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Creating income in retirement

Creating income in retirement

You’ve spent decades working and saving. Now you’re retired, with a “nest egg” of savings you believe will last for the balance of your life.  But how do you turn those savings into cash in a tax-efficient, cost-efficient way? And how do you minimize the risk of running out of money?

Start with a plan

To start, create a financial plan. It will help you figure out how much you can spend in retirement. A robust plan will address other critical issues as well. They include whether you have sufficient insurance, appropriate estate planning documents and sensible investments.

To figure out how much you can spend annually, you will need to make assumptions about how long you will live, how your investments will perform and what other expenses you may have. If you cannot or do not want to do this yourself, get help from a CERTIFIED FINANCIAL PLANNER™.

Advisors will use tools like “Monte Carlo analyses”. It determines how much you can spend and still have a high likelihood of not running out of money. A short cut some individuals use is the “4% rule”. Google it for more details. It is probably a decent “rule of thumb”, although we believe 3.5% is safer.

Once you have a working estimate of how much you can spend, the next question is: how do you convert your savings to annual income?  There are two options:

  1. Annuities, in which an insurance company creates income for you
  2. Traditional investing, in which you create income for yourself

Typically, we recommend traditional investing.

Option 1: Annuities

One option popular among retirees is buying an immediate annuity, offered by many insurance companies. You deposit a lump sum, and they pay you a predetermined, fixed amount monthly for your lifetime.

The advantages:

  • Certainty – you know exactly what you will get, every month.
  • Protection if you live far longer than the average person. The insurance company must keep paying you, regardless of how long you live.

The disadvantages:

  • Inflation may erode the payments significantly.
  • If you die prematurely, you may receive far less than you paid to the insurance company.

You can buy other, more complex annuities, including variable annuities. We seldom recommend them. The fees are typically 3-4% per year. As a result, you are almost always better off to buy a fixed annuity with part of your money and invest in low-cost mutual funds with the balance.

Option 2: Traditional investments

Many retirees believe that, with a monthly Social Security check (and sometimes a company pension, too), they have enough protection against out-living their savings. They opt to invest their savings in a mix of stocks and bonds. But how do you decide the right mix, and how do you convert that money into a monthly check?

The mix

The most important decision any investor makes is what percentage of stock to own compared to bonds or cash. That decision is the key driver of risk and return. The decision is personal. It depends on your goals and your ability to tolerate risk.

Many mutual fund companies recommend that the average person entering retirement have about 50% of their investments in the stock market, with that percentage declining to about 25% after 10-15 years of retirement. But many factors may make your optimal mix different.

Creating income from your investments

There are two methods to create income from savings:

  1. Buy investments that generate income, for example from dividends or interest payments
  2. Create income by combining dividend and interest income with sales of portions of your investments.

We recommend method 2.

Method 1: Buying high-income stocks and bonds

If your investments all generate “current income”, you have what may be a predictable income without selling any of your investments. But with today’s low interest rates and low dividends, that income may not be sufficient. Another disadvantage: you may be forced to take significant risk by only buying stocks and bonds that have higher current payouts.

The risks may not be obvious, but they are real. Bonds that pay higher than average interest have a higher than average likelihood of not paying back principal, and/or losing value. “High-yield bonds” (also known as “junk bonds”) are an example. Stocks that pay high dividends do not always continue paying the same dividend. For example, in 2009, the final year of the “Great Recession”, 57% of dividend-paying companies in the US either reduced or eliminated their dividends. (1)

Method 2: Create your own income

This is the way most professional investors generate income. They start by taking interest from bonds and dividends from stocks. But that is not enough to cover their cash flow need. They get the balance by selling a small portion of their investments. What do they sell? They sell whatever went up the most, or down the least. That keeps a portfolio “in balance” and almost always avoids selling anything that went down a lot.

A key advantage to this strategy is that an investor does not have to limit their investment choices to those stocks and bonds with high dividends or interest rates. Instead, you can have a broadly diversified mix. That reduces risk.

Another advantage is tax reduction. Dividends and interest payments are 100% taxable, assuming they come from a taxable account instead of an IRA. But if you sell a portion of your investments, you are only taxed on the gain. If you held the investment for more than a year, the tax rate on those capital gains is lower than the rate applied to salary income, interest income, and some dividend income.

Why dividends are so misunderstood

Many investors prefer stocks that pay a high dividend. They believe they are getting an annual return without having to sell their investments. They also believe stocks that pay a high dividend are, by definition, better investments.

Both beliefs are mistaken. The truth:

  • When a company pays a dividend, its stock price will, on average, fall by exactly the amount of the dividend. So, receiving a dividend is exactly like selling a small portion of the stockholding. If the stock didn’t fall, every savvy investor would buy the stock a day before the dividend, pocket the dividend check and then sell the day after. That’s free money – which, of course, is not on offer. What you need to know: dividends do not create value. They distribute value.
  • Historically, according to research by Dimensional Fund Advisors, companies that pay a high dividend have done no better and no worse as investments than companies which pay a low dividend or no dividend. Yet if you buy only high-dividend stocks, you have limited your choices and reduced diversification. That increases your risk, without increasing your likely return.

(1)  “Global Dividend-Paying Stocks: A Recent History”, Stanley Black, Dimensional Fund Advisors, March 2013.

This article is not intended to provide tax, legal, accounting, financial, or professional advice. Readers should seek advice from qualified professionals who can review their specific circumstances. Old Peak Finance endeavors to provide information that is accurate and current. However, we cannot guarantee that this information has not been outdated or otherwise rendered incorrect by new research, legislation, or other changes. Old Peak Finance has no liability or responsibility to any individual or entity with respect to losses or damages caused or alleged to be caused, directly or indirectly, by the information contained on this website.

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