Retirement Income Planning

    The main challenges of retirement income planning are to create an income that lasts a lifetime, keeps pace with inflation, and allows enough flexibility to cover emergencies. While there are countless strategies to meet these challenges, they boil down to two fundamentally different approaches: the Probability based approach  and the Safety first approach.

     The Probability based approach, favored by investment manager types, has you assemble a sizable portfolio during your career and systematically draw from it during retirement to underwrite your retirement life-style. This approach requires significant participation in the Stock Market, a sizable portfolio, and a plan to deal with inevitable stock market swoons. Some call this approach the “4% Solution” drawn from the work of Bill Bengen during the 1990s. Bengen examined rolling 30 year periods from 1926 and discovered that a Portfolio of 60% S&P 500 and 40% Intermediate Bonds could sustain an annual withdrawal rate of 4% (and each year upping the withdrawal by the inflation rate). For example, a $500,000 portfolio would prescribe a $20,000 withdrawal (in retirement’s first year ($500,000 X 4% = $20,000). If inflation was 3% in year two, the next withdrawal would be $20,600 ($20,000 X  3% = $600) and so on, each year raising the annual withdrawal amount by the preceding year’s inflation rate.

     Bengen found that there was never a 30 year period among the 100 or so he studied where a portfolio was fully depleted before 30 years expired. In some 30 periods, it was nearly fully depleted, where as in other 30 year periods, the retiree could have withdrawn 8% per year and still have funds left at the end of the period. It just depended on how the markets performed and the time sequencing of market downturns occurred during the 30 year periods. Bengen assumed 30 years as a proxy for a retirement life-time.

     Many variations of “the 4% rule” have appeared over recent decades. Vanguard’s iteration suggests setting “guard rails,” allowing somewhat greater withdrawals than 4% during Stock Market booms, while requiring withdrawals less than 4% in years when the Stock Market doesn’t deliver.

     The RMD variation follows the required distribution percentages the IRS mandates from most qualified plans. Here you make withdrawals somewhat less than 4% in retirement’s early years, and gradually increasing the withdrawal percentage each year as your life expectancy shortens. 

     Some 4% strategies suggest drawing 4% plus inflation “on a total return basis” each year, combining investment income along with capital gains (and investment principal, if necessary) from the entire portfolio. Other 4% withdrawal strategies exempt guaranteed buffer (emergency) assets from annual withdrawal considerations. 

     In contrast, The Safety first approach emphasizes guaranteed incomes as the centerpiece of retirement income planning. Payouts from defined benefit pension plans, Social Security’s retirement benefits, and commercial annuities with guaranteed incomes are used to implement this approach. Withdrawals from Investment assets, though present, are used primarily to “inflation hedge” fixed incomes and to provide emergency or buffer funds. 

   The (SFA) also employs commercial annuities to “risk pool” in generating life time, guaranteed incomes, virtually impossible to assure in any other way. Insurance companies can guarantee life-time incomes because their actuaries know everyone (as a group) dies at a predictable rate. This allows the insurance company to spread the risk among populations of annuitants to cover the life-time income needs of even the longest lived. Immediate annuities, deferred income annuities, and longevity insurance (advanced life deferred annuities) in various combinations are the insurance products used to implement the plan. Each provides life income either immediately, some time in the near or distant future.

   With payout annuities you exchange a lump sum of money to an insurance company for a promise to provide you with a life-time income. The life-time income can begin immediately, some time in the near future, or in decade or more hence. For a given monthly income, the longer you delay the income to commence, the lower the cost. For example, in 2021, a 65 year could buy a a life-time annual income of $6,340 for $100,000. In contrast, a 65 year old could buy the same life-time income to begin at age 65 (20 years in the future) for only $16,000 today.

   Because some buyers of these future income products do not live to receive the payments, these unused dollars are distributed among those who do to provide them with additional income. These enhancements to the incomes of the survivors are called “mortality credits” and provide additional income to survivors difficult to replicate in any other way. Also, the IRS waives required minimum distribution (RMDs) requirements for qualified retirement plans up to $130,000 if they use advanced life deferred annuities in this way. They’re called Qualified longevity annuity contracts (QLACs). Once the life-time income is initiated, the annuitant is subject to the RMD requirements.

     Every retiree has a retirement income plan. Often, the plan is by default where the retiree never actively creates a plan but simply withdraws funds from accounts randomly. Occasionally, a retiree’s pension and Social Security represent such a large portion of his/her retirement income that plan creates itself. We hope this discussion provides you with the impetus to be an active participant in creating your own plan. The two approaches described above (Probability based approach and the Safety Approach) provide templates to consider. Retirees need to take the best of each approach for themselves to create a plan they can live with. Successful retirees will combine portions of both to reflect their needs for certainty, willingness to take risks, and legacy considerations. Good luck on your journey!



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