Retirement is about one thing, replacing income from your job with income generated from a number of different sources. As you get close to retiring, the traditional approach to allocation has been to add more bonds into your portfolio to help reduce stock market risk. However, in today’s low-rate environment, bonds might not generate sufficient income on their own. When we factor in longevity risk and inflation, the hardest part is to make sure you don’t outlive your money. Let’s take a look at the retiree income equation.

Most retirees will have social security, some will have pensions and almost every retiree will have to supplement their income utilizing their savings.

Social Security

When considering Social Security – Maximizing your social security benefit is extremely important, especially for those that are without a pension. More than 45% of people take Social Security benefits as early as they can, at age 62. For those who have taken early benefits, perhaps because of poor health, this often makes sense. But grabbing benefits early comes at a steep cost.

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Generating Income from Savings

Planning to retire takes decades of diligent saving and a disciplined investment strategy to weather uncertain times in the market. During that entire time, your main goal was to grow your nest egg as big as possible. One day, you look up and notice that you have amassed a large sum of money and then start to think… Now what? How do you utilize that money to live off of and still pass some down to your family or charity? This is where income planning comes in. There are numerous ways to generate income in retirement, we will look at the 4 most common sources. Please note, this is not a recommendation of one particular strategy, it is a look into the various options available.

• Bonds
• Dividends
• Annuities
• Rental Properties

BONDS

Bonds, whether individual or bundled in funds, are loans you give to governments, municipalities or corporations that then pay you regular interest. There are many different types of bonds and they vary based on who they are issued by, the length until maturity, the interest rate and risk. When planning to retire, some investors may consider a “Bond Ladder”.

A bond ladder is purchasing individual bonds with staggered, or laddered, maturities. In retirement, this can be effective to provide a cash flow for funds that are needed yearly. Bonds are a lower-risk option than other investments, but that usually means a lower return. One challenge to investing in bonds today is the low interest rate environment we are in. On 3/15/2019, the 10-year treasury yield was 2.592%, one year later on 3/16/2020, the yield was 0.734%.

In a survey by Fidelity, 40% of pre-retirees over the age of 55 said that they believed they could spend 7% or more per year without exhausting their assets. When investing with yields this low, it can be challenging to not eat into principle year in and year out depending on the withdrawal rate.

DIVIDENDS

Dividends can be a great source for retirement income, especially with bond yields as low as they are. As of March 16th, the yield for the S&P 500 is 2.9 times that of the 10-year Treasury, a multi-decade record. While a portfolio of dividend growth stocks will experience some variability in market value, the income that a good portfolio churns out should consistently grow over time.

Even during the financial crisis, over 230 companies increased their dividend. According to the Wall Street Journal, over the past 50 years the S&P 500’s dividends grew at an average 5.7% per year, outpacing the average 4.1% inflation rate. A dividend investing strategy preserves and grows your principal over long periods of time, unlike most annuities and withdrawal strategies. This allows you to leave a legacy for your family or favorite charities.

Dividend investing also provides flexibility to sell off assets if you need to fund special purchase or offset some unexpected dividend cuts. The hardest part for most investors is sticking to a disciplined investment strategy. When the market pulls back, the first thought in most retirees’ mind is “I am going to lose all of my retirement savings”. Investing with emotion tends to lead to bad decisions like panic selling.

ANNUITIES

Annuities can be a great source of income and are often referred to as “buying a pension”. However, annuities are complex, and it is important to understand all of the aspects of an annuity prior to purchasing, starting with the basics.

What Is an Annuity?

Before talking about other aspects of annuities, it is important to first realize that unlike other forms of investments, annuities are often considered a form of insurance by safeguarding the holder against running out of money later in life. Annuities allow a person to make a onetime payment or a series of payments to guarantee that the holder of the annuity will to receive monthly payments in the future.

There are two main types of annuities: immediate and deferred. Immediate annuities offer monthly income starting as soon as you purchase it. Deferred annuities start to pay out at a fixed future date. Annuities can provide much needed income for a set period or for the lifetime of the holder depending on the annuity the person owns.

Besides knowing the difference between immediate and deferred annuities, you need to be aware that some annuities are variable, fixed, or indexed annuities. Make sure you know which type you are purchasing. You can find out more about variable annuities from the SEC site1 and other types of annuities on the NAIC website.2

Benefits of Purchasing Annuities

Annuities provide several advantages for owners, but each annuity is different, and therefore it is essential to educate yourself about the particular annuity you are planning to buy. Besides providing a guaranteed monthly income, most annuities offer:

– A great way to defer paying taxes on your income. While you can use your 401(k) and IRA to shield some income from being taxed, both have limitations. Annuities are unique in that they are no limits placed on the amount of money you can use to purchase them. Once you purchase an annuity, the interest generated by the annuity is typically tax deferred.

– Protecting your money from probate and creditors. For people who worry about probate fees or have a concern that creditors may seize their assets, annuities can provide a much-needed sense of security. Many states treat certain annuities as a retirement accounts and are accordingly protected. Annuities are secure during probate throughout the US.

– The opportunity for your child to qualify for financial aid for school. As long as the owner of an annuity is not yet receiving payouts from an annuity, the government does not require parents to list it as an asset when filling in the Free Application for Federal Student Aid (FAFSA) form. This can help students qualify for need-based financial aid.

The Downside of Annuities

Annuities provide several benefits, but they have their own set of cons you need to consider as well. The downside of annuities includes:

– Paying taxes on payouts. While annuities may be a good way to defer paying taxes on income, once you start to receive payouts from an annuity, any payout which is not part of your principal will be taxed as earned income, and therefore will not qualify as capital gains.

– Lots of fees and other costs. Whether you are paying the initial commission which can be as much as 10 percent of the total value of the annuity or covering the annual management fee which may reach 1.5 percent or more, annuities are one of the most expensive financial products to purchase. That doesn’t even cover the surrender fee which you may have to pay on deferred annuities you need to cash out early.

Annuities are complex. Always speak with your financial advisor to see if they are the right option for you. A best practice prior to purchasing an annuity is to run a financial plan with and without an annuity and analyze the difference between the two.

1. www.sec.gov/reportspubs/investor-publications/investorpubsvaranntyhtm.html#wvar
2. www.naic.org/index.htm

RENTAL INCOME

Rental properties can be a great way to fund some of your retirement. For the most part, they produce steady, predictable income without eating into principle. However, renting out property requires a hands-on approach, and in many cases, more work than you might have anticipated. Most retirees did not expect to become a landlord when they left their career.

When first thinking about purchasing rental properties, it is important to think of the costs that go into purchasing and maintaining a property. Whether or not you take out a mortgage, or hire a management company, both of those eat into the amount of income coming in. It is easy to think about the rent that comes in every month and how that will add to your income however, most retiree landlords forget that properties are not occupied 100% of the time and that anytime the property is not rented, there is no income coming in.

One of the other challenges for rental income is that the principle is not as liquid as other options. If there is a need for a large sum of money, it can be difficult to either liquidate, or tap into the equity that may be in the property.

Adding It All Together

Retirement is usually funded from a number of income sources and working with a financial advisor who can help analyze the effectiveness of different streams of income is very important when considering retirement. Maximizing Social Security and optimizing every asset to ensure adequate cash flow is just one of the many ways an advisor can help.