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Retirement is an exciting milestone for many — an opportunity to restore balance, cultivate connections, and check experiences off their bucket list. But life after work also brings with it a new financial challenge: converting your nest egg into income.
Regardless of how well you've saved, you’ll need a withdrawal strategy that ensures you can cover your monthly living expenses without outliving your assets. With a portfolio that likely includes personal savings, brokerage accounts, and pretax retirement funds along with guaranteed income from Social Security and perhaps even a pension, that can be easier said than done.
“Even if you’ve done a good job of saving for retirement, the shift from accumulation to distribution can be paralyzing,” said Brock Jolly, a financial professional with Veritas Financial in Tysons Corner, Virginia. “Add to that the concerns regarding longevity, market volatility, inflation, and more, and it’s a challenge that can be daunting to many.”
Doing the retirement math
Before you begin distributing assets from your savings and investment accounts, you must first determine how much retirement income you need.
Start by estimating your future living expenses, including housing, health care, car payments, utilities, and groceries.
One common financial rule of thumb suggests that retirees will need roughly 75 percent of their pre-retirement income for each year they spend in retirement, which accounts for the fact that they no longer need to save for retirement, college tuition may be behind them, and their mortgage may be paid off. But your actual income needs may be higher or lower depending on your lifestyle. For example, if you plan to dine out often and travel extensively, you may need up to 100 percent of your pre-retirement income. (Learn more: A closer look at 6 common financial rules of thumb)
Don’t forget that while some expenses during retirement may drop as you slow down (entertainment, travel), others will likely climb (health care). MassMutual’s Retirement Income Gap Calculator can help provide guidance on future expenses.
Once you’ve projected your income needs, determine how much you’ll receive monthly from guaranteed sources of income, such as Social Security and pensions or trusts, if you have them. Any shortfall between your projected living expenses and guaranteed income is the amount you’ll need to generate from your savings and investments.
Some of the most commonly used financial tools that can potentially help you convert your savings into a paycheck include:
- Annuities
- Cash value life insurance
- Investment returns
- Dividend-paying stocks
- Bond ladders
- Reverse mortgages
Annuities
Annuities are financial contracts that make payments to you, either immediately or at some point in the future, in exchange for an upfront payment or series of payments. They are designed to help you accumulate assets on a tax-deferred basis and can provide a guaranteed stream of income that cannot be outlived, which makes them a potentially useful way to save for retirement. (Learn more: 5 reasons why you may need an annuity)
Annuities can also allow savings to potentially grow faster, because income taxes on any growth in an annuity aren’t due until there’s a withdrawal. However, each type of annuity has advantages and drawbacks that should be considered carefully before purchase.
A deferred income annuity, for example, is designed to provide a guaranteed lifetime income beginning on the date you choose. Such protection products can be structured to kick in at, say, age 85, to help mitigate longevity risk. (Learn more: Different types of annuities explained)
In some cases, retirees choose to purchase deferred income annuities (specifically a qualified longevity annuity contract, or QLAC) at age 73, when RMDs from their 401(k) and other tax-deferred retirement accounts begin.
Why? By using qualified funds from your 401(k) or traditional IRA to purchase a QLAC, you can potentially delay RMDs and their associated taxes from the portion of your account used to buy the QLAC. If structured correctly, such RMD payments may be delayed up to age 85. (Learn more: What is a QLAC? How can it help with RMD rules?)
Conversely, those who require immediate income when they retire may instead opt for an immediate annuity, which begins making payments right away. Some choose an immediate annuity for only a finite period of time, say, until age 67 when they can begin collecting their full Social Security retirement benefit or until their mortgage is paid off. (Related: When is the right time to buy an annuity?)
“By transferring several forms of risk — including market, withdrawal rate, and longevity risk — to an annuity company, an investor can create guaranteed lifetime income that they can never outlive,” said Jolly. “In an era in which pensions are rare and people continue to live longer than ever, minimizing these risks becomes critical.”
That said, annuities are not necessarily ideal for everyone. The downside of annuities is that you give up control of the money you use to purchase them. The money you spend to purchase them may also lower the size of your estate for your heirs. It’s important to consult a financial professional for guidance before making any major financial decision.
Permanent life insurance
Life insurance is primarily intended to protect your loved ones — replacing a portion of your income if you should pass away prematurely. But permanent life insurance can also potentially be used during your lifetime to supplement your income during retirement.
Permanent life insurance, such as whole life insurance, accumulates cash value as premiums get paid. You can borrow from your life insurance cash value penalty-free at any age and for any purpose, like paying college tuition, covering an emergency expense, or paying for living expenses during retirement. Cash value growth in a life insurance policy is typically tax-deferred. And the death benefit of the policy is paid out tax-free to your heirs.
According to Jolly, permanent life insurance can be a valuable asset when market conditions are volatile, providing a source of “safe money” that is not tied to market performance and from which distributions can generally be taken tax-free. (Learn more: How life insurance can help supplement retirement income)
That said, there are consequences to borrowing from your cash value. It increases the chances that the policy will lapse, reduces the cash value and death benefit to your heirs, and may result in a tax bill if the policy terminates before the death of the insured. A financial professional can help you determine whether permanent life insurance may help you meet your financial objectives.
Some hybrid life insurance policies also include long-term care (LTC) benefits, which may help with future costs related to assisted living if there is a need.
“So many of my clients have seen their own elderly parents’ fortunes dwindle because of long-term care costs, which helps make the case for why life insurance with LTC benefits can be a crucial part of their portfolio,” said Jason Sebell, a wealth management specialist for Baystate Financial in Boston, Massachusetts.
Investment returns
Despite the temptation (especially when the stock market declines), retirees can’t keep their money under the mattress. They would lose purchasing power every year due to inflation, which may increase their odds of outliving their assets.
Many financial professionals urge retirees to consider keeping a portion of their portfolio invested for growth — especially those who under saved. (Related: Is your retirement portfolio inflation ready?)
That’s easier to stomach if you have an oversized cash stash (money held in a liquid savings account) from which to draw during bear markets, giving your investments time to recover.
“Whenever possible, I am a strong advocate for my retiree clients keeping a portion of their portfolios invested for growth, especially in light of how long they are likely to live,” said Sebell. “More and more of my clients have parents living into their 90s, so longevity risk is a real factor in developing their financial plan.”
In an ideal scenario, retirees withdraw only a portion of their investment earnings as income every year, a strategy that helps preserve their principal. Financial professionals have long relied on the 4 percent rule, which suggests that the average retiree can safely siphon off about 4 percent of their portfolio in the first year of retirement and adjust annually for inflation thereafter.
If their investments are earning more than 4 percent after inflation, they would theoretically never run out of money. But those who leave the workforce before the traditional age of retirement may need to adjust that withdrawal rate lower to make their savings last longer. On the other hand, those who enjoy strong portfolio returns in the early years of their retirement might be able to convert a greater percentage of their portfolio into income later on without putting their financial security at risk. (Learn more: The ideal retirement withdrawal rate)
Dividend-paying stocks
Stocks that pay dividends regularly can also potentially provide income to retirees. Dividend stocks, mutual funds, or exchange-traded funds pay out a portion of their earnings to shareholders, often quarterly, as either a cash payment or stock reinvestment. Dividends paid as cash can help to supplement your retirement income, while the underlying security offers upside potential for capital gains.
As with all financial securities, however, be aware that past performance is no guarantee of future returns. And a company can stop paying dividends on its stock at any time. It’s important to maintain a diversified mix of income-producing stocks to help reduce exposure to company- or industry-specific risk.
To determine whether it might make sense to allocate a portion of your investment portfolio to dividend-paying stocks, consult your financial professional.
Bond ladders
Similarly, a portfolio of fixed-income securities can potentially serve as a paycheck proxy.
For example, by purchasing a collection of certificates of deposit (CDs) or bonds with staggered maturities, you could create a 10-year bond ladder in which one bond matures every year.
Investors who structure their bond ladder correctly could also conceivably generate a predictable income stream based on coupon payments with different maturity months. The proceeds could then be used to help cover immediate living expenses or reinvested, which may help mitigate interest rate risk.
Historically, bonds offer less upside potential than stocks, but they are also traditionally less volatile, which may help to diversify investment portfolios. (Related: Investing basics)
Sebell cautioned, however, that bond ladders are no longer a magic bullet for retirees seeking steady income.
“Too many of my clients in a 60/40 allocation of stocks and bonds have gotten beaten up by the bond market over the past few years and are hungry for alternative assets classes that produce reliable, tax-efficient growth,” he said, noting that he often encourages clients who are healthy enough to pass medical underwriting to consider permanent life insurance instead.
Jolly agrees, noting that bonds offer no guarantees.
“Depending upon market conditions, they can work very well,” he said. “But my concern is always around the myriad risks that exist with this type of strategy. Those include market volatility, longevity risk, withdrawal rate risk, and the fact that stocks and (non-municipal) bond ladders are still taxable investments that are held at a time when many investors don’t have the same tax deductions they may have enjoyed while they were accumulating wealth.”
For those reasons, retirees should carefully consider whether bonds are a fit for their portfolio.
Reverse mortgages
Finally, older homeowners may be able to supplement their retirement savings through a reverse mortgage loan.
A reverse mortgage enables homeowners aged 62 and older to tap into their home equity without having to move. There’s no repayment on a reverse mortgage loan until your home is no longer your primary residence. But when you move out or pass away, the loan must be repaid in full.
It is important to note that you are still responsible for property taxes and insurance under a reverse mortgage. And your mortgage balance will grow over time, since interest on the cash payments to you will be added to the loan. (Learn more: Reverse mortgages: What you need to know)
The Consumer Financial Protection Bureau cautions that reverse mortgages are not “free” money: “With a reverse mortgage loan, the amount the homeowner owes to the lender goes up — not down — over time. This is because interest and fees are added to the loan balance each month. As your loan balance increases, your home equity decreases.”1
Before you even consider a reverse mortgage, it is critical that you understand the pros and cons.
Conclusion
Converting savings into income during retirement is no easy task.
With guidance from a trusted professional and knowledge of the financial strategies available, however, you can help create a tailored plan that meets your goals and objectives. Having a financial plan also helps eliminate stress and anxiety, which may give you permission to enjoy the assets you worked so hard to accumulate.
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