There are several ways to line up investments in a way that will produce the income, or cash flow, you will need in retirement. There is not a perfect choice. Instead each approach has pros and cons.
Below I cover five different approaches to setting up a retirement income portfolio.
1. Guarantee the Outcome
If you want a certain outcome in retirement, you can have it – it just may cost a bit more than a strategy that has less certainty.
To create a certain outcome you would use only safe investments to fund your retirement income needs. There are several ways to do this.
You might use a bond ladder, which means for each year of retirement you would buy a bond that would mature in that year. You would spend both the interest and principal in the year the bond matured. This approach has many variations.
For example, you could use zero coupon bonds, which pay no interest - instead you buy them at a discount and receive all the interest and return of principal when they mature. Or you could use TIPS (Treasury Inflation Protected Securities) or even CDs.
Or instead of using bonds and CDs you could insure the outcome with the use of annuities.
- Certain outcome
- Low stress
- Low maintenance
- Income may not be inflation-adjusted
- Less flexibility
- You spend principal as safe investments mature (or use principal for purchase of annuities) so this strategy may not leave as much to heirs
- May require more capital than other approaches
Caution: many investments that are guaranteed are also less liquid. What happens if one spouse passes young, or due to a life-threatening health event you want to splurge on a once-in-a-lifetime vacation? Be aware that certain outcomes can lock up your capital making it difficult to change course as life happens.
Learn more about guaranteeing the outcome in 7 Ways to Create a Floor of Guaranteed Retirement Income.
2. Total Return
With a total return portfolio you are investing by following a diversified approach with an expected long-term return that is based on your ratio of stocks to bonds.
For example, with a portfolio of stock and bond index funds, using historical returns as a proxy, you can set expectations about future returns.
Historically stocks, as measured by the S&P 500, have averaged about 9% (1926 – 2012 resulted in a 9.8% gross return per DFA Matrix Book 2013).
Bonds, as measured by the Barclays US Aggregate Bond Index have averaged about 8% (1976 – 2012 resulted in an 8.2% gross return.)
Using a traditional portfolio approach with an allocation of 60% stocks/40% bonds that would lead you to set long-term gross rate of return expectations at 8.6%. Net of estimated fees of about 1.5% a year that results in a return of 7%.
If you expect your portfolio to average a 7% return you might estimate you can withdraw 5% a year and continue to watch your portfolio grow. You would withdraw 5% of the starting portfolio value each year thereafter even if the account did not earn 5% that year.
You would expect monthly, quarterly, and annual volatility, so there would be times where your investments were worth less than the year before. But if you are investing based on a long-term expected return, this volatility is expected and part of the plan. If the portfolio underperforms its target return for an extended period of time you would need to begin withdrawing less.
- Historically this strategy has worked – if you stick with a disciplined plan
- Flexibility – you can adjust withdrawals or spend some principal if needed
- Requires less capital if expected return is higher than using a guaranteed outcome approach
- There is no guarantee this approach will deliver your expected return
- You may need to forego inflation raises or reduce withdrawals
- Requires more management than some other approaches
Learn more about total return portfolios in Withdrawal Strategies for Retirement Income Portfolios.
3. Interest Only
Many people think their retirement income plan should entail living off the interest their investments generate. In a low interest rate environment this is difficult.
For example CDs that used to pay 5% to 6% are now paying 2% to 3%. If you had $100,000 invested, you may watch your income go from $6,000 a year down to $2,000 a year.
Lower risk interest bearing investments include CDs, government bonds, double A rated (or higher) corporate and municipal bonds, and blue-chip dividend paying stocks.
If you abandon lower risk interest bearing investments for higher yield investments, you then run the risk that the dividend may be reduced, which would immediately lead to a decrease in the principal value of the income producing investment. This can happen suddenly, leaving little time to plan.
- Principal remains intact if safe investments are used
- May produce a higher initial yield than other approaches
- Income received can vary
- Requires knowledge of the underlying securities and the factors that affect the amount of income they pay out
- Principal can fluctuate depending on type of investments chosen
Learn more about interest producing investments in 3 Types of Investment Income.
4. Time Segmentation
This approach involves choosing investments based on the point in time where you will need them. It is sometimes called a bucketing approach.
Low risk investments are used for money you may need in the first one to five years of retirement, slightly more risk can be taken with investments needed from years six to ten, and riskier investments are used only for the portion of your portfolio you wouldn’t anticipate needing for years 11 and beyond.
- Investments are matched to the job they need to do
- Psychologically satisfying – you know you don’t need higher risk investments any time soon so volatility may bother you less
- There is no guarantee the higher risk investments will achieve the return they need to achieve over their designated time period
- Must decide when to sell higher risk investments and replenish your shorter term time segments as that portion is used
Learn more about Time Segmentation in Is Reliable Retirement Income Worth 10 Minutes?
5. Combo Approach
With a combo approach you strategically choose from the options above. You might use the principal and interest from safe investments for the first ten years, which would be a combination of Guarantee the Outcome and Time Segmentation. Then you would invest longer-term money in a Total Return Portfolio. If interest rates were higher at some point in the future then you might switch to CDs and government bonds and live off the interest.
All of the approaches above work. To make one work for you, you need to understand the approach you have taken, and be willing to stick with it, or have pre-defined guidelines on what conditions would warrant a change.