We spend most of our working lives putting money into our retirement accounts (hopefully), but what happens when we retire? How do we turn that nest egg into income that will last at least as long as we do? Let’s take a look at some options:
Live off interest and dividends
The most conservative option would be to live off your interest and dividend income. The advantage of this approach is that you have no chance of running out of money since you never touch your principal. If you stick to TIPS (treasury inflation protected securities), you also don’t have to worry about your income being reduced or eroded by inflation.
However, your income wouldn’t be very high. 30-year TIPS are only currently paying about .125%. (Unlike most other bonds, the value of their interest paid is adjusted with inflation.) The current yield on the S&P 500 is only about 1.29%, and it comes with more volatility and the risk of dividend cuts.
You could increase your dividend income by choosing stocks that pay higher dividends. In particular, you may want to look for “Dividend Aristocrats” that have raised their dividends every year for the last 25 years and “Dividend Kings” that have done the same for 50 years straight. You could be taking more risk with fewer stocks though.
Purchase an immediate annuity
Another option is to use part of your savings to purchase an immediate income annuity (not to be confused with a deferred annuity) that pays an income to you and possibly to your survivor as long as one of you is alive. On immediateannuities.com, a 65-year old woman living in CA could purchase an immediate annuity for $500,000 that would pay her $2,292 a month (or about 5.5%) for as long as she lives. Think of it like buying yourself a traditional pension.
There are several downsides though. First of all, the income isn’t adjusted for inflation and annuities that are inflation-adjusted pay a lot less. Second, you typically lose access to your principal and the ability to benefit from investment growth or to pass anything on to heirs. (This is why you want to keep some savings aside.) Finally, there’s the risk that the insurance company won’t be able to pay the annuity, although insurance companies are generally re-insured and you can minimize this risk by purchasing from more than one high-rated insurance company.
Take withdrawals each year
The most common strategy is known as the 4% rule. It was developed by a financial planner named Bill Bengen after he discovered that a portfolio of 50% stocks and 50% bonds could survive a withdrawal of 4% of the initial portfolio value and increased annually by inflation for every 30-year period starting in 1926. For example, you’d withdraw 4% of a million dollar portfolio or $40k and increase the withdrawals with inflation each year regardless of what the actual portfolio’s value is.
Many financial planners use this as a starting point since it offers higher income than just taking interest and dividends from a similarly diversified portfolio, has less risk than sticking to just a handful of high-dividend paying stocks, and avoids the problems with immediate annuities. There have also been a number of variations developed that use a more flexible withdrawal strategy to reduce risk or claim to have a higher “safe withdrawal rate” with a different investment strategy. (One timing strategy based on a concept called “dual momentum” even claims a 0% risk of drawing down your portfolio to 50% or less of the initial value after 2,500 Monte Carlo simulations of 30-year time periods.) Bengen himself now thinks the safe withdrawal rate may be 4.5% or 5%.
There are downsides with this approach too. First, it assumes that you only need income for 30 years and that you need to withdraw a fixed amount of income (rising with inflation), ignoring the possibility that you may need to withdraw more until debts like your mortgage are paid off or until you collect a pension or Social Security benefits. (A free tool called FIREcalc allows you to run your own historical simulations using your choice of time frame, withdrawal needs, and even asset allocation.) Second, the original 4% rule, the variations, and the FIREcalc tool are all based on historical returns that may be very different from the future. In particular, many investment experts are predicting below average returns for both US stocks and bonds based on high stock valuations and low interest rates.
The best retirement income strategy for you depends on your retirement time horizon, your income needs, and the risks you’re willing to take. In any case, you might want to consult with an unbiased and qualified financial planner to discuss your options. (Your employer may even offer access to one for free through a workplace financial wellness program.) Otherwise, if you pick the wrong approach, it may be way too late once you’ve discovered you’ve made a mistake.