For most of us, it’s very important to have an income or some type of cash flow during retirement, especially if you want to enjoy your retirement years. But how do you plan for this income and where does it come from? For most of us, Social Security is the first source that comes to mind. Yes, I do believe Social Security will be around in some form or fashion for most of us as one of our retirement income sources. If you are one of the lucky ones, you may work or have worked for a company that offers a defined benefit plan or pension. This is a second source of income that can help you with retirement income needs. The third source of income, which is becoming more and more important because of the increased social pressures on the first two, comes from personal savings and investments.
It is important to understand that you can have assets without income, but you cannot have income without assets. In other words, you can have a pile of gold, which is an asset that produces no ongoing income or cash flow. So, it’s important to have the type of assets that have the ability to produce an income. Some of these income-producing assets generate income that is not guaranteed, while others have income that is guaranteed. A few examples are as follows:
Rental property has many benefits to the owner, including capital appreciation, taxes, and income. However, if the property is vacant, there is no income.
Stock Dividends/Bond Interest
Dividends from stocks or interest from bonds is another source of income. But, once again, this income is not guaranteed. Corporate boards can vote to lower and even eliminate company dividends due to company financial weakness in a bad economy. Interest from bonds is usually safer, but bonds can default.
Many advisors are helping their clients create a diversified portfolio of stocks and bonds using a cash-flow approach. This approach is defined as simply taking a flat percentage from the portfolio and adjusting that for inflation annually. Meaning, this cash flow will come from the dividends and interest but could also come from principal. Many studies have taken place trying to conclude how much this flat percentage should be so you don’t run out of money during your lifetime — hence the 4% Rule was born. In the October 1994 issue of the Journal of Financial Planning, William P. Bengen, CFP, M.S. concluded that if you have a diversified portfolio of approximately 50% in stocks and 50% in bonds, you should be able to withdraw approximately 4% of the value per year — of which this annual income is adjusted for inflation — and not run out of money during a 30-year retirement. In other words, if you have a $1M diversified portfolio balanced with 50% stock and 50% bond, you should be able to withdraw $40K a year.
Things have sure changed — in the market and economy — since 1994. According to a more recent study published January 15, 2013, “The 4% Rule is not safe in a Low-Yield World” by Michael Finke, Ph.D., CFP, Wade Pfau, Ph.D., and David Blanchett CFA, CFP, it was concluded that the safe bet is a withdrawal rate of 2.5%1. The safety of a withdrawal strategy depends on asset return assumptions. Hence the recommended withdrawal rate has declined from 1994 to 2015, due mainly in part from the low interest rate environment and increased stock market volatility. The $1M diversified portfolio from above just dropped from an income of $40K to an income of $25K. Even though this may be the safe bet given the current state of the market and interest rates, it is still not guaranteed.
Many different types of annuities can provide a contract owner investor with income for a certain period of time, or even for life if an optional income rider is purchased. The one that most people think about when it comes to income is the Single Premium Immediate Annuity (or SPIA). A SPIA works in a similar way to a pension; you give the insurance company a lump sum of money, and, in return, the insurance company will give you a systematic income stream for a certain period of time — or for life with the optional rider. For example, if you have a 10-year SPIA on your life, the income stream will last for 10 years. If you were to die in year five, then the income can continue for five more years, payable to a beneficiary. Unfortunately, after 10 years, the income stops. You can also have a SPIA that will actually pay an income stream for your entire life. Many other types of annuities can be annuitized to produce an income, however, if the owner dies prematurely, then any balance in the account is reverted back to the insurance carrier. Nonetheless, a fairly new type of annuity was developed in 1994 by the insurance industry: the Fixed Indexed Annuity (or FIA). Many FIAs have optional income riders. That means, for an extra fee, the insurance company can provide the owner with income for life. This income can also be joint for life with a spouse. In many cases, it can increase annually with inflation. And, if the owner dies prematurely, any balance in the account goes to the beneficiaries and does not revert back to the carrier. The income amount is based on the balance in the account and the age of the owner at the time the income is elected. In many cases when abiding by the terms of the contract, this withdrawal rate can exceed 5%, which is higher than the recommended withdrawal rate of the diversified stock and bond portfolio, plus the annuity income is guaranteed — while income from rental income, dividends, interest, and utilizing the cash-flow approach discussed above are not.
If you are concerned about your future retirement income, and you think an annuity might be an important vehicle for your retirement portfolio, please contact a financial advisor to discuss your options.
1 Finke, Michael S. and Pfau, Wade D. and Blanchett, David, The 4 Percent Rule is Not Safe in a Low-Yield World (January 15, 2013). Available at SSRN: http://ssrn.com/abstract=2201323 orhttp://dx.doi.org/10.2139/ssrn.2201323.
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