The weather is unpredictable in the high mountains. We carry special clothing for sun, bugs, wind, rain, and cold. There is no single garment that works for all conditions.
In generating retirement income, you need diversity too. There is no single income source ideal for all conditions. Some types of retirement income are good for a lifetime, but lock you into a set cash flow. Some protect against the menace of inflation, but cost more up front. Some maintain flexibility, but expose you to market fluctuations.
The only way to obtain true security in a modern retirement is to generate income from multiple sources which, taken together, protect you from the range of financial risks.
My framework for thinking about retirement income comes from Steve Vernon’s excellent Money for Life. In his book, Vernon spells out four goals for retirement income: longevity protection, inflation protection, flexibility for emergencies or inheritance, and minimizing exposure to market risk. To this essential list, I’ll add two goals of my own: solvency, and simplicity.
Let’s explore each of these goals, and the retirement income sources that can achieve them….
Surveys show running out of money is one of retirees’ greatest concerns. You need some level of retirement income to last your full lifetime. And yet you don’t know how long that will be. Dying early is “good news,” financially. But most of us would prefer the “bad news” of living longer. You can look at your personal and family health history and make some rough guesses about your likely life expectancy. But you can’t be certain. This is the essential conundrum of retirement planning: How do you generate income for life? Fortunately, there are some answers. The retirement income sources that provide longevity protection by design are annuities, pensions, and Social Security.
Over the decades of retirement, inflation is a serious threat. You have more control over your personal rate of inflation than most pundits allow, but you can’t ignore its potential effects on a long retirement. At the historical inflation rate of about 3%, the value of your dollars will be cut in half in about 23 years. That’s a time span that many of us, or our spouses, will live to experience. There are two ways to secure inflation protection in your retirement income. One is through contractual or legal guarantees, like an inflation rider on an annuity policy, or Social Security’s annual cost of living increase. The other way to obtain inflation protection is by owning the underlying assets that are inflating in value — businesses (stocks), real estate, commodities — rather than keeping much of your wealth if cash.
The most important lesson of my early retirement so far has been this: “Stay flexible!” Despite careful planning, our financial life has been less than predictable. Our tax returns have been dramatically different each year. Some of the news has been good: an inheritance, a modest income from this blog. Some of the news has been bad: medical bills, car repairs, travel expenses. Even though we are currently in our ideal retirement location, our feelings or needs could change, and we could move on. That would be an expense. Like many, we want to pass on assets to worthy causes and the next generation when we die. That requires not locking all our wealth up in annuity contracts. How do you retain maximum flexibility in retirement income? The answer is simple: maintain a balanced, liquid portfolio of stocks, bonds, and cash.
Unfortunately, stocks entail market risk. Stock prices fluctuate based on supply and demand and the economic cycle. For experienced, long-term savers this is not a problem. It comes with the territory of investing. But, in retirement, when you must draw on your assets for income, when you must factor in an uncertain lifespan, when you may be battling physical or mental decline, volatile assets are a serious issue. You can’t necessarily wait out a market downturn in your 80’s or 90’s. The traditional income sources that insulate you from exposure to market volatility are fixed income: bonds, CDs, bank savings. People often think of these kinds of assets as “safe.” Yet they are not safe from longevity risk or inflation. Annuities and Social Security are safer still. They potentially protect against three risks — longevity, inflation, and market exposure. But, with them, you lose flexibility. There is no access to your principal.
And, with annuities, in the worst case, there is solvency risk. Annuities are sold as a sure thing, an asset no different from owning a business or real estate. But, in fact, an annuity is a contract with an insurance company. You are betting that company will stay in business to make regular income payments for decades. Under normal conditions that should not be a problem: Insurers are heavily regulated and insured, and most are highly profitable. But we aren’t just concerned with “normal” conditions here. Under normal conditions you can also put all your money in a broad-based stock index fund and come out way ahead of most other potential retirement income sources. It’s when economic conditions are abnormally bad that we need to be especially concerned about solvency. And I’m not convinced that insurance companies would be any better off than the rest of us. If the economy is so weak that a diversified investment portfolio is permanently damaged, can we be certain that insurance company payments wouldn’t be affected?
The Federal government may be marginally better off than insurance companies in a prolonged downturn. It can “create” money, after all, at the price of inflation. But, without changes, Social Security will be insolvent in less than two decades. According to the Annual Report of the Board of Trustees, Social Security will only be able to pay about 75% of scheduled benefits starting in 2033. Bottom line: The portions of your retirement income that depend on private or public pensions are only as good as the institutions standing behind them. At some level, almost no retirement income source is free from solvency risk. But your risk is lower anywhere there is less bureaucracy. The more directly you own your assets — living on your own fully paid up farmland would be the ideal — the less chance you will be affected by somebody else’s bankruptcy.
My final goal for retirement income is simplicity. Many seem to think that financial success is about technical sophistication, or gaming the system. But my experience says the opposite: Wealth building is about transparency and simplicity. Spend less than you make, grow the savings, and don’t lose it. It’s much easier to accomplish this if you minimize the moving parts. The often-unseen risk of complexity is that you may not be getting what you think you are. And that’s truer than ever in retirement, when you are less and less able or inclined to manage exotic financial assets. What’s the simplest way to maintain simplicity? Reduce the number of your financial holdings, and reduce their cost. Expenses have proven a highly reliable negative indicator: High costs typically mean high complexity, low returns, and bad news….
Ultimately, most retirees will need multiple sources of income just to make ends meet. But there is an equally important reason to seek multiple streams of income in retirement. Financial security in your later years requires meeting the competing goals of longevity protection, inflation protection, flexibility, reduced volatility, solvency, and simplicity. Given that no single retirement income source achieves all of those goals on its own, you will need more than one source of income in retirement.
For maximum security, most retirees will want one income stream that is market-based (stocks), one that is insurance-based (annuity), and one that is socially-based (pension or Social Security). With those three types of income in place, you will be prepared for any kind of retirement weather….