A Roadmap for Creating Tax-Favored Income in Retirement
For decades, retirement income planning was portrayed as a three-legged stool. These legs have traditionally been pensions, social security income, and personal savings. However, in today’s environment, there are many valid reasons for concern about these sources of retirement income.
Back in 1980, approximately 38% of America participated in a defined benefit pension plan. As of 2023, this figure has dropped to approximately 15%. For individuals with pensions, there can be a flurry of options: a single life payout, 100% joint life payout, and sometimes a lump sum payout, and often times others in between. Even for fortunate individuals who have these options available, some of the defined benefit plans have changed to act more like additional retirement savings rather than a source of monthly income.
The second leg, our social security system, has been experiencing its own challenges as well. On the Social Security Administration’s website, it discusses options proposed by the Social Security Advisory Board to reduce benefits as the “projected reserve depletion date for the combined OASDI trust funds is 2035”. Some of the options provided include reducing benefits for individuals who are currently collecting benefits, adjusting based on average monthly earnings, and reducing benefits for individuals who have not yet started to collect benefits. This may lead some people to think that turning on their benefits before their full retirement age may be an appropriate option to receive more income from Social Security. A potential flaw with this thinking is that it could result in a significant decrease in income benefits over the course of one’s lifetime. There is no correct solution for all retirees. It is becoming increasingly imperative to work with a fiduciary retirement planner who can help design an income plan to aid in this decision-making process.
Without the strength and stability of these two legs of the stool (Pensions and Social Security), the stool becomes increasingly unstable. For retirees, a greater dependency on their retirement savings may be necessary to provide their retirement income. ‘But what is an appropriate investment vehicle/strategy to achieve income in retirement’? For the past century, the U.S. stock market has produced very strong returns; however, this may not be the right place to have all funds necessary to provide income in retirement.
You may be hard pressed to find a fiduciary retirement planner who recommends investing purely in the stock market. Besides the fact this is likely above most retirees’ risk tolerance, it may not be the recipe for success. With the raging bull market that has taken place after 2009, it may be easy to forget the dot-com bubble which caused the Nasdaq to fall by 78% between 2000 and 2002 or the 2008 financial crisis which caused the Dow Jones to drop 54% between 2008 and 2009. Based on the extraordinary market growth of the last 16 years, these events feel like a lifetime ago. For those who do not remember these crashes, it could be beneficial to look back and remember a quote often attributed to Mark Twain, “history never repeats itself, but it does often rhyme.”
The flaw with having all of your wealth in the stock market can be seen in the period between 2000 and 2013. In March of 2000, the S&P 500 index was valued at 1,498.58. Over the following 13 years, the major indices were incredibly volatile due, in large part, to the Dot-Com bubble and the 2008 Financial Crisis. By January of 2013, the S&P 500 index was again valued at 1,498.58. In essence, an investment in the broader U.S. stock market during this period, would not have had any capital appreciation. For retired investors, this had a devasting result as they relied on their portfolios for income. Relying on portfolio income during this time could have led to lower “highs” and lower “lows” due to the combination of a lack of market appreciation and a need to withdraw income from a portfolio.
In order to avoid these major cases of volatility, many investment advisors recommend investing in the bond market, which in modern finance, have the reputation of being conservative. While this is one way to diversify from the stock market, over recent years it has had a major impact on portfolio valuation. Some investors have portfolios that have not recovered since the bear market in 2022. This could result from a large portion of their portfolio being in bond mutual funds or exchange traded funds (ETFs). It is becoming more and more uncommon for traditional bonds with a coupon rate and maturity dates to be held in retail investors portfolios. Indices such as the S&P U.S. Aggregate Bond and other funds created by the large financial brokerage firms have become some of the most common placed vehicles. How has the AGG performed over the years? The AGG has returned negative results of -14.69% over the last 5 years (02/21/2020 -02/21/2025) and has decreased by -3.81% in market value since 01/01/2003. An investment that can decrease by -21.57% over the course of approximately 2 years may not be considered conservative by some investors. Fortunately, there are alternatives to provide retirement income from an investment portfolio.
In this ever-changing economic environment, we believe it is crucial to work with an independent fiduciary retirement planner who is not limited in the options deployable from a portfolio. Real estate can be a wonderful option to receive income tax-efficiently in retirement, however, most do not view this as a pure investment as it often can require significant time and energy spent on maintenance and management of tenants. Another option is annuities. Multi-Year Guaranteed Annuities (MYGAs) provide a predetermined interest rate that typically last 3 to 10 years. This can be an excellent option for retirees who want to receive a fixed rate of interest. Typically, these offer an interest rate greater than traditional bank products like savings accounts and CDs; however, they are usually locked in for a greater length of time. Unlike traditional bonds offering a fixed interest rate, the MYGAs are not subject to market devaluation as they are principal-protected. This means when the stock market is down or the interest rates increase, the value of these contracts has not decreased, and income could still be taken from them. In most cases, there is still limited accessibility to these funds, and they are not something that someone could take more than a fixed percentage or interest out before maturity.
Another option for individuals who want the opportunity to achieve greater earnings potential than MYGAs are fixed index annuities. These contracts are tied to various indices such as the S&P 500 and usually change in value once per year. It is worth noting that these annuities vary greatly from variable annuities. Variable annuities often do not provide principal protection and can often have high fees built into their products. Fixed index annuities can have no fees or substantially lower fees as compared to variable annuities for the owner and are principal-protected.
A fixed index annuity designed to provide income can be a very powerful tool for individuals who are concerned about running out of money in retirement, especially if they do not have enough coming in from pensions or Social Security. This strategy can be funded by transferring funds (they can be retirement or non-retirement funds) into this vehicle and turn on a monthly, quarterly, or yearly stream of income. This income is guaranteed by the company used and, even if the account value were to go to $0, these contracts can continue to pay out the owner (or their spouse if a joint option is selected) the same stream of income for as long as he/she lives. A drawback for this certain type of annuity can be lower capital appreciation due to a lower crediting method and annual fees. It is important to note that just like all categories of retirement strategies, some fixed index annuities are better than others. This is also a crucial reason to work with a fiduciary retirement planner who is able to provide appropriate options and strategies specific to each investor’s situation and circumstances.
If a consistent monthly or yearly income from your portfolio is not necessary at this time, but may be in the future due to inflation, a fixed indexed annuity designed for growth could be a viable option. These strategies give interest tied to an index such as the S&P 500. One way they can provide interest is using a cap rate. For example, if there were an 8% cap on the S&P 500, funds allocated in this strategy would earn the full growth of the stock market up to 8% on a one-year basis. If the stock market was up 6% over 12 months the account would be credited 6% in interest. If the stock market was up 10% over the course of 12 months, the account would be credited 8% interest. However, one crucial benefit of these strategies is during the periods of extreme volatility. If the stock market were to decrease by -20%, or -50%, or any amount, fixed index annuities are guaranteed not to lose account value based on market fluctuation.[13] These strategies can also have limited liquidity features allowing for some liquidity, typically 10% per year over the duration of the surrender period, which can vary from 5 to 14 years or more. It is important to consult a fiduciary retirement planner who can explain the benefits and drawbacks of these investments as well as find one suitable for an investor’s personal circumstances.[DB19]
When it comes to taking income from the portfolio, one strategy to consider is taking income from the equity accounts when markets are up, effectively “selling high.” When the markets are down, consider taking income from a fixed index annuity account to avoid locking in losses when the market is down. This can be one way to leverage personal savings to help provide income as a firm foundation to stabilize a shaky three-legged retirement stool.
Advisory services are offered through A Better Way Financial, LLC., an Investment Advisor in the State of Pennsylvania. Insurance products and services are offered through ABWI, LLC, an affiliated company.
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