How to turn your savings into an income stream

(Note: This is Part 3 in a 3 part series that I did for the Omaha World Herald on retirement planning for different life stages.)

To state the obvious, farming and cooking are two different things.  One is about creating.  The other is about consuming.  A similar relationship exists between preparing for retirement and being retired.  One is about filling the barn—your 401(k), IRA, pension, Social Security credits, etc.—and the other is about emptying it by using what you created to provide for your needs.

That transition—from accumulation to distribution—has a lot of moving parts.  Any missteps can impact your retirement for years to come.  Taking too much too soon from the wrong accounts or in the wrong markets can be the difference between retirement bliss and retirement blunder.  So what can you do to improve your odds of success and get your retirement off on the right foot?  Begin by asking yourself the following four questions.

How much do I need?

Before you can begin drawing income, you need to figure out how much you’re going to need.  Your costs will largely depend on the lifestyle you choose to live, so start by thinking about what you have planned for retirement.  Do you want to travel?  Are you planning on moving?  Is there a particular hobby you want to focus on?  Once those decisions come into focus, it will be easier to craft a detailed retirement budget.  To help with this process, you can download a free Retirement Budget Worksheet at www.intentionalretirement.com/resources/.

Where is it going to come from?

Once you have a good handle on your expenses, determine what percentage of them will be your responsibility.  Start by making a list of all of your potential income sources.  Social Security and Medicare will likely do some of the heavy lifting.    If you are lucky enough to have a pension, it will cover another portion of your expenses.  If you plan on working part-time or have some other source of income, list that as well.  Using this information, fill in the blanks to the equation below.  The difference between your total need and the income provided by things like Social Security and your pension is the amount that you will need to draw from your nest egg each year to fund your retirement.

Is my nest egg up to the task?

Now that you know how much you need and where it’s going to come from, you can determine if your nest egg is up to the task.  When you retire, your portfolio takes over the job that the payroll department handled during your working years.  If you retire at 65 and live until you’re 85, it needs to cut you 240 monthly paychecks.  There is no foolproof answer for how much you can safely draw from your portfolio each year, but much of the research points to around 4 percent. 

With that in mind, grab a calculator and divide the number you came up with in the previous question by your total retirement assets.  If the result is less than or equal to .04 (4 percent), you’re in pretty good shape.  If it is greater than .04, it should raise a red flag.  All is not lost, but some changes are likely in order.  To avoid running out of money, you may need to save more, work longer, work part-time, or cut retirement expenses.

What is my withdrawal strategy?

The last piece of the puzzle is to decide on a withdrawal strategy that is right for you.  There are a number of ways to draw from your accounts.  You can take dividends only, convert all or a portion of your accounts to guaranteed payments by purchasing an annuity, or structure the accounts to self-liquidate over your lifetime, to name a few. 

The strategy that I prefer is often referred to as the bucket strategy.  Done correctly, it gives you the most flexibility and greatly increases your chances of outliving your money.  It involves structuring your investments into different “buckets” that you can pull from at different times or under different conditions.

For example, you would have one bucket that contained several years of needed distributions in a very safe investment like a money market or certificate of deposit.  In another bucket you would have riskier investments like your stocks and bonds.  In still another bucket, you would have your tax advantaged investments like your IRA or an annuity. 

The idea is to pull your distribution each year from the most appropriate bucket.  If you retire just prior to a bull market, you can pull income from your growing investments.  If you retire on the cusp of a bear market, you can take withdrawals from your cash.  The safe bucket keeps you from being forced to sell your riskier assets in a declining market.  The risk bucket increases your odds of outpacing inflation.  The tax-advantaged bucket allows you greater control over your tax bill. 

The primary advantage of this strategy is that it gives you options.  If you, your spouse, and your advisers are able to evaluate those options and make distribution decisions each year that accrue maximum benefit to you, you are likely to see a significant increase in the amount of money you can draw from your portfolio over the years without a commensurate increase in your risk of running out of money.

Monitor and adjust

No matter which distribution strategy you choose, you should never “set it and forget it.”  Take time each year to meet with a trusted adviser for a periodic portfolio check-up.  This is especially critical during the early years of retirement when your sequence risk (the risk that you will retire and begin withdrawing money during a period of low or negative investment returns) is highest.  Some questions you should consider during your annual review:

  • Is your withdrawal rate sustainable? 
  • Is your income still sufficient and keeping pace with inflation? 
  • Is your asset allocation still appropriate? 
  • Is the amount of risk you’re taking still suitable? 
  • Has the value of your assets changed significantly? 
  • Has your life expectancy changed?

Your answers will help determine if you can keep your withdrawals the same or if a change is in order.

Keep in mind that anyone can retire.  Staying retired is the challenge.  By crafting a well thought out distribution strategy you can help ensure that your resources will see you through your retirement years.

 

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