MARK RIEPE: About four hours after I’m done recording this episode, a remarkable thing will happen at my home. To be more precise, it will happen above my home.
The International Space Station will cross right overhead at 7:37 p.m. tonight. and it should be visible to the naked eye. I’ve spotted it many times before and even dragged my kids out into the backyard to see the spectacle.
I’ll admit, they weren’t all that impressed. And I suppose that’s my fault.
I just wasn’t able to convey to them how impressive it is that this man-made thing, roughly the length and width of a football field and weighing almost a million pounds, was hurtling around the earth at 18,000 miles per hour.
Not only that, it was doing so in such a controlled fashion that NASA could put together a website telling everyone, to the minute, when the ISS would appear over their town.
The existence of the ISS is an incredible human achievement, but like many incredible achievements, it didn’t happen overnight—it took ten years of international cooperation and over 30 complex construction missions.
Since then, 239 people from 19 different countries have visited the space station, but the transition from near-earth orbit construction project to working scientific laboratory wasn’t entirely smooth.
It’s one thing to build a space station, but ongoing repairs and governance have their own complexities. While the builders were developing a maintenance plan, the operators were juggling the participating space agencies’ competing priorities and figuring out how to bring private companies and academic institutions into the fold.
All of which is to say that when you focus on building something over a long period of time, shifting gears and adopting a different mindset to actually use what you’ve built can be challenging—and that’s the subject of today’s episode.
Building a nest egg for retirement is a massive, multifaceted project. But after decades of saving and accumulating wealth, there comes a time when you need to transition into spending mode.
In other words, you face the decision of how best to pay yourself a regular income in retirement.
I’m Mark Riepe, and this is Financial Decoder—an original podcast from Charles Schwab.
It’s a show about financial decision-making and the cognitive and emotional biases that can cloud our judgment.
One of the decision-making techniques we’ve discussed in past episodes is mental accounting. We use mental accounting when we divide up our financial affairs into discrete categories and make different decisions depending on the category.
For example, I sometimes hear investors talk about their so-called “play money.” This is their label for a part of their portfolio where they are willing to be more adventurous and take more risk than they would with their “serious” money.
Now, money is money. Whether you lose $1,000 of so-called play money or $1,000 of your serious money, the loss is the same. You’re still out $1,000 bucks.
However, it feels very different from an emotional perspective. Those investors who psychologically label some of their funds as “play money” have, it seems, already accepted the possibility of losing that money and are at peace with it if the loss actually occurs.
The emotional jolt from losing $1,000 of serious money would be much greater, and so the labels we give to these mental accounts really do matter.
To see how this connects to living off your portfolio during retirement, consider the traditional advice to “never touch the principal.”
This means living solely off the dividends and interest that your portfolio generates and not selling assets. But implicit in this advice is a sort of mental accounting.
Principal is put into a mental account that we’ll call “the foundation.” It’s the bedrock that we want to always be there far into the future no matter what happens.
Dividends and interest are put into a different mental account that we might think of as “spending.” It’s income, so we allow ourselves to use it.
There’s a lot to be said for this approach when it comes to generating a paycheck from your portfolio, but it may not be realistic—or even necessary—for everyone.
I’m sitting here with Kathy Jones. Kathy is our chief fixed income strategist, and she’s here to explain why thinking about retirement income differently makes sense for many investors nowadays.
Kathy was a guest back in season one, when we talked about bonds and risk. Nice to have you back, Kathy.
KATHY JONES: Good to be here.
MARK: A top concern among those who are retired or about to retire is how to generate income from their portfolio. They’re leaving their primary job, and they need to replace the paycheck they used to get from their employer and are looking for their portfolio to help make that happen. This is a more difficult problem than it used to be. Why is that?
KATHY: Primarily because yields are so much lower than they were in the past, and getting a higher yield requires taking a lot more risk. So, for example, the range in 10-year Treasury yields from, say, 1990 to 2007 was you know, 8½- to 3½%, and most of that time yields were well above 4%, which means that an investor could get a risk free rate of return in the 4- to 5% region. That’s pretty comfortable when planning retirement. Now that yield is somewhere around 2% or lower.
MARK: So you need to have a pretty big portfolio to live off 2% if you’re just going to live off interest, right?
KATHY: That’s correct.
MARK: And while people want a higher yield so they generate more income, at the same time, as you just mentioned, they don’t really want to take on a lot of risks. That of course is hard to achieve. Give me some examples of where people are maybe unintentionally taking on more risk than may be prudent.
KATHY: Well, the three kind of risks that people are taking are in credit and in duration, and then equity-type risk, say, with high-dividend-yielding stocks.
MARK: Define what you mean by each one of those and tell me a little bit about where exactly that extra risk is coming from.
KATHY: So credit risk really refers to the risk of default or the issuer defaulting. You get a lot of credit risk in, say, high-yield bonds or emerging-market bonds because they have a history of defaults, these are the less credit worthy issuers. Duration risk is a measure of the volatility and the price of, say, a bond relative to interest rate changes. So in other words, the longer the duration of the bond, the more sensitive it’s going to be to interest rate changes. 10-, 20-, 30-year bonds are going to have much higher duration and more volatility than shorter-term. And then dividend-paying stocks tend to have both lower credit quality than, say, a Treasury bond and long duration because stocks are perpetual securities—they have no maturity, and that makes them significantly more volatile than, say, core bonds. There’s also a risk if you have a heavy allocation to high-dividend-paying stocks, along with other equities, that your entire portfolio has been skewed to just equity-like risk.
MARK: And of course the equity market tends to be more volatile than the bond market.
MARK: You mentioned core bonds. What exactly does that mean? What goes into, say, a core bond fund?
KATHY: So when we talk about core bonds, we’re generally referring to higher-credit-quality bonds, such as Treasuries, other government-backed bonds, investment-grade municipal bonds, and highly rated investment-grade corporate bonds.
MARK: And for most investors, the word “core” comes from … that can be the core or the kind of the foundation of your bond portfolio.
KATHY: Yeah, that’s correct. You probably want most of your fixed income holdings to be in those core bonds to reduce the volatility.
MARK: Kathy, when most people think about living off of their portfolio, they think about living off just the dividends and the interest. Is that really possible for most people?
KATHY: Not really. You would need a very large portfolio with this low-interest-rate environment to make that work. So for most people, they’re going to have to tap into the principal at some point.
MARK: So why is that? Is that just driven by the fact that, you know, rates are low?
KATHY: Rates are low, and people are living longer in retirement. So they need that nest egg to last quite a bit longer, and typically they’re going to have to use some of that nest egg as time goes by.
MARK: So if dividends and interest are insufficient for most people, what’s the alternative?
KATHY: Well, the alternative is to figure out a way to tap into the principal over time without reducing it to a level where it’s not going to generate much income. So here’s a good example. Say you have a million dollars for retirement and you need that to generate about $40,000 a year. You can earn much of that with a diversified portfolio of bonds and dividend-paying stocks, but you will probably need to use capital gains when you rebalance the portfolio. So if there are gains because of the markets are up, that could likely fill the gap and get you to that $40,000. But there may be years that you need to tap into the principal to get to that $40,000. What you need is a good estimate of how long your money will last. That can help you make those decisions. You might choose to spend less some years and spend a little more other years depending on those projections. But you really need a good projection to calibrate what your spending should be. And actually many retirees, because they’re worried about this, underspend what they could in retirement because they don’t have a good estimate of how much they can spend.
MARK: So one of the important things is to be flexible—to be able to kind of adjust your situation as market conditions change.
KATHY: Yeah, absolutely.
MARK: Another complication with creating income for retirement is that most people don’t have just one account. A couple might have accounts in the names of one partner or the other. There might be accounts that are jointly held. Some accounts are taxable. Some are tax-deferred. Some are tax-free. It’s kind of a mess for most people. How do you take all that into account?
KATHY: Yeah, it is, it gets very complicated because there are different rules and regulations around each of them. But our view is you take from all of them by drawing a portion from all of those accounts to spread out your tax burden and to be able to tap into all of them at any given time.
MARK: The intuition for many people might be, well, you just start with one account, and you just keep pulling from that until it’s drained, and then you move to another account. What you’re saying is you’ve got to kind of spread things around a little bit right from the get-go.
KATHY: Yeah, we think it’s important or wise to do that because your tax rates go up and down over time, and you don’t want to use your accounts in such a way as that it pushes you into a higher tax bracket at some stage of the game.
MARK: So let’s explore that a little bit. Let’s start with some definitions. What do we mean when we say an account is taxable? What is a tax-deferred account—what is that all about? What is a tax-free account?
KATHY: So a taxable account is just a regular investment account where the income on interest and dividends, as well as any gains, are taxed every year. So you will owe taxes each year on the income and any gains from that account.
A tax-deferred account might be like an IRA or a 401(k), where you don’t have to pay taxes on the gains until the money is withdrawn. So you also get an immediate tax break because the money you put into it isn’t taxed as income that year.
And then there are tax-free accounts. You put in after-tax money, but the gains in income aren’t taxed when you withdraw the money. And the best example of that would be a Roth IRA.
MARK: And another complication is if your withdrawals are being taxed as income, that typically is at a different rate than if your withdrawals are being taxed at, let’s say, a capital gain rate.
KATHY: Absolutely. So it does get complicated.
MARK: OK, so let’s try to keep things simple. You’ve got three accounts. Let’s say one is taxable, one is tax-deferred, one is tax-free. Where do I start?
KATHY: So you want to start with the one where you have a required minimum distribution. And so those are required by the IRS. It’s usually a tax-deferred account, and you’re required every year after a certain age to withdraw a certain percentage of that and pay taxes on it. So you need to do that because, you know, that’s a requirement. After that you should take money proportionally from the other types of accounts except for the Roth IRA, which is tax-free. You want to push that one off as far into the future as you can.
MARK: So you start with your RMD. You get that withdrawal first. Why is that so important?
KATHY: Well, the penalties are big. So if you for some reason don’t do it, the IRS will impose a penalty of 50% of the money that’s not withdrawn. You need to take that RMD.
MARK: That is a good incentive, exactly. So you start fulfilling your RMD requirements and then you take proportionally from both the taxable and the tax-deferred accounts. Is that right?
KATHY: That’s correct, yeah.
MARK: So why is the Roth last?
KATHY: Well, because it’s tax-free, and so there’s no taxes owed on it. It’s really nice for estate-planning purposes. You can pass that money on without taxes. Withdrawing money from that account won’t push you into a higher tax bracket. So that’s one we like to save until the end; let it grow as much as possible.
MARK: Let’s talk a little bit about tax rate changes. How does that come into play, given that they can change over time?
KATHY: Yeah, so consider that, say, that your tax rate goes from, say, 20% to 30% in a given year. If you have a little flexibility in terms of which account you’re drawing from that you don’t maybe have to push yourself into the higher tax bracket. So, say, tax rates go up, you want to minimize your taxes. Maybe you start to use some of that tax-free money to kind of fill in in order to keep from being pushed into a higher tax bracket and having a higher tax burden.
MARK: Yeah. I think one of the disadvantages of just focusing on pulling all your money out of your taxable account is you’re really letting those tax-deferred accounts build up, and then if tax rates go up and you start making these big withdrawals from these tax-deferred accounts, you’re going to have a really big tax hit.
MARK: Great information, Kathy. Thanks for coming by.
KATHY: Great to be here.
MARK: Every year millions of Americans are finding out that the skill set required to accumulate a portfolio is not the same as that required to draw down that portfolio in a manner that’s sustainable over ever-lengthening life spans.
This is especially true when people realize that they have to optimize their draw-down strategy across multiple accounts.
Here are a few things to keep in mind if you find yourself in this situation.
First, make sure you take your required minimum distributions, or RMDs. If you don’t, then the penalties can be quite large.
Second, coordinate your withdrawals across your accounts. While it may be simpler to just draw down one account at a time, it’s usually not the wisest way to proceed.
Third, be flexible. Don’t lock yourself and your entire portfolio into one strategy forever.
Although it’s important to have a realistic projection of how long your money will last, the fact is that the world has a way of throwing surprises at us—including shocks in the market that could dramatically alter your original projection. Revisit your situation and your planning assumptions and adjust as needed.
Fourth, automate where it makes sense.
And what I mean by automate is using an automated investment service like Schwab’s Intelligent Portfolios that can help you generate a monthly paycheck from your retirement accounts.
Fifth, seek help. Everyone’s situation is different, and it can help to talk to a financial advisor or certified financial planner professional to find the best strategy for you.
After a lifetime of earning a regular paycheck, it can be daunting to figure out exactly how to pay yourself from the various accounts you’ve built up over the years.
If you’d like to learn more about Schwab’s new way to pay yourself from your portfolio, check out schwab.com/IntelligentIncome.
If you want to see when the International Space Station is passing over your home, go to spotthestation.nasa.gov.
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If you want to go back and listen to previous to episodes or read more about our previous topics, you can always visit schwab.com/FinancialDecoder.
For important disclosures, see the show notes and schwab.com/FinancialDecoder.
Please note that the RMD age changed with the passing of the SECURE Act in 2019. If you turned 70½ before 2020, then you may be subject to RMDs. For 2020 and beyond, the age at which individuals may be required to take RMDs from retirement accounts is 72.