Retirement Income Planning

A Retirement Paycheck is Essential

Last week’s post, Where Have All the Pensions Gone? made the point that given (a) the scarcity of traditional defined benefit pension plans, (b) the inability of 401(k) plans, employee and self-employed retirement plans, and many nonretirement investment vehicles to provide for a predetermined monthly lifetime income beginning at a specified age, and (c) the inadequacy and uncertainty of the Social Security system, it behooves each and every one of us to create our own pension plan.

With this week’s post, I want to expand upon and clarify the conclusion in last week’s post. I understated the point when I said that it behooves each and every one of us to create our own pension plan. It isn’t simply beneficial or worthwhile to create our own pension plan – it’s imperative that we do so. To do otherwise is to leave our retirement exposed to too many variables beyond our control and, in turn, risk that we will outlive our retirement assets.

Retirement Roadblocks

Outliving one’s retirement assets can happen in any number of ways, including, but not limited to, experiencing one or more of the following eight retirement roadblocks:

  • Insufficient investment assets to sustain a longer- than-average life expectancy
  • Prolonged higher-than-average inflation
  • Sequence of returns with bad early years. See the October 5, 2009 post, The Sequence of Returns – The Roulette Wheel of Retirement.
  • Withdrawal drag. See the September 28, 2009 post, Withdrawal Drag – The Silent Killer.
  • Excessive investment withdrawals relative to available retirement assets
  • Uninsured events, e.g., long-term care
  • Unfavorable income tax law changes
  • Poor investment management

As you can see, too many things can happen, many of which are beyond our control, that can prematurely deplete one’s investment assets. Although unplanned, the occurrence of one or more of these events could easily derail what’s suppose to be our golden years.

Something we have the ability to control, and, furthermore, as previously stated, is imperative for us to do, is creation of our own pension plan. Specifically, we need to replace employment income with a retirement paycheck.

The risk that we will outlive our retirement assets is shared by individuals of all means. A sizeable nest egg, while it can sustain one through many years of retirement, can also be depleted before the end of one’s and one’s spouses, if married, lifetime(s) in the absence of a sound retirement income plan.

Although a retirement paycheck doesn’t guarantee that we won’t outlive our retirement assets, it will eliminate our exposure to several of the eight retirement roadblocks, and, in turn, improve our odds for success.

Retirement Asset Planning Retirement Income Planning

Retirement Income Planning – The End Game

If you’re a subscriber to Retirement Income Visions™, you may have noticed that, although there have been nine posts prior to this one, none of them has stayed true to the theme of this blog, i.e., Innovative strategies for creating and optimizing retirement income. This post will be no exception. As the saying goes, there’s a method to my madness. In order to understand and appreciate the strategies and apply them to your situation, it’s important to understand the origin of retirement income planning, including the limitations of the retirement asset planning approach.

As explained in The Retirement Planning Paradigm Shift – Part 2, retirement planning is undergoing a paradigm shift. Instead of relying on retirement asset planning as a solution for both the accumulation and withdrawal phases of retirement, people are beginning to recognize, understand, and appreciate the need for, and value of, employing retirement income planning strategies during the withdrawal phase. No doubt about it, per Retirement Asset Planning – The Foundation, retirement asset planning is the way to go in the accumulation stage to build a solid foundation for a successful retirement plan. However, as discussed in The Retirement Planning Shift – Part 2, as a result of the uncertainty of traditional retirement asset planning as a solution for providing a predictable income stream to match one’s financial needs in retirement, retirement income planning was born.

Is Your Retirement Plan At Risk? introduced six risks common to all retirement plans: inflation, investment, income tax, longevity, health, and Social Security benefits reduction.

Beginning with Retirement Asset Planning – The Foundation, the inadequacy of retirement asset planning during the “spend-down” phase was discussed. This begins with the process itself. Unlike most types of financial planning where you get to see the results of your plan after reaching a specified target date, this is not the case with retirement asset planning since the timeframe is undefined.

Withdrawal Drag – The Silent Killer contrasted the beauty of compound rates of return during the accumulation stage with the erosion of portfolio income and the associated benefit of compounding, otherwise known as “withdrawal drag,” in the withdrawal stage of retirement. There is yet another phenomenon that can wreak havoc on your portfolio if you only rely on a retirement asset planning strategy during your retirement years. The Sequence of Returns – The Roulette Wheel of Retirement exposed this investment phenomenon and provided an example of how “luck of the rate-of-return draw” can prematurely devastate a conservative, well-diversified portfolio.

As if all of these variables and financial phenomenon were not a wake-up call to your planning, we mustn’t forget about the “safe withdrawal rate.” Safe Withdrawal Rate – A Nice Rule of Thumb demonstrated how the widely-accepted 4% “safe” withdrawal rate doesn’t necessarily guarantee that you won’t outlive your investment portfolio. Furthermore, the withdrawal amount that is calculated using this methodology typically won’t match your retirement needs.

All of the foregoing financial risks and phenomenon contribute to the inherent uncertainty associated with the retirement asset planning process during the withdrawal phase of retirement. As pointed out in Retirement Asset Planning – The Foundation, even if you’ve done an excellent job of accumulating what appear to be sufficient assets for retirement, you generally won’t know if this is true for many years

Retirement income planning is truly the end game in financial planning. Assuming that your goal is to generate a predictable income stream to match your financial needs in retirement while minimizing your exposure to withdrawal drag, the sequence of returns, and the various risks common to all retirement plans, it generally makes sense for you to begin employing retirement income planning strategies for a portion of your assets ten years before you plan to retire. The amount of assets and the exact timing of implementation are dependent upon your particular retirement and other financial goals as well as your current and projected financial situation.

Retirement Asset Planning Retirement Income Planning

Withdrawal Drag – The Silent Killer

As you approach retirement, are you aware of the silent killer lurking on the horizon? Let’s call our silent killer “W.D.” When you enter the retirement zone, W.D. will be right behind you, looking over your shoulder, waiting to spring into action. When you dare to take your first withdrawal from your portfolio, W.D. will pounce – only you won’t know it. You will continue on, as if nothing happened, innocently taking your withdrawals each month. As each deposit hits your checking account, W.D. will extract a toll on your portfolio, one that will increase in size with each transaction. And guess what? You will never know what hit you. You see, W.D., or “Withdrawal Drag,” is the ultimate portfolio silent killer.

Before we expose the secrets of “withdrawal drag,” first some background. When you’re saving for retirement, or you’re in the “accumulation stage,” as we retirement income planners like to refer to it, assuming that you take no withdrawals from your portfolio, you realize the beauty and grace of compounding rates of return. To appreciate compounding, let’s start with simple interest.

With simple interest, you earn interest on your principal. Let’s say you have a portfolio that’s worth $500,000 and it earns simple interest of 7%. In year 1, you will earn $500,000 x 7%, or $35,000. Your portfolio will be worth $535,000 ($500,000 + $35,000) at the end of year 1. In year 2, you will earn $500,000 x 7%, or $35,000. At the end of year 2, your portfolio will be worth $570,000 ($535,000 + $35,000). And so on. That’s OK, however, there’s a better way to go – compounding.

Through compounding, in addition to earning interest on your principal, you also earn interest on your interest. Using the previous example, after year 1 when your portfolio is worth $535,000, in year 2 you earn interest on $535,000, not just $500,000. You earn $535,000 x 7%, or $37,450 vs. $35,000 and your portfolio is worth $572,450 vs. $570,000 at the end of year 2 using simple interest. The benefit to you of earning compound vs. simple rates of return increases each year. For a simple example of the magic of compounding, please see Exhibit 1 – $500,000 Growing At 7% Compound Interest. Per Exhibit 1, over 26 years, you have earned $2,403,676 and your portfolio has grown from $500,000 to $2,903,676. Although it isn’t illustrated, this is an increase of $1,493,676, or more than double, over the value of your portfolio of $1,410,000 using simple interest.

Enter Mr. W.D., or “Withdrawal Drag.” Continuing on with our example, let’s take a look at Exhibit 2 – $500,000 Growing at 7% Compound Interest With Annual Withdrawals. Now you’re 65 and you’ve entered the retirement zone. You’re still earning a compound rate of return of 7% on your portfolio, however, you’re taking withdrawals from your portfolio each year. Let’s assume that your withdrawals at age 65 total 5% of the value of your portfolio, or 5% of $500,000, or $25,000, and they increase by 3% each year. Per Exhibit 2, after starting with $500,000 at age 65, after 26 years, or at age 90, (1) your withdrawals total $964,000, (2) you earned $926,000, and (3) your portfolio is worth $462,000, or $38,000 less than what you started with. Not a bad result, right? Well, yes and no.

To answer the question, let’s step back and look at what your $500,000 portfolio would have been worth if you never took any withdrawals and you subtract your total withdrawals and ending balance of your portfolio at age 90 after taking withdrawals:

$500,000 growing at 7% compound interest for 26 years per Exhibit 1: $ 2,903,676
Less: Total withdrawals at age 90 per Exhibit 2 (   963,826)
Less: Ending balance of portfolio at age 90 per Exhibit 2 (   462,230)

Withdrawal Drag $ 1,477,620

What happened to almost $1.5 million? Ah, hah – mystery solved! The culprit is, guess who? Mr. W.D. Sure enough, per Exhibit 3 – Withdrawal Drag, the difference between your total earnings of $2,403,676, assuming no withdrawals per Exhibit 1, and your total earnings of $926,056, assuming withdrawals of 5% of your starting principal increasing by 3% per year per Exhibit 2, is exactly $1,477,620. At first, seemingly innocent, extracting a mere $1,750 from your portfolio at age 65 per Exhibit 3, Mr. W.D. doesn’t seem like such a bad guy. With each, passing year, however, Mr. W.D. gets greedier and greedier, taking almost $20,000 at age 72, $59,000 at age 80, and helping himself to $160,000 at age 90.

And so ladies and gentleman, as you enter the retirement zone, keep a close eye out for Mr. W.D. each and every time that you take a withdrawal from your portfolio. He’ll be watching you!