3 Ways to Manage Your Income in Retirement

August 16, 2012

When people think about retiring, they often are concerned that because the only direction their portfolios will move is down, they might outlive their savings. But it doesn't have to be that way.

There are a number of strategies to help generate income in retirement, from earning interest and dividends and managing your portfolio wisely, to investing in an annuity with an optional guaranteed lifetime withdrawal benefit.

With numerous options for generating income in retirement, the question arises: where to begin? To help answer this question, we sat down with Rande Spiegelman, vice president of financial planning at the Schwab Center for Financial Research.

"It can be really unnerving to go from a steady paycheck to living off a portfolio whose value is fluctuating at any point in time," Spiegelman says. But he believes many investors can generate sufficient cash to cover expenses in retirement—and help make their money last—if they plan ahead. 

The 4% Rule

Spiegelman says people might retire with more confidence if they first figure out their post-retirement monthly cash needs. He advises establishing a rudimentary budget that separates discretionary spending from the costs of necessities like rent, food, healthcare and utilities. Knowing the second number makes it easier to understand how much income you'll need to sustain your monthly must-have spending.

Next, calculate how much income you're likely to draw from other sources—Social Security, rental income, part-time work or pension benefits. The difference between that and your annual spending requirement is how much cash you need your portfolio to generate each year.

Spiegelman suggests those nearing retirement apply the oft-cited "4% rule" as a start, which seeks to answer the question: "How much can I safely withdraw from my retirement portfolio?" This basic rule of thumb is that investors should aim for a retirement portfolio that is approximately 25 times as large as their first-year withdrawal. This roughly translates into a 4% withdrawal rate in the first year of retirement. A retiree who withdraws $50,000 in the first year of retirement would therefore want to target a retirement portfolio of about $1,250,000¹.

It's rare that investors find that their other income sources are sufficient to fund the retirement of their dreams, Spiegelman says. "Depending on the desired lifestyle, many retirees will need to rely on their portfolio for most of their spending needs in retirement," he says.

Here are three suggested approaches that investors might consider to generate income in retirement, depending on their spending needs and risk appetite.

Approach #1: Interest and Dividends Only

Many new retirees prefer to rely on interest and dividends, an easy-to-understand approach that keeps savings intact. This approach entails investing retirement savings in bonds and other fixed income investments designed to generate income, along with dividend-paying stocks. The retiree withdraws interest and dividends as they are generated, drawing down investment principal only if necessary.

This strategy, though, typically requires a substantial portfolio to work in isolation. And this approach doesn't generally account for inflation, which can greatly impact spending power during a long retirement.

"If you have a huge portfolio and interest and dividends cover your spending needs, you're done," Spiegelman says. "But that's not the case for most people, especially with today's low interest rates."

Approach #2: Total Return

A more likely scenario is for retirees to make regular withdrawals from their investment principal in addition to drawing income from interest and dividends.

This "total return" approach requires advance planning so you don't have to sell assets on an ad-hoc basis. Spiegelman advises investors to set aside the next 12 months of spending cash in a mix of liquid, short-term accounts, such as a money market fund, a bank account and a short-term certificate of deposit (CD). Beyond that, investors might set aside two to four years of cash flow in a mix of CDs of slightly longer maturities and short-term bonds or bond funds. 

How you establish the rest of your portfolio depends on your risk tolerance. Spiegelman says retirees should invest anywhere from 20–60% of their portfolios in stocks to help hedge against inflation and seek growth. Investors looking for greater returns might opt for greater weighting in equities, but Spiegelman advises against investing more than 60% in stocks if a retiree is relying on his or her portfolio for income, with 40% stocks generally being an ideal allocation for most just starting their retirement.

When deciding which portfolio investments to sell, a simple guideline is to rely on your target asset allocation. If your target allocation is off by more than 5% in any asset class, rebalance back to your target and take out the cash you need from assets that are overweight. For example, if your target allocation is 40% stocks and 60% bonds, but your portfolio has drifted to 45% stocks and 55% bonds, you can cash out what you need from the stock portion to get back on target.

When selling overweight assets, there are rules of thumb about which ones to sell first. To maximize tax savings, start with taxable accounts before turning to tax-advantaged accounts. Within taxable accounts, Spiegelman advises selling lowest-rated securities first, and then work your way up from unrealized short-term losses through to unrealized short-term gains.

"Following a systematic hierarchy for selling securities in your retirement portfolio may add value over time," Spiegelman says.

Approach #3: Total Return with Annuity

Some retirees may want to add a guaranteed income stream for at least a portion of their retirement needs. These individuals, Spiegelman says, might consider annuities—contracts with insurance companies that pay set distributions over time. 

Let's look at two common types of annuities: immediate fixed annuities and variable annuities. With immediate fixed annuities, investors pay the insurance company a lump sum up front in return for a fixed monthly payment for life (or some other specified period of time). Spiegelman says such annuities make sense for retirees who don't want to worry about fluctuations in capital markets or about actively managing their portfolios. With an immediate fixed annuity, you "buy it, set it and forget it." As long as the insurance company is solvent, the insured generally gets a check for the same amount every month. The rate of return on your initial investment depends on how long you live.

"Fixed annuities are great for those who want reliable monthly income and don't want to lose sleep at night," says Spiegelman. "It's a lot like creating your own pension in that it has similar benefits and risks. The main difference is that the insurance company is the provider of the income benefit instead of the employer."

Variable annuities, by contrast, don't require retirees to turn over cash to an insurance company unless they wish to annuitize the contract and receive periodic payments. Instead, investors pay a premium but retain oversight of their money. When purchased with a guaranteed lifetime withdrawal benefit (GLWB) feature², variable annuities protect investors against market downturns by guaranteeing the ability to take withdrawals for life without annuitizing the contract, even if their account value is depleted to zero. Investors can even enjoy the upside during times of favorable market performance, as annual payments are generally based on an income (or benefit) base³ that is set to the highest contract anniversary value.

Variable annuities, though, generally have lower payout rates than immediate fixed annuities. In either case, insurers typically offer survivor benefits as part of the contract or for an extra fee.

While it's typically not a great idea to buy an immediate fixed annuity when rates are low, Spiegelman cautions retirees against waiting too long. "People have been saying they're not going to buy bonds because interest rates are bound to go up, but they've been saying that for four years now and they've made nothing in the meantime," he says. Spiegelman says investors might consider buying a smaller annuity now and adding others in future years when rates eventually rise.

No matter your approach, Spiegelman stresses that flexibility should be a key feature of planning. "Even though the 4% rule is a great planning tool, you should free yourself up to take out more money if the market is doing well, and maybe less if it's not," he says. "If you have no idea how much you need and you're pulling money out at the spur of the moment, odds are a lot higher that the portfolio isn't going to last."

1. A more refined retirement portfolio target will vary with each person's situation, such as the length of retirement, portfolio investment return, future inflation expectation, and the acceptable confidence level. Go to schwab.com/retirementcalculator for such a calculation.

2. A Guaranteed Lifetime Withdrawal Benefit (GLWB) is an optional rider available for an additional cost. Restrictions and limitations apply. See the prospectus for details.

3. The income (benefit) base is not a contract value and is not available for withdrawal like a cash value. Your actual contract value and death benefit will deplete with each withdrawal. Withdrawals in excess of the specified annual payout amount may permanently reduce the income (benefit) base.