One of the biggest challenges facing new retirees is how to replace their regular paycheck with a steady stream of income from their savings and other sources.
Social Security and pension plans—which provide a reliable monthly paycheck for life—certainly help, but they’re unlikely to cover most retirees’ ongoing expenses. Indeed, Social Security was designed to replace only about 40% of average annual earnings (the percentage is actually lower for those in upper-income brackets), and the median monthly benefit is just $819 for private pension plans.1
As a result, most retirees must figure out on their own how to cobble together guaranteed payouts, irregular income streams, and withdrawals from their hard-won savings to create a steady “paycheck” in retirement.
“Generating predictable retirement income is like putting together a puzzle,” says Rob Williams, vice president of financial planning at the Schwab Center for Financial Research. “Because every retiree’s puzzle looks slightly different, there’s no one way to put it together.”
Here are five steps for creating your own retirement paycheck, whatever your individual circumstances.
1. Nail down expenses
One rule of thumb is to assume you’ll need only 75% to 80% of your current income once you reach retirement, since some big work-related expenses—such as retirement contributions and commuting costs—will likely go away. That said, a ballpark estimate gets you only so far, so it’s best to create a budget where you can assign real numbers to your expenses.
2. Subtract guaranteed income
Once you know your monthly outflow, it’s time to figure out how much guaranteed income you can expect to receive. Social Security figures prominently here, and the timing of when you collect can have a big impact on your total benefit.
Collecting early—anytime from age 62 through to your full retirement age (between 66 and 67 for today’s retirees)—means taking a reduced benefit of up to 30% for life. By contrast, every year you wait to collect past your full retirement age (up to age 70) increases your benefit by 8%. Go to ssa.gov/OACT/quickcalc to estimate your benefit.
After you estimate your monthly Social Security benefit, add to that any pension or other guaranteed income, then subtract the total from your budget. The remainder is the amount you’ll need to come up with from other sources.
3. Factor in supplemental income
According to the Bureau of Labor Statistics, roughly one in five people age 65 and older participates in the workforce. Even part-time work can supplement Social Security and other sources of guaranteed income, allowing you to minimize the impact on your retirement savings until you stop working completely. “After all, every additional dollar you don’t need to withdraw from your retirement savings is a dollar that can remain invested,” Rob says.
Be aware, however, that earning income in retirement could push you into a higher tax bracket, which may affect the taxability of your Social Security benefits and the cost of Medicare.
Another common source of income is from rental properties—be it an investment or vacation property, or even a portion of your primary residence—which can provide not only regular cash flow but also potential tax benefits. For example, you may be able to deduct certain expenses, such as depreciation, from your annual rental income.
Keep in mind, however, that you’ll likely face a host of tax obligations as well. Apart from property taxes, any rental income could potentially push you into a higher tax bracket. Also, if you use a second home as both a rental property and for extended personal use, you may not be eligible for all the deductions a rental property alone would provide.
“Supplemental income sources can provide extra cash flow in retirement, which is always appealing, but they may also come with tax consequences that shouldn’t be ignored,” Rob says. “It’s wise to consult a qualified financial planner or tax advisor about the potential benefits and drawbacks of such income sources as you map out your income plan.”
4. Estimate investment income
With interest rates near historic lows, income-generating investments aren’t as powerful as they once were. Even so, regular interest and dividend payments can play an important role in your retirement income.
For example, purchasing bonds with staggered coupon and maturity dates—see “How to build a bond ladder,” below—can help even out your portfolio’s yields over time and provide a steady stream of income.
Dividends, on the other hand, are less regular and therefore harder to plan for, but you can still estimate how much income you can expect from a stock or fund based on its annual dividend yield.
5. Turn to your retirement portfolio
After accounting for all other income sources, you can estimate how much of the principal in your retirement accounts you’ll need to tap each month. But how will you know if that withdrawal rate is sustainable?
“That’s where the so-called 4% rule comes into play,” Rob says. “That is, if you withdraw 4% of your portfolio value in your first year of retirement, and then adjust that amount in future years to account for inflation, it’s highly probable your savings will last 30 years.”
For example, imagine an investor with $1 million in retirement savings. Using the 4% rule, she should be able to withdraw up to $40,000 in her first year of retirement, or about $3,333 per month.
Of course, market volatility can cause your portfolio value to fluctuate, making your income less predictable than you might like. In such cases, you may want to consider a fixed annuity, which can provide a steady stream of income for life.
Plan for change
As you move through retirement, you may find that your income sources change from year to year. If you stop working part time, for example, you may need to make up for that lost income by taking a larger withdrawal from your retirement portfolio. Likewise, once you reach age 72, required minimum distributions (RMDs) from traditional IRAs and 401(k)s kick in, which may force you to rethink your income approach. (Note: As part of the Coronavirus Aid, Relief, and Economic Security Act, RMD requirements have been suspended for 2020.)
If the task of generating a steady income stream feels daunting, consider working with a financial advisor, who can help you determine which assets to tap when and in what proportions. Some low-cost robo-advisors—including Schwab Intelligent Portfolios®—can even do this for you (see “Robo-advisors to the rescue,” below).
“Whether you plan to generate your own retirement paycheck or turn to a professional for help, know that your income needs could change over time and your plan should account for that,” Rob says.
1“Income from Pensions,” pensionrights.org, as of 2018.