How to Create a Retirement Income Stream

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November 21, 2012

by CATHY MENDELL of Elevation Capital Strategies
You spent years feathering your nest egg: tracking your investments, adjusting your allocation and sacrificing a percentage of your paycheck every month to finance a comfortable retirement.
Who knew that would be the easy part?
The biggest challenge for people in retirement is recreating the income streams they had when they were working. You have to figure out how to take your assets and turn them into income by taking withdrawals, selling your investments or purchasing an annuity.
Indeed, the complexity of tapping a mixed bag of retirement assets, from personal savings to pensions to IRAs and 401(k) plans, is compounded by a litany of distribution requirements, potential penalties and tax liabilities.
It’s made harder still by who is in the Oval Office. The general level of tax rates can and does change over time in response to economic conditions, the agenda of the reigning political party or current and expected budget deficits or surpluses. Therefore, retirees must learn to adapt their withdrawal strategy to a changing tax environment as well as compensate for inflation, market decline, longevity and maintaining health as they age.
Steps to Creating an Income Stream
Determine your withdrawal rate
Before you can decide how to set your accounts up, you’ll need to crunch the numbers to determine how much you income you’ll need to maintain your desired standard of living, without running the risk of outliving your cash. Your withdrawal plan, in fact, is the most important piece of your post-retirement financial plan. To develop a sustainable strategy, you’ll need to consider your age, life expectancy, living expenses and rate of return on your investments.
Let’s follow a purely imaginary case: Mark is 67 years old and married to Ellen, 65. The year is 2012 and, finally, Mark is about to retire. The couple estimates that it needs approximately $70,000 per year to live comfortably, which they understand should be adjusted for yearly inflation. Additionally, they are extremely adverse to longevity risk and would like to maintain a $70,000 standard of living for life.
The $70,000 number, of course, is after tax. Mark estimates they would require a gross income of $100,000 so they can actually enjoy the $70,000 after all income taxes are paid. Their Social Security income generates $28,000 per year and Ellen has a pension of $17,000 per year. They also own a rental which after expenses nets $10,000 per year. They want $100,000, and are receiving $28,000 + $17,000 + $10,000, which is $57,000 in income, leaving a gap of $43,000 per year. Additionally, Mark and Ellen have a 401k, IRA and savings totaling $1,000,000. How is their income deficit financed?
For retirees with all their ducks in a row, meaning they have adequate savings set aside and are generally healthy; the traditional rule of thumb was to draw down no more than four percent of their portfolio each year, adjusting that rate gradually higher to account for inflation. Is this rule of thumb still valid? Given the history of the stock market over the last ten years, if your investments followed the returns of the S&P 500, a $100,000 investment started in 2002 would be worth $127,000 today reflecting an actual annual return of only 2.4 percent. If market conditions continue to be random and unpredictable with some years a negative return, using a four percent withdrawal rate formula Mark and Ellen would be out of money in 21 years. The chart below illustrates actual S&P 500 Returns 2002 – 2011, and then a hypothetical repeat of the same market performance.

 

Back to Mark and Ellen. Ellen says, “We’re retiring and don’t have time to recover from any stock market losses. How much risk should we take with our precious nest egg?”
Harsh as it may sound, as Harry S. Truman said, “If you can’t handle the heat, stay out of the kitchen.” If you think about it carefully, there’s a strong similarity between the process of gambling on a roulette wheel – your money going up and down – and the process of investing and spending during retirement. The difference between them is: 1) your portfolio moves up and down continuously, depending on the stocks and bonds you’ve selected, and 2) you’re spending money from this portfolio, which increases the chances your portfolio will shrink in value over time. Dr. David Babble, Professor of Risk Management at the Wharton School of Business warns: if you have a stock portfolio and you withdraw percent per year + inflation…you have a 90 percent chance of running out of money in retirement (over 30 years). Source: Marketplace 5/2011.
Retirement Income Lesson: Your income shouldn’t depend on the markets, it should depend on MATH. All else being equal, the more income you receive from pensionization sources, the greater the sustainability of your retirement plan. By pensionized I mean that the income source is guaranteed for life. Let’s go back to Mark and Ellen and assume that they have structured their retirement differently. Rather than retire with $1,000,000 in a market account, Mark transferred $600,000 of his 401K to an Index Annuity with a lifetime income guaranteed rider four years prior to retirement. At retirement Mark and Ellen have the following income sources: their Social Security income of $28,000 per year and Ellen’s of $17,000 per year, their rental nets $10,000 per year and their Index Annuity lifetime Income payment of $43,146 =$98,146 annual income, leaving a gap of only $2,000 + inflation. Additionally, Mark and Ellen have $400,000 left from their IRA and savings to use for enjoyment, emergencies and income gap.
As you map out your retirement withdrawal strategy, make sure you take the time to understand the rules, penalties and tax liabilities associated with each of your accounts.
And don’t forget, the trick to making your nest egg last is not the size of your account, but how well you manage what you’ve got.
Cathy Mendell of Elevation Capital Strategies can be reached in Bend at 541-728-www.elevationcapital.biz, cathy@elevationcapital.org
Securities offered through GF Investment Services, LLC, Member FINRA/SIPC.
Investment Advisory Services offered on a fee basis through Global Financial Private Capital, LLC, an SEC Registered Investment Adviser.

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