You spend most of your adult life saving for retirement, but have you ever thought about what you’ll do once it’s time to tap into those savings? Learn the different strategies you can use to provide yourself with a retirement income.
Retirement income has traditionally meant a combination of Social Security, pensions, and personal savings, such as 401(k) accounts, IRAs, or other investment vehicles. Now that many workers believe Social Security and pensions will no longer be available in retirement, strategies for creating income must change as well.
Sources of Income
Social Security. According to a 2012 report by the Social Security Administration, the most used form of retirement income in 2010 was Social Security, with 86 percent of people over 65 receiving payments. This same study found that 65 percent of retirees depend on Social Security for over half of their income. You can see that, if Social Security is providing for retirees at its current level when you retire, it could play a large role in your income plan. Alternatively, if you don’t believe you can rely on social security to be around like it is today, you have a large percentage of retirement income to make up for.
Pension plans. Like Social Security, pensions are a form of retirement income that many workers are no longer depending on. Pensions and other defined benefit plans are waning in popularity among employers, and many companies have already phased them out. You may have a better chance at pension income if you work for the military or government, but for many future retirees, a pension will not be part of their retirement income plan.
Savings. The final piece of your income plan is your personal savings and investments; this may be the only piece many future retirees will depend on. Investment accounts, real estate, bonds, CDs, dividends, high-interest savings accounts, and anything else that appreciates can provide income in your golden years.
Your income strategy may be comprised of some combination of the aforementioned income sources, or you may be relying solely on your personal savings. To develop an effective strategy, you’ll need to estimate how long you’ll be in retirement (what year you’ll retire and your life expectancy), the value of your savings (how much you’ve saved, how much you can save before you retire and how much it is expected to appreciate), and how much you need to live on.
Safe withdrawal rate. The 4 percent rule was established as a one-size-fits-all safe withdrawal rate. To follow this rule, retirees would take 4 percent of their entire portfolio’s value in the first year of retirement to use as living expenses. This amount is then what they’d use annually throughout their retirement, adjusting only for inflation. Four percent is considered a safe withdrawal rate because it is not likely to deplete your savings before the end of your life. Many factors render this rule ineffective: excessive inflation, lifestyle changes, unexpected expenses, long lifespan, and more. Additionally, 4 percent might not be enough for you to live on, or it might force you to live more frugally than necessary. Nevertheless, it is a good rule of thumb to keep in mind.
Another strategy is to tie your withdrawals to your portfolio’s value, increasing when the market is up and decreasing when it is down. This works well in theory, but only if you can afford to live on a smaller distribution in a bear market.
Annuities. For guaranteed, regular income throughout your retirement, consider purchasing an annuity, which you can think of as a cross between an investment account and an insurance plan. You purchase an annuity through an investment company who then professionally invests your money and uses the growth to provide you with a steady income stream. You can choose between different types of annuities to find one that fits your needs best, including the following:
- Fixed annuity. The safest type of annuity, these pay the same amount of money regardless of how the market performs. You won’t have to worry about a down market, but you also won’t reap the benefit of an upswing.
- Variable annuity. On the contrary, a variable annuity varies its payout with market trends. Your income correlates with market fluctuations, which is riskier but also has the capacity for better returns.
- Equity-indexed annuity. Perhaps the best of both worlds, the equity-indexed annuity guarantees a minimum return, but fluctuates with an equity index to provide higher payments in a good market. Returns won’t be as high as actual market returns, but they can be better than a fixed annuity. Here, you have the possibility of high returns without the risk of losing everything.
- Other strategies. You can additionally live on income from part-time retirement jobs, rental income on owned real estate, royalties from past work, laddered CDs, stock dividends, and more.
There is always the risk of unexpected expenses (especially health care costs) and not saving enough for retirement. Even if you do everything you can to mitigate these risks, you cannot have an entirely risk-free retirement. One of the biggest risks facing retirees today and in the future is increasing life expectancy. Many retirees save for a 30-year retirement and end up outliving their savings. Another risk is market volatility. You could lose more of your retirement savings than you can afford if the market takes a downturn. Keeping safe, low-risk investments might seem like a good idea, but this actually puts you at risk of losing money to inflation. Inflation is another risk that is a real issue for those on a fixed income.
Although many turn to the guaranteed income of an annuity to avoid these problems, annuities are not without their risks. Annuities require large initial investments and cannot be liquidated easily—any early closure or withdrawal from a retirement income annuity before age 59½ triggers a 10 percent tax penalty and possible surrender charges. (Annuity payments are already subject to income tax, which reduces the real value of your payments.) Additionally, an annuity’s guarantee of income is only as valid as the company providing it. If an annuity provider becomes insolvent, the annuity may terminate, leaving a retiree without income. Because of these factors, loss of principal is a frightening possibility when purchasing an annuity.
Income in retirement is never a sure thing. With possible Social Security decreases, the elimination of pension plans, a volatile economy, and increasing health care costs, there is no way to guarantee a certain amount of income in retirement. The best way to approach the retirement income quandary is to create a realistic strategy that accounts for as much risk as possible while providing a comfortable lifestyle throughout your retirement.