Harvesting Portfolio Income

I once worked with a lawyer who wanted me to do a calculation for his clients that would show that their retirement income would never run out. A guarantee (the song "Wouldn’t It Be Nice” came to mind) When I told him I couldn’t do that, our relationship ended.  Abruptly.  He said that he found another financial planner who informed him (the attorney) that he had software that would make such a guarantee.  

Sadly, there is no such software, annuity, or any product that can guarantee your financial future, especially your retirement income.  There are too many variables, particularly longevity. However, there are many ways to create a retirement income that should allow you to never run out of money.

Retirement income is most often derived from four sources:  Social Security, pensions, savings and work.  We spend hours educating on the best ways to get the most from Social Security and pensions.  And those who decide to create income from work after leaving full-time employment don’t need any suggestions from us (I plan on being a soccer referee into my 70s — I just hope it's not your grandkids on the field with me).  With that in mind, let's focus on turning your savings into retirement income.

Annuitize or not? 

Many of us would like to take our life’s savings and create instant income for life, especially if we can transfer the risk to someone else.  The challenge is finding a product that does this with low cost, transparency and maintains reasonable liquidity.  At best, that’s a no-load immediate annuity (now offered by a few reputable firms); at worst that’s an index annuity sold with a large commission and massive surrender fee.  The biggest issue I have with an immediate annuity is the minuscule amount you will earn on the money you handed over and the lack of any inflation protection. You may be happy to get guaranteed income, but it will look pretty puny in 20 years if inflation increases at its historical 3 percent a year rate.  For most of us, an immediate annuity is like eating a rich dessert; it will feel good in the near term, but the long-term benefits are harder to find.

4% rule  

If you have read anything in the past 30 years about retirement investing, you have no doubt heard of the 4% rule.  The idea is that you won’t run out of money if you only take out 4 percent of your portfolio savings a year. This FIXED withdrawal strategy has worked (including adding inflation) for the past 46 years, but only if you had exposed a healthy amount of your portfolio to stocks.  For example, a portfolio 60 percent in a globally diversified stock portfolio and 40 percent in government bonds would have survived and left money to heirs.  Conversely, a portfolio all in those same government bonds would have run dry in less than 30 years.  In other words, to assure your income for a long retirement you had to expose a good deal of your retirement portfolio to risky stocks— something many of you don’t want to do after your working years end.  Further, this strategy faces “point in time” risk when you decide to stop working and draw on your assets to provide income.  Retiring in 2001 or 2008 was a painful experience for some.  Therefore, taking a fixed 4 percent (plus inflation) from your portfolio each year may result in long-term challenges.

5% flexible 

How do you feel about getting a variable distribution from your portfolio each year in retirement.  Doesn't sound too great, does it?  But here’s the upside:  you should never run out of money.  And, in your later years, you should have plenty of money to pay for unexpected health or housing issues.  In my classes, I jokingly tell people who use this strategy that in the good years they will get to go to Europe or Hawaii, but in the lean years, you can only afford tickets to a local amusement park. Put another away, this strategy would have allowed you to take out large sums of money in the roaring 1980s and late 1990s’ but you would have felt the pinch in 2001 and 2008.  

DFA Target Date Income Funds (TDIFs). 

The smart folks at Dimensional Funds took their time before entering the world of “target date funds.” A target date fund, as you may know, is a mutual fund managed for a particular time — usually the retirement year of an investor.  Typically, these funds hold significant amounts of stocks when the investor is younger but add more and more bonds as that same person moves closer to retirement.  Going one step further, Dimensional looked at the problem that exists for people after retirement: having a stream of income while protecting against drawdown risk. DFA’s solution was to create funds that hold significant amounts of inflation-protected bonds and a smaller number of stocks when an investor reaches retirement.  The fund owner can draw money from their holdings while having some comfort that they can increase their distribution as the cost of living increases.  It’s a relatively novel approach and very new, but it appears to be a reasonable way to creating retirement income.  However, what is does not do is provide for legacy giving.  The target date income strategies are designed to spend the money down during retirement.  That may conflict with your estate plan.

Which approach is best for you? 

I wish I could give you a box to check (along with boxes for life’s other tough decisions!)  While there isn’t a “correct” answer, sound financial planning can help most of us create a stream of stable retirement income.  The start is getting a good handle on your spending.  Most people we meet with do not know how much they are shelling out for basics and the extravagances. Clarify that number and work from there.

My personal plan calls for me to work to age 70, collect Social Security and take my qualified retirement accounts and use Dimensional’s Target Date Income Funds to pay our day to day expenses.  My other money will likely be managed with a good deal of global stock exposure.  The money from that account will pay for the fun stuff — vacations, grandkids and other non-essentials.  That’s just my plan.  Your plan should match your needs, your emotional ability to take risk, and wishes for legacy giving.  A qualified financial planner should be able to help you create such a plan— and allow you to spend your retirement doing the things you truly enjoy.