5 Options for Retirement Income Portfolios

There are several ways to line up investments to produce the income or cash flow you'll need in retirement. Choosing the best can be confusing, but there really isn't any single perfect setup.

In general, five approaches have met the test for many retirees. Each has its pros and cons, and their suitability can depend on your own personal circumstances.

Guaranteed Outcome

If you want to be able to count on a certain outcome in retirement, you can make it happen, but it will probably cost a bit more than a strategy that comes with less of a guarantee.

Creating a certain outcome means using only safe investments to fund your retirement income needs. You might use a bond ladder, which means buying bonds that would mature during each year of retirement. You would spend both the interest and principal in the year the bond matures.

This approach has many variations. For example, you could use zero-coupon bonds that pay no interest until maturity. You would buy them at a discount and receive all of the interest and return of your principal when they mature. You could use treasury inflation-protected securities (TIPS) or even certificates of deposit (CDs) for the same result, or you could ensure the outcome with the use of fixed annuities. There are also income annuities, which involve essentially paying a lump sum of cash in exchange for a guaranteed paycheck.

Many investments that are guaranteed are also less liquid. What happens if one spouse passes away young, or if you want to splurge on a once-in-a-lifetime vacation due to a life-threatening health event along the way? Be aware that certain outcomes can lock up your capital, making it difficult to change course as life happens.

Total Return

With a total return portfolio, you're investing by following a diversified approach with an expected long-term return based on your ratio of stocks to bonds. Using historical returns as a proxy, you can set expectations about future returns with a portfolio of stock and bond index funds.

Using a traditional portfolio approach with an allocation of 30% stocks and 70% bonds would let you set long-term gross-rate-of-return expectations at 7.7%. 

If you expect your portfolio to average a 7.7% return, you might estimate that you can withdraw 5% per year and continue to watch your portfolio grow. You would withdraw 5% of the starting portfolio value each year, even if the account didn't earn 5% that year.

You should expect monthly, quarterly, and annual volatility, so there would be times when your investments were worth less than they were the year before, but that volatility is part of the plan if you're investing based on a long-term expected return. If the portfolio underperforms its target return for an extended period of time, you would need to begin withdrawing less.

Interest Only

Many people think that their retirement income plan should entail living off the interest that their investments generate, but that can be difficult in a low-interest-rate environment. If a CD is paying just 2% to 3%, you could see your income from that asset drop from $6,000 per year down to $2,000 per year if you had $100,000 invested. 

Lower-risk, interest-bearing investments include CDs, government bonds, AA-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. That would immediately lead to a decrease in the principal value of the income-producing investment, and it can happen suddenly, leaving you little time to plan.

Time Segmentation

This approach involves choosing investments based on the point in time when you'll need them. It's sometimes called a "bucketing approach."

Low-risk investments are used for the money you might need in the first five years of retirement. Slightly more risk can be taken with investments you'll need for years six through 10, and riskier investments are used only for the portion of your portfolio that you wouldn’t anticipate needing until years 11 and beyond.

The Combo Approach

Nothing says you have to choose just one of these four methods and stick with it. In a combo approach, you would strategically mix the above options to fit your goals.

For instance, you might use the principal and interest from safe investments for the first 10 years, which would be a combination of guaranteed outcome and time segmentation. Then you would invest longer-term money in a total return portfolio. If interest rates rise at some point in the future, you might switch to CDs and government bonds and live off the interest.

All of these approaches work, but make sure you understand the one you have chosen. Be willing to stick with that choice rather than changing direction every few years. It also helps to have predefined guidelines regarding what conditions would warrant a change.