The 3 Stages of Retirement Income

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In real life, retirement cash flow is not as simple as the pundits would have you believe.

Try a typical retirement calculator, and you’ll be prompted for a single expense number: How much would you need to spend from savings to live in retirement each year? But research shows that your gross expenses will change, likely declining as you get older. The assumption of constant retirement withdrawals simply isn’t realistic.

But this post is about the flip side of the retirement balance sheet: For many of us, retirement income will also change over time. As the years go by, we’ll need to take action to ensure regular payments keep coming in, and perhaps adjust our lifestyle if they aren’t enough.

Based on my experience living in retirement, I’m seeing three irreversible stages of retirement income. Once you leave each one behind, you’ll be fully dependent on only what’s left….

Stage 1: Early Retirement

The first stage of retirement income is early retirement. If you think you couldn’t possibly retire early, think again. This blog is full of ideas on how to do it. More critically, many people won’t have a choice. Due to layoffs and health issues, many are forced to stop working sooner than expected. U.S. News reports that about 45% of workers retire earlier than planned.

So this first stage of retirement income is about living off your savings, and possibly some part-time work, until your Social Security, or increasingly less likely, a pension, can begin. Ideally, to maximize your Social Security benefit, you want to delay claiming it until at least your full retirement age, and until age 70, if possible. Unfortunately, for many, it won’t be.

There are two keys to being able to delay Social Security: living off your investment assets, and part-time work. This is the stage that my own retirement income is in right now. My wife and I are predominantly living off our accumulated savings — cautious not to damage our investments. We supplement that primary income stream with a small income from this blog. In the past, I’ve called this Flexible Capital Preservation. That means living off interest, dividends, growth, and some part-time work income, all with an eye to preserving assets. In my view, that’s the only sensible strategy for early retirement. It’s simply unwise to draw down your retirement savings significantly, when there could still be decades of life in front of you.

Working in retirement? Isn’t that an oxymoron? Some people are quick to question whether it’s really a retirement if you’re “working.” But retirement has never been a precise word. This stage of life is about personal and financial freedom, not full-time leisure. Any part-time work in retirement should be about convenience and fulfillment. If you need or want to work, choose something that fits your schedule, is fun, and makes you feel good.

Better yet, design your own perfect “job,” as I have with this blog. I research and write a couple of articles a month on topics that I need to know about anyway. Whenever a blog-related task (like maintaining a discussion forum) gets to be too much like “work,” I simply drop it, and go do something fun outdoors instead. Meanwhile, the modest income generated affords us some regular “mad money” and keeps the pressure off our investment portfolio. What do you enjoy doing, that helps others, and could produce a bit of income on the side, if needed?

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Stage 2: Traditional Retirement, with an Upside

The second stage of retirement income is what most people traditionally think of as “retirement.” You’re old enough now either to have started receiving Social Security, or you’re one of the lucky few getting a pension. At any rate, you have some guaranteed, inflation-adjusted income. And, in most cases, you also have some investment assets on the side. How large those assets are, in relation to expenses not covered by guaranteed income, governs how long you’ll remain in this stage.

To actually live in this stage with some “upside” — the potential to spend more on occasion — requires some relative wealth. Technically, you need to have investments in the stock market. And the amount you are pulling from those investments each year needs to be no greater than the conventional “safe withdrawal rate” — usually in the range of 3-5%. In that case, you can have a reasonable expectation of those investment assets lasting for your lifetime. And, in many possible outcomes, though not all, those assets can grow significantly. That gives you a potential upside for your discretionary retirement spending. So, for example, when times are good, you can go on an extra vacation, or splurge on the grandkids….

In this stage of retirement, the potential for investment outperformance is really your only hope for upside flexibility: Part-time work is no longer an option due to health issues or physical limitations.

The critical decision at this stage is preparing for the next one: If, when, and how should you annuitize your assets? Like so many financial planning decisions, nobody can give you a precise answer, not even the professionals.

If you have relatively few assets, you may need to put them all in an annuity, sooner than later. If you’re very wealthy, you may be able to forgo annuities altogether. For the rest of us, the fundamental tradeoff is between safety and upside: The more money you annuitize, the more you can count on a certain fixed income in retirement. But, the more you leave in the market, the more you can hope for growth and an upside.

That relatively complex calculus is made even more complicated and uncertain by today’s distorted economic environment: With interest rates at record lows, annuities are “expensive” for the income received. And, with higher inflation looming on the horizon, their ultimate value over long time spans is open to debate.

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Stage 3: Fixed Income

The final stage of retirement cash flow is when you’re dependent on a generally fixed income. The wealthy may never enter this stage. Those less well-off may begin here. It means you’re living month-to-month on a certain cash flow, with no options available for increasing it. The capacity for part-time work is gone, along with your investment assets — either consumed on living expenses or, better, used to purchase an annuity.

This is the end game of retirement finances, though it could go on for many years. In the best case, you have adequate income and most of it is adjusted for inflation. It could be partly Social Security and partly an inflation-adjusted annuity or pension. In some cases, a reverse mortgage could contribute to your support. In the worst case, your income is barely adequate or is inadequate, and isn’t adjusted for inflation. The unfortunate prospects then are for a declining standard of living over time.

This, sadly, is the likelihood for a substantial portion of the baby boom generation. The Wall Street Journal has reported that “The median household headed by a person aged 60 to 62 with a 401(k) account has less than one-quarter of what is needed in that account to maintain its standard of living in retirement.”

If and when you reach this stage of retirement income, you’ve bumped against the financial “floor” for your lifestyle. Hopefully your essential living expenses — food, shelter, health care, transportation — are being met. But there is no more discretionary income for splurges, for legacy giving, or for emergencies.

While this stage sounds potentially frightening, let’s admit that it’s inevitable for many, if we are fortunate to live long enough. And it doesn’t have to be a catastrophe.

There comes a time in life when we simply can’t generate more income. But, if we’ve saved diligently and planned intelligently, our essential needs will be met. In fact, with fewer financial details to worry about, plus a sense of accomplishment at having taken good care of ourselves, along with time to focus on the most meaningful aspects of living, this could yet be a very satisfying stage of life.

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So, I’ve identified three possible stages of retirement income: Early Retirement, Traditional Retirement with an Upside, and Fixed Income. At least two of these are inevitable for most of us. And some of us will pass through all three.

For example, if you leave work at the same time that a pension or Social Security starts, then you’ll skip stage 1 — Early Retirement. If you have relatively few investment assets compared to your uncovered expenses in retirement, you’ll pass quickly to stage 3 — Fixed Income.

How do you know exactly which stages you’ll enter, and when? There is no simple formula. The number of variables involved is high, and everybody’s circumstances are different. Inflation, investment returns, and life span are unknown. Your and your spouse’s personal career trajectories may be as well.

But there are excellent tools available to project how your financial life may progress through your own personal stages of retirement. The best retirement calculators can give you some visibility into the future, and some hope for planning the outcomes you desire.

I’ve done extensive reviews of high-fidelity retirement calculators here on this site. Some are free. The rest are cheap, compared to the potential value in managing your financial life. If you haven’t already, invest an hour or two with one soon, and find out what stages your own retirement income will take….

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