Last week, we began looking at the four most common ways to tap into your retirement funds for a regular income stream.
Let me do a quick recap in case you missed it, then I’ll cover the third and fourth methods.
1. Interest only. This once most-common method involves depositing or investing one’s funds so they will produce interest, which is paid out and used as income. As we said last week, one risk is that interest rates fall so low that one can’t live off the pittance of interest produced. Like today.
2. Spend down. A spend down may be an intentional strategy, but is too often an unintentional consequence (of overspending). In a spend down, you spend not only the income your assets produce, but also a portion of the principle. If you strategically stretch this process out over about twenty years, you can create an after tax income stream roughly twice what might be possible using interest only. The problem is that after the twenty years…you’re broke.
3. Safe Withdrawal Rate. Wall Street would love to see you leave your money in a portfolio of their design, blending stocks and bonds and taking out a “safe amount,” so that negative return years don’t do irreparable damage to your portfolio.
If investment returns on such a portfolio are positive, you can have your cake and eat it too, by withdrawing income and seeing your portfolio balance grow. But everyone knows that if markets can go up, they can also come back down. So software programs have been developed to evaluate the damage potentially done by any periods of negative returns. What these programs are showing today is that a safe withdrawal rate is somewhere around 3% these days.
4. Self-made pension. You know what a pension plan is. A retiree gets a monthly check (usually) for life, and perhaps for the life of any surviving spouse. Nothing fancy. No account to manage, no investments to go up or down. Just a check. Every month. For life. Most folks like that.
For that reason, insurance companies offer the opportunity for individuals to create their own, self-made pension plans.
One could give an insurance company a lump sum of money to create such a self-made pension. To keep things equal, this would be the same lump sum we used to produce
“interest-only” income or “spend down” income or used to create a “safe rate of withdrawal”.
The insurance company issues a guaranteed income annuity to the individual to create the self-made pension. The insurance company is able to achieve actuarial diversification by covering lots of people. That way, they know that for every person who lives longer than average, there will be someone who dies earlier than average.
The benefit of such broad diversification means the company can pay a high annuity payout rate. A male at retirement age could expect something in the 7% range, guaranteed for life.
The downside is that when you die, so does your income and your asset. It’s gone.
No one of these income methods is perfect and each has its serious downsides. They are tools to be used, not stand-alone solutions that solve everyone’s retirement problem.
Like most tools, they work best in the hands of an experienced craftsman. And that craftsman usually works best when following a plan.
So step one in deciding which of the four methods (or combination of methods) to use is to get a retirement oriented financial plan.