Plain and simple, your retirement income plan will make or break you in retirement. In this episode, we discuss the importance of creating an actual plan that focuses solely on how you will get your income in retirement, and the greatest risks your income will face.
An appropriately structured income plan is crucial so that you can avoid entering retirement being uncertain about how much you can spend each month, vulnerable to the big retirement risks, and unstructured with your nest egg – meaning that you really have no idea how to arrange your affairs, what accounts to have, what investments to select, and what accounts they should go in.
Your retirement income will drive your lifestyle, not necessarily the amount of money you have. The more confidence you have in your retirement income plan, the more likely you will live a happy and fulfilling lifestyle that allows you to focus on the more important things in life.
More specifically, I discuss:
- How to Determine of You Are a Constrained Investor
- The #1 Danger of “The 4% Rule”
- Retirement Timing Risk (Sequence of Returns Risk) Explained
- Inflation and Longevity Risk
- Advantages of "Segmenting" or "Bucketing" Your Nest Egg
Resources From This Episode:
Related Episode #8: The Greatest Threat to Your Life Savings
0:00:28 Hello, everyone, and thank you for joining me on this episode of Retired-ish. I'm your host, Cameron Valadez, and this episode may go down as one of my absolute favorites because today, I am talking specifically about retirement income planning, which is my specialty, and it's what I do every day for a living. I am extremely passionate about this subject, and although I deal with this stuff on a daily basis, I am always looking for more ways to learn more about the subject in different viewpoints and experiences because it's definitely both a science and an art.
Retirement income planning is a single component of financial planning or retirement planning. In previous episodes, we have discussed some of the other components of retirement planning, such as investing, taxes, Medicare, Social Security, estate planning, and so on and so forth. And we've touched a little bit on income planning, but today we're gonna take an even deeper dive.
This episode is specifically for those of you who are nearing retirement or maybe just entered retirement, and you wanna know how you can structure your life savings in a way that can provide you with a sustainable income throughout retirement that hopefully also allows you to maintain your a desired standard of living. The main premise of today's discussion is to structure this in a way that doesn't leave your retirement income up to chance.
Since it is your income that truly drives your retirement and your lifestyle, not necessarily the amount of money that you have going in. An appropriately structured income plan is crucial so that you can avoid entering retirement being uncertain about how much you can spend each month, vulnerable to the big retirement risks, and unstructured with your nest egg, meaning that you really have no idea how to arrange your affairs what accounts you have, what investments to select, and what accounts they should go in.
If you enter retirement and just begin haphazardly withdrawing money from your nest egg, you greatly increase the chances of running out of money, and the stakes are high. When you transfer from the savings and accumulation phase of your life to the spending phase or what I call the distribution phase, everything changes. The strategies you used before and the assumptions you made won't work. And now you'll have to take other things into account, like taxes, especially those shadow taxes we discussed last episode.
0:02:52 If you recall, in episode eight of the Retired.ish podcast, we touched on the idea of a bucketing strategy, which is basically a way of positioning your life savings in a way that can help protect you from certain risks that you will face. Specifically, sequence of returns risk, also known as timing risk, and your own investor behavior. I'll put a link to that episode if you missed it in this episode's show notes.
But this timing risk essentially shows us that the probability of you running out of money early or having to cut back on your lifestyle mid-retirement depends largely on how your investments perform in the first few years of retirement, which of course, you won't know for certain until after you've lived through it. We will get into some specific examples on this later. In today's episode, we will add more context to that discussion and understand some other ways you might begin to structure a retirement income strategy.
Ultimately, the best retirement income strategy is the one that makes the most sense to you, that will work given your circumstances, and, most importantly, is one that you will be able to manage and follow for the entirety of your retirement. So it needs to keep operating efficiently each and every year, potentially for decades.
0:04:07 Okay. So let's start with where a retirement income strategy comes into play. If you're lucky enough to enter retirement with a massive pension from a private company or government-related agency, congratulations! You truly are very lucky. But if you're someone who doesn't have a nice fluffy pension with cost of living adjustments to offset inflation, or maybe you have a public service pension, but it's not enough to fully fund the lifestyle you want in retirement, you'll need a supplemental retirement income plan.
Most new retirees these days, however, have been left to fund retirement completely on their own. If you are one of these people that has to fully fund or supplement other retirement income using your hard-earned savings, you may be what is called a constrained investor. A constrained investor, according to David Macchia, author of the book Lucky Retiree, is a retiree who has saved a sizable nest egg, which is great, but that life savings isn't extremely high compared to the monthly income the retiree wants to generate with it.
Said differently, the retiree has very little room for error when it comes to their investments and retirement income plan. You don't have so much money that your income is essentially unlimited, but you also don't have so little that your income will come primarily from Social Security. You're somewhere in between.
The most important and most widespread example of potential errors that you could make as a constrained investor is your own investing behavior, which we have discussed many times previously on this show. For example, if your investments, such as stocks, drop in value over a week's time span or continue to drop over a two-month or even a two-year time span, you may be inclined to get out of those investments due to the fear of losing your money forever. This is a completely normal feeling because you're human. But reacting in that way to that feeling can destroy your retirement income for good. And depending on your situation, you may only need to make that mistake once, hence the term constrained investor.
0:06:13 So how do you know if you're constrained? Well, it depends on the amount of income you'll need your nest egg to produce in order to fund your lifestyle versus the amount of savings you've accumulated, or the size of your nest egg. To figure this out is actually very simple and is often referred to as a withdrawal rate or income-to-assets ratio. To start, you simply take the amount of income that your savings needs to produce, such as forty thousand dollars a year, for example, and you divide that by the total amount of savings or investments that you have across all of your accounts, let's say one million dollars, for example. This gives us a four percent per year withdrawal rate.
In my opinion, if you are overfunded for retirement, this figure might be in the realm of two to three and a half percent or lower. And if you are underfunded, it may be more like six to eight percent or more. However, please note that this greatly depends on your exact situation and financial plans. For example, if you are going to live off of your entire higher retirement nest egg until both you and your spouse reach age seventy and begin collecting Social Security, you may be able to have a high withdrawal rate, such as seven percent for several years beforehand, provided that you reduce or stop those withdrawals completely once you start collecting your Social Security benefits.
In any case, we often find in practice that many retirees end up with an income-to-assets ratio or withdrawal rate between three and a half to six percent. These are constrained investors who need to seriously consider creating a retirement income plan that addresses several risks that put their retirement income in danger.
0:07:54 And while we're on the withdrawal rate topic, I wanna tackle the commonly used and followed four percent rule or strategy. Essentially, this is a widely regarded rule of thumb that stems from an older retirement study that showed if you withdraw no more than four percent of your retirement savings each year that you would have a near ninety percent probability of not running out of money in retirement.
Not only that, but you can also adjust your income for inflation. While this may have worked for some people in the past, it won't work for that ten percent statistic. And guess what? You have no way of knowing whether or not you are the statistic. That ten percent refers to those that were rather unlucky with the timing of their retirement as it relates to their investments, which is the biggest risk to retirees.
So let's dive in. Of course, no one knows whether or not if the year or even the exact month they retire will be good or bad for the stock or bond markets. If the markets do well right when you retire, you're lucky. If they do bad right after you retire, you may be very unlucky if you haven't planned appropriately.
To explain this risk, let's make a hypothetical case study for two different retirees. We have Brad and Angela, who each have a total nest egg of one million dollars. And this doesn't include their home. Both of them have their one million dollars invested the exact same way, which would be sixty percent in stocks, thirty percent in bonds, and ten percent in cash. Each of them will take sixty thousand dollars a year or five thousand dollars a month from their nest egg to supplement their retirement income in order to fit their desired lifestyle. This is a six percent withdrawal rate. We got that by taking the sixty thousand dollars a year and dividing it by their one million dollar nest egg.
Brad decides to retire in a year that just happened to be good for stocks. Although he didn't know that yet. His returns for the first four years of retirement were a positive four percent, five percent, nine percent, and seven percent, respectively. And remember, he took his sixty thousand dollars in withdrawals during each year. Angela, however, retired just before stock prices were set to decline for the next couple years. To her surprise, Angela endured a twenty percent loss loss in her very first year of retirement, then a fourteen percent loss, until finally, in years three and four, she had positive returns of eleven and thirteen percent, respectively. All the while, she, too, was taking sixty thousand dollars each year. After just four years, Angela's nest egg is worth four hundred and sixteen thousand dollars less than Brad's nest egg. But they invested the exact same way.
0:10:39 Obviously, this is a devastating scenario for someone like Angela, but it's very real. Brad had lucky timing. Angela had unlucky timing. And the reason for this is that Angela had to sell some of her stocks in her portfolio to meet her withdrawals since the value of her account was declining simultaneously. This means that she's selling the very investments that have the significant chance of rising in value later in life. Not only that but in this example, we assume that Angela didn't act on her natural fears and get out of her investments completely during, say, year two when she had even more dramatic negative returns, which obviously would have prevented her from getting any returns in years three and four. Which would have made matters much, much worse.
So now let's look at how even shorter times, as little as ninety days, can make such a dramatic difference using an example with real market returns from nineteen sixty-eight to nineteen seventy from the book Lucky Retiree again by David Macchia.
David looks at the results of ten different retirees, each with a five hundred thousand dollar nest egg to start retirement. And each takes twenty-one thousand dollars for income in the first year, and then they increase that annually by the previous year's rate of inflation. Keep in mind that that figure, the twenty-one thousand, is a starting withdrawal rate of just four point two percent. He also assumes that all retirees pass at the same age of ninety-two. So the only difference between the ten retirees will be the quarter in which they retire or the timing in which they retire.
0:12:18 The first retiree, Bob, retires in January of 1968. And each thereafter retires in the following quarter. So the second retiree retires in April 1968, then July of ‘68, so on and so forth. The first retiree Bob is able to take the income every year of his life and even has one hundred and ninety-eight thousand seven hundred and seventeen dollars left for his heirs. Retiree number two, Mark, is also able to take the income and ends up with more than one million dollars when he passes to lead to his heirs. This means he makes another eight hundred and fifty thousand dollars more than Bob just for retiring ninety days later. He then goes on to show the results of the remaining eight retirees, whose outcomes were all drastically different.
Susan, who retired in April of 1970, dies with two point six million dollars. She was the luckiest of them all. While Ted, who retired in January of 1969, runs out of money entirely before age ninety-two. In other words, he was the statistic.
This is timing or sequence of returns risk at its core. Which is your greatest risk as a retiree. If you are aware of this ahead of time and plan appropriately, you can manage this risk as a constrained investor. Which begs the question, why would you not put a plan in place and leave your retirement up to chance? Why gamble your retirement security?
Timing risk isn't the only risk, of course. It's just the most impactful, in my opinion. There are a couple more risks that will need to be accounted for when beginning to create a retirement income plan. Another meaningful risk is the fact that you will naturally become poorer as you age.
Why? Because of inflation. About every ten years or so, you can buy about twenty-five percent less than you could the decade before with the exact same amount of money. Now we get here by assuming a two and a half percent average rate of inflation. Now we can't say for sure what the future holds and if that inflation rate will be the average going forward. However, the US Federal Reserve has said over and over again that their goal is to keep inflation at a two percent level for a healthy economy. And it's important to keep in mind that two percent is the desired perfect scenario for the Fed, and they won't ever be perfect, at least not for long.
0:14:36 Depending on how long you live in retirement and the average rate of inflation, you may very well need to double your income by the time you get to your later years. Therefore, after hearing the last example about stock markets and retirement timing, you can't just go hide and not invest either. If you did, you certainly wouldn't be able to keep up with inflation. In an environment like today in 2023, you may see that you can take little to no risk by buying things like CDs and government bonds and make maybe four to five percent in interest just by holding them until they mature.
However, this won't always be the case. For example, seven years from now, those same investments may only generate two or three percent, which won't be enough for you as a constrained investor. This will cause you to have to take more and more risk with your investments, such as investing more of your nest egg in things like stocks to potentially earn a higher rate of return. In addition, inflation is currently running higher than those rates. So you're still just trying to keep up. Therefore, you can't put your entire nest egg in ultra-conservative investments if you plan on having an income stream that you don't outlive and that keeps up with inflation.
The key in developing your retirement income strategy will be the art of balancing between higher-risk and lower-risk investments and exactly how you structure that plan. Again, one example of structure might be similar to the bucketing approach I mentioned previously in episode eight of the podcast. Again, there will be a link to that episode in the show notes.
Even if you have structured your nest egg in a way that makes you confident in your plan and you have carefully allocated your assets in a way that fits your income needs, there still remains one very impactful risk. And that's the risk that you live a very long life.
0:16:21 Even though it sounds weird when you think about it, there is a risk to living a long life and therefore a long time in retirement. This risk is mostly financial but important nonetheless. Why? Well, because it's more time that the machine that is your retirement income strategy needs to operate and be well maintained. There will be more room for error, whether that be from investing mistakes along the way or needing expensive care later in life. And it will exacerbate inflation risk as well since your money must outpace it for longer. Think of long-term care as one example of this risk of longevity.
If you live into your mid to late eighties, there's a good chance that at some point, you'll need in-home, round-the-clock care or care in an assisted living facility. And I don't know if you've looked recently, but these are prohibitively expensive. What if you need this care and there is a substantial initial payment of tens of thousands of dollars just to start or get set up, then something to the tune of sixty to a hundred thousand dollars a year thereafter? Would those new and unplanned for withdrawals ruin your retirement income strategy or maybe that inheritance that you intended to leave the kids in the grandkids? Likely so.
All that being said, you'll want to plan to live a long life because that's the worst-case scenario when it comes to adequate retirement income. And you'll want to account for it when making a retirement income plan.
So finally, what are some of the different ways we can build this retirement income plan, and what might be some of the components? Well, now that you know the main risks that threaten your retirement, you can actually use them as the blueprint to creating your plan.
0:17:55 Since you are likely to have a twenty to thirty-year retirement, the first piece of the blueprint is to structure your nest egg in a way that will help control emotions when it comes to investing. Remember, you need to keep up with inflation and plan for longevity. So part of your investments will need to grow over a long period of time, such as ten to twenty years. Which means that you will have to take some risk with that money in order to do so.
Therefore, it would be prudent to consider taking some risks in things like stocks. And in order for your stocks to grow over a long period of time, they can't be consistently interrupted by emotional selling when markets are lousy or make surprising moves. This will happen many times over the course of your retirement, and you will feel the need to do something about it. However, if you make a big investing mistake during retirement, you won't have as much time to heal compared to making that mistake in your thirties and forties.
0:18:48 One way to do this is to segment your stock investments in an account or hypothetical sleeve bucket, whatever you wanna call it, that you have earmarked for one thing, one job, and that is to grow over the next ten-plus years. That is its only purpose. You will not be making any regular retirement withdrawals from this account. That's not its job. You might earmark this money for unplanned lump sum expenses later in life, an inheritance for your heirs, or maybe it's meant to replenish your income in years twenty to thirty in retirement.
Now, you may already own stocks in various accounts, such as retirement accounts like IRAs, Roth IRAs, 401(k)s, or even non-retirement accounts like brokerage or trust accounts. And in this case, you'll wanna consider simplifying as much as possible by maybe owning stocks in one or two of those accounts and other investment types in the rest.
I know this isn't the answer you wanna hear, but this will ultimately depend on the types of accounts you have when you reach retirement and your tax situation. For example, you can't do much here if you've accumulated all of your wealth in your 401(k) or IRA and have no other savings. Don't get me wrong. This is completely okay. You just won't have as much flexibility.
In a case like that, you can however, create multiple IRAs with that money, give each one a different role and choose the investments in them based on their role in your income plan. So you could have one IRA that is comprised of mainly cash, CDs, treasury bonds, or money market mutual funds, for example and is meant to fund years three through five in retirement. Then you could have another one invested differently to fund years six through ten in retirement. And one or two more that have riskier investments, such as stocks, to help fund years eleven and beyond.
0:20:37 You may be wondering what to invest in to fund the very first and possibly second year of retirement. And the answer is nothing. You see, in order to help mitigate timing risk like in my previous examples, you should have at least your first year's retirement income need and an emergency fund ready to go in cash. You may choose to have, say, another two years in cash or cash alternatives such as money market mutual funds or treasury bonds, depending on the interest rates when you retire.
This will be different for everyone. However, don't get caught up too much in what you're earning on this segment of money. Its purpose is to be spent in the near term. So the small additional return you may be able to get over such a short period of time is likely not worth the hassle. By segmenting this short-term money, you can develop confidence in your plan since it won't matter what the stock markets, economy or interest rates are doing as you transition into retirement. Your paychecks are ready, so to speak. This will also allow you to let your other investments ride out a potential unlucky start.
Now there is no perfect income plan and no black-and-white answer on how to structure one. It will always depend on your exact needs and situation, of course. But one very important thing I wanna make sure you understand when building your plan is that you should only take the level of overall risk that you need to take. For example, if you're on the lower end as a constrained investor regarding your withdrawal rate, so you're in that low two to three and a half percent range, or maybe lower, then you likely don't need to take an exuberant amount of risk.
In a case like this, you may place more of your nest egg in non-stock market investments and a smaller chunk in things like stocks. So if you only require a three to three and a half percent withdrawal rate to be successful, your total investment portfolio shouldn't be invested in a way that aims to achieve fifteen percent returns.
0:22:27 By now, you may have asked yourself, what if, by chance, my long-term segment of stock investments doesn't perform as it should? Or what if it did grow significantly over the last decade but then was decimated near the exact time I needed it to replace my short-term segment for income? Because this can be a potential outcome, it's worth considering segmenting some of your nest egg to a backup plan or safety net.
That being said, your safety net can't have risk because it has to back up the segment that has the risk of not performing as intended. You can do this by transferring that risk to another party via insurance.
In the case of retirement income, this can be done with an income-paying annuity. The role of the annuity should be thought of as a potential alternative to certain bond investments you may have in your income plan. Think of that income you'll need to rely on, say, in years ten to twenty or maybe even years twenty-five and beyond if your riskier investments fail you.
Income annuities are essentially a promise from a large insurance company to pay you a guaranteed amount of income for life, no matter how long you live and no matter what the stock market does. There are over a thousand different flavors of annuities, so we will save the deep dive on annuities for a later episode. Just know that these investment vehicles are one option if you're looking to further decrease the risk of your retirement income plan.
Now I want a caveat that annuities surely aren't for everyone. But for the right constrained investor, a properly structured income annuity can make a drastic difference in your plan's success and greatly reduce the risk of you outliving your money. Most people wouldn't think twice about ensuring the most important things in life, such as their health, their house, their cars, or even their life, so ensuring your income in retirement should rightfully be considered.
0:24:20 If you are unfamiliar with these types of income segmenting strategies, this information may seem revolutionary, and you may feel like you just unlock the secret to retirement. However, that's not the case quite yet. You see, knowing what to do and doing it are two very very different things.
As you know, all of this information is completely meaningless if you do nothing with it or have to implement because you eventually get confused about something or lose confidence. Not only that, but these are strategies you must continue to implement every year in retirement. It is actually very easy to give up on your plan or strategy or simply let it fall to the wayside by not giving it any TLC. It's also just as easy to make a knee-jerk reaction due to investment performance and break the entire machine.
So the choice will ultimately be yours on whether or not you leave your retirement income and, therefore, your retirement lifestyle up to chance. Because whether or not you choose to implement the big risks that threaten your retirement will eventually show up. Stock markets will jump up and down all the time. You won't know if you were unlucky with your retirement timing until you've lived through it and it's too late. Inflation will continue to affect your livelihood as it always has. And there's always a chance that you live a longer than expected retirement. You now know that you can do something about it, so take advantage of it.
That's all for today's show. Hopefully, you now understand the importance of planning for your future retirement income and have a better idea of how to prepare.
0:25:51 There is obviously much more to creating a retirement income plan that meets the eye, and managing risk is just one piece. Choosing the appropriate investments and structuring your plan in a way that is most tax efficient for you or some additional steps to look into. Of course, you can always refer to other episodes of the Retired-ish podcast to learn how.
If managing all of these potential issues on your own is too daunting or time-consuming, don't be afraid to reach out to knowledgeable professionals to delegate these responsibilities of your life to. You'll likely get even more value from other additional tax investment and time savings tips and advice. However, when it comes to retirement income planning, make sure you find someone who specializes in this area.
If you have a minute and find this information actionable and insightful, and you wanna stay up to date on the latest and useful retirement planning content, please subscribe to or follow the show on your podcast app. If you'd like to learn more about the rules and strategies discussed in today's show, you can find links to the resources we have provided in the show notes on your podcast app, or you can visit us at retiredishpodcast.com/15.
There, you can also sign up for our monthly Retired-ish newsletter, where each month, we discussed money and emotions, investing, tax, estate tips, Medicare and Social Security, and even a brief discussion about the current markets in layman's terms. We always include something actionable in our newsletters so that you can implement them right away, such as how-to guides and other simplified strategies. Again, this can all be found at retiredishpodcast.com/15.
Thank you for tuning in and following along. As always. See you next time on Retired-ish.
0:27:51 Securities and advisory services are offered through LPL Financial, a registered investment advisor, member FINRA, SIPC.
The opinions voiced in this podcast are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA.
In addition, if you are required to take a required minimum distribution, RMD, in the year you convert, you must do so before converting to a Roth IRA. Investing involves risk, including the potential loss of principle. No investment strategy can guarantee a profit or protect against loss. Past performance is not a guarantee of future results.
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Treasury inflation-protected securities, or TIPS, are subject to market risk and significant interest rate risk as their longer duration makes a more sensitive to price declines associated with higher interest rates. Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free, but other state and local taxes may apply. If sold prior to maturity, capital gain tax could apply.
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