One of the biggest challenges most people face in retirement is generating the regular income they need and maintaining it for the rest of their lives.
The solution is easy if you’re flush with cash: Just put it all in Treasury bills. It won’t earn much, but at least the money will be safe.
For instance, if you have $5 million and want $100,000 in annual income—a mere 2 percent withdrawal rate—you’ll never run out of money. If you never earn a dime in interest, your money will last 50 years. If it earns 1 percent, it will last 70 years. At 2 percent, it will last forever; and if you earn more than 2 percent, you will die richer than you are now.
If you’re reading this, however, that probably isn’t your situation. You may have substantial assets, but they’re not limitless, so you must be careful how you manage them.
“To meet the dual goals of generating needed income and sustaining it, I recommend engaging in a process I call ‘reverse engineering.'”
To meet the dual goals of generating needed income and sustaining it, I recommend engaging in a process I call “reverse engineering.” I don’t have the space to cover all the details here (it’s fully explained in my forthcoming new book, “The Truth About Retirement Plans and IRAs”) but essentially this is what you do.
First, determine the amount of annual income you need currently—say, $75,000—and then determine the best place(s) to get it. It won’t all come from your retirement account because you likely have other income sources: Social Security, perhaps a pension, an inheritance, earnings from a part-time job and funds from other savings and investments.
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All of those could reduce dramatically the amount you need to generate annually—perhaps to as little as $25,000 or $30,000.
Future income from these sources can, of course, be expected to vary, and you must allow for that. Your expenses will go up, and if you’re in good health you can expect to live to age 95 or longer.
To determine the rate of return you need to earn on your investments in retirement, factor together all of these realities and your personal preferences: Do you want to leave something for your heirs, preserve principal or spend it down? Then it’s time to design a portfolio to meet that target—and a financial advisor can help you.
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Once you have the right portfolio, what is the best way to invest it? Well, if diversification is important to use throughout your working career, as I have long espoused, then it’s doubly important once you’re in retirement.
A diversified portfolio, of course, contains some assets that don’t generate income or dividends, along with others that produce those unpredictably, making it difficult to carry on your lifestyle.
That’s solved by what I call a “systematic withdrawal plan” or “SWP.” It’s simple and effective and it works like this: You decline to pocket the interest and dividends from your investments, instead reinvesting them back into the portfolio. To compensate for giving up that income, you arrange to receive a similar monthly amount from your account.
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There’s a big difference between that and drawing the income that a portfolio produces, as many retirees opt to do. Here’s an illustration: Say you had invested $100,000 in a one-year bank CD and received the annual interest each year from 2003 through 2012. The interest would have fluctuated wildly—from $700 to $5,210—and produced $24,520 in income over the 10 years. The original $100,000 remained unchanged.
However, if you instead created a diversified portfolio that produced an income equal to the CD and reinvested it, the account’s value would have grown to $220,126. You could then start producing twice as much income and easily offset inflation.
You could have systematically withdrawn twice as much in annual income as the CD, and your account value would still have been 83 percent higher than the CD’s value. Even if you took triple the income of the CD, your account would still have ended nearly 50 percent higher than the CD.
Simply matching, doubling or tripling the CD’s income, however, would have left you with inconsistent monthly and yearly amounts. To solve that problem, you could have arranged for a consistent monthly withdrawal, just as you get from Social Security or a pension.
If you took a 5 percent income stream, for example, you would have received double what the CD would have paid, and your ending value would still have been $220,680—or 121 percent more than what you started with.
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Of course, my illustration is hypothetical over a specific time period. Different periods and asset mixes would produce different results and, as always, past performance does not guarantee future results.
But you get the idea. I recommend the SWP as the best approach for generating the regular income you want/need to live on in retirement and sustaining it for your lifetime.
Ric Edelman’s new book, “The Truth About Retirement Plans and IRAs,” was published April 8 by Simon and Schuster.