Investing for Life Part II—Creating Income
By James R. Cook, CFP®
Senior Manager for Large Employers
Last month in part one of this two-part series we focused on the first major financial stage in most people’s lives, the Accumulation Phase. You will recall that this phase occurs during your working years when you are earning income and saving and investing some of your earnings. Your goal is to accumulate enough assets to provide income during your retirement years.
This second article focuses on the Spending Phase and the decisions that you need to make to create a stream of income that can support your lifestyle in retirement.
What are my sources of income?
Let’s start by looking at the different sources of income that you can expect to be able draw upon in retirement. For many years, financial planners talked about retirement income as being a three-legged stool, supported by three income sources: Social Security, Employer Pension and Personal Assets. Increasingly though, many planners are beginning to think that a fourth leg plays a significant part of many individual’s plans, and that leg is Work.
Let’s look at each of the legs and some important considerations for each.
Your potential income from Social Security is based upon your earning history, your projected benefit at your full Social Security age, and the age at which you actually begin to draw your benefit. The longer you work and/or delay drawing your benefit, the larger your benefit is likely to be.
Employer Retirement Plan
For many, this will mean a retirement plan with a cash balance in a 401(k) or 403(b) retirement plan, although there are other less common types of employer sponsored plans. Savings from an employer sponsored retirement plan is likely to be the largest invested asset most people have outside of the ownership interest in their personal home.
This is a rather broad category, but it can include other cash value savings and investments that you have outside of your employer sponsored plan and investments, such as business interests, real-estate, or anything else of value that you can potentially convert to cash to provide income in retirement.
You may ask, “If I’m working, how can I be retired?” For some individuals, the goal is not necessarily to stop working altogether, rather it may be to downsize their work life. Downsizing your work life can mean exiting a high stress job to something more manageable, working part-time, or even engaging in employment wholly different from your professional career, possibly in work that is aligned with a hobby or other personal interest. For many, it may become the next chapter. Adding this fourth leg does not mean that you plan to work the rest of your life; however, being open to work as an income source for part of your retirement—usually the early years—may allow you to delay using some of your other sources, thus allowing them to continue to gain value.
How much money will I need?
Now that you have a good idea of the sources that you can tap for income, the most important question that you need to answer is How much income will I need in retirement? You may have heard a lot of rules of thumb as answers to this question…70% or 80% of your preretirement income. The reality is that the only way to determine this important number is to track your expenses and make a spending plan. Note that we did not say make a budget. There’s a difference.
As you start retirement, you need a spending plan that includes a budget, but your spending plan is more comprehensive than a budget.
Why? Because for many people, retirement involves the desire for a significant change in lifestyle, with different patterns of spending. Being realistic and thorough about this change is more than writing a budget.
How do I create a spending plan?
Begin by creating a four-column table like the example below
Your expenses may fluctuate through several retirement stages:
During the first stage of retirement, your expenses may be higher if you plan to relocate, travel, pursue hobbies, or other activities that cost money.
In the second stage of retirement, discretionary spending on activities may decrease, because you may not continue to participate in as many activities.
Expenses in the third stage are largely dependent upon personal health. If your health is good and you can continue to live independently without costly support services and medical expenses, your expenses may be very low. Conversely, if your later years are marked by the need for support services and significant medical care, your expenses may be higher.
Next, begin to track your actual expenses for a period of three-to-six months, differentiating between required and discretionary spending. If your plan involves a move to a new home, you will need to estimate your new expenses. Once you believe you have a solid feel for your spending, use the figures to estimate your total annual required spending. (Remember to capture things like insurance and property taxes that may be paid once or twice a year).
Last, take the discretionary spending from the first worksheet and add it to the discretionary spending from your expense tracking. Separate one-time from ongoing expenses.
How do I create an income plan?
The first goal is to create an income plan that will, at a minimum, provide a safe and secure income to meet your nondiscretionary income. This plan should allow for inflation over your lifetime, and take as little risk as possible, so that the likelihood of you either outliving the funds, or falling behind to inflation is as close to zero as possible.
Let’s look at the four income sources and see how they work as part of the plan. You can create a worksheet like the illustration to track your progress toward meeting your income needs.
If it the total suggests that you will be short on income, there are things you can do:
If your income sources appear to be able to support your required spending, your next steps are to look at the discretionary portion of your spending plan. Start with one-time fixed expenses and then evaluate the total cost of expenses that are ongoing. Start with your ongoing discretionary expenses. Evaluate the cost of funding them for five years. Does your portfolio support those costs plus your one-time discretionary expenses?
This article offers a high-level overview of things to consider as you approach retirement, and outlines a few options for creating a safe income stream that may need to last thirty or more years.
We understand that your situation is unique, and that all the suggestions outlined here may not be appropriate for you. Working with a MMBB Certified Financial Planner™ professional is a great way to get support and guidance as you plan for your future. Give us a call at 800.986.6222 if you would like to speak with a planner.