believe that you should do everything in your power to create a guaranteed income floor for yourself by late retirement. (The time period when you cannot reasonably return to work.) You want to use every means at hand to assure yourself of a reliable income stream that meets your essential living expenses, from the time you can no longer work until the end of your life, however long that may be.

This process starts by first understanding your essential living expenses. This involves some personal choices about what you consider indispensable. That is going to be a function of your past lifestyle, your location, your obligations, and your flexibility with respect to your living surroundings. For me, essential expenses allow for a small condo or townhome, food, insurance, medical care, taxes, and utilities. That works out to about 60% of our current retirement budget. The rest is discretionary spending, and could be foregone or cut way back if necessary, especially later in retirement.

Next you must add up all the guaranteed, inflation-adjusted sources of income that you can rely on receiving at retirement. Many of us can count on some Social Security and/or other pensions. You might also include net income from rental real estate in this figure, plus income from any government inflation-adjusted securities that you intend to hold indefinitely.

Finally you compare those two values. If your expenses exceed your income, as they will for many, you must "backfill" up to the amount of your essential expenses from a new guaranteed income source. That means you must annuitize or purchase a guaranteed lifetime withdrawal benefit with whatever portion of your nest egg is required to lock in this essential income floor. In essence, you will pay a portion of your nest egg to an insurance company (or multiple companies, for diversification), in exchange for a lifetime income stream.

Don’t like the idea of parting with some of your nest egg permanently? Most will have no choice in order to generate the income they need. But research does suggest that if your uncovered annual expenses are less than about 2-3% of your assets, you might be able to skip the annuitizing step without undue risk. In other words, if you have sufficient assets, and a low enough draw against them, then your portfolio should survive most conceivable economic conditions over most conceivable life spans. But few will fall into this select wealth bracket. And, even if you do, you still might sleep better, and enjoy fewer money management hassles, by purchasing a small annuity.

Once you’ve accepted the need to part with a portion of your nest egg, you can enjoy the benefits of knowing you and your spouse will never want for basic living essentials as long as you live.

Then you can apply your time and energy to managing your remaining assets for an upside. That’s right, the balance of your portfolio can stay invested in the market and assume some modest risk, or not, as you choose. (Many of us will continue to hold a diversified, balanced, all-weather portfolio.) You can decide to consume only the income from that portfolio, or you can choose to devote some of the principal to things, activities, or causes that might increase your happiness. In most cases, given a reasonable draw, your portfolio will grow enough to compensate. But in some cases it won’t. Either way, you can be confident that you won’t be destitute if your portfolio diminishes or even runs out in later years. Because you will have long ago established a baseline of guaranteed income for life….

So that is a non-technical overview of how to establish a retirement income floor, while keeping an upside. I started by reviewing the risks to a distribution portfolio. Then I discussed the options for additional income in early versus late retirement. Lastly I presented the case for annuitizing as needed during the latter phase of life. And I believe that most of us, once we take all the retirement factors into account, will choose this path.

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