People face many questions as they transition from work to retirement, but perhaps none more daunting than how to provide a reliable income stream without running out of money. While accumulating assets is a necessary part of retirement planning, at most levels of wealth, it is not sufficient to ensure a worry-free retirement. A strategy is needed to coordinate these assets with other sources of retirement income, such as pensions and Social Security, to provide a reliable stream of income that is adequate to sustain a desired standard of living, while at the same time preparing for the uncertainties that life will invariably throw their way. No small task, but one that a thoughtfully-designed retirement income plan can help address.
Start at the beginning
Designing a retirement income plan begins first with an analysis of anticipated retirement spending. Isolating expenses in this first stage will help determine whether sufficient wealth has been accumulated for retirement and whether additional resources or an adjustment to one’s desired standard of living should be considered. Depending on the circumstances, saving more or working longer may be enough to shore up a projected shortfall, while others may need to make lifestyle adjustments to help ensure that their funds last through retirement.
For many retirees, spending habits are firmly rooted and difficult to adjust. Reducing spending, whether temporarily in response to slumping stock markets or permanently, involves uncomfortable tradeoffs that may require time, effort and considerable discipline. Good budgeting skills can help retirees feel more in control and will facilitate better decisions. There are many articles and resources available to help you develop and maintain your budget.
In addition to your ongoing mandatory and discretionary expenses, be sure to include allowances for health care related costs, such as Medicare premiums, supplemental insurance plans and out-of-pocket medical costs, as well as the replacement of automobiles, maintenance to your home, computers, and other high-cost gadgets that you’ll need to replace over time.
Once you’ve identified your expenses, prioritize them and develop a plan for which expenses may be reduced if necessary.
Identify your retirement resources
Marshalling your resources is well-nigh impossible if you don’t keep track of your assets and sources of income. Begin with a simple balance sheet that lists your assets by type (cash, retirement, taxable investments, etc), along with sources of income such as Social Security, pension or deferred compensation. Compare your non-discretionary (i.e., mandatory) expenses with your guaranteed income to see whether a deficit or surplus exists. A large deficit suggests a high-level of dependence on withdrawals from your investments, while a surplus means that the basics are covered and portfolio withdrawals are needed to cover only discretionary expenses. Be mindful that the purchasing power of fixed income streams (i.e., those not adjusted for inflation) will cause this ratio to change over time. Nonetheless, this simple exercise serves as a starting point for decisions surrounding asset allocation, Social Security benefits and whether the use of a guaranteed income annuity should be considered.
Have multiple income sources
Diversification is often discussed in relation to investments, but having multiple income sources with different tax treatment is particularly effective when developing a retirement income plan. This diversification provides opportunities to structure your retirement income in a tax-efficient manner and can improve your chances of success.
To illustrate, consider two retirees, each with similar expenses and overall wealth. The first with a tax-deferred 401 (k) account and income from Social Security, and the second with a 401(k), Social Security income, taxable investments and a Roth IRA.
Retiree number one has guaranteed income from Social Security and will augment this income by withdrawals from his retirement assets. While he has the same control over discretionary expenses as retiree number two, he does not have control over the tax treatment of his retirement plan withdrawals. Every dollar withdrawn is subject to tax as ordinary income. In contrast, retiree number two may use a combination of withdrawals from her tax-deferred retirement account, Roth IRA and taxable investments to satisfy her income needs. This flexibility allows her to minimize withdrawals from tax-deferred assets that trigger a higher rate of tax, in favor of distributions from her tax-free Roth IRA or taxable accounts that may be taxed at lower capital gain rates.
In addition, retirees with large balances in tax-deferred accounts must take required minimum distributions upon attaining age 70.5. If this income is not needed, these distributions can result in the payment of unnecessary taxes. No similar requirement exists for the owners of Roth IRAs and taxable accounts.
Match guaranteed income to non-discretionary (mandatory) expenses
Guaranteed income sources such as Social Security and pensions provide reliable income that is not directly affected by the ups and downs of financial markets. As a result, those with high levels of guaranteed income tend to worry less about funding their retirement than do those that rely heavily on withdrawals from their investments.
Matching guaranteed income to mandatory expenses ensures that those core expenses are covered, and reduces the need to withdraw funds from investment accounts during periods of poor market performance. Those with a substantial pension benefit may find that they have more than adequate income to cover these expenses, while those without a pension often come up short. As the prevalence of pensions declines, fewer retirees can expect to derive a substantial portion of their retirement income from such plans. Many will seek alternative ways, such as the use of guaranteed income annuities, to increase their guaranteed income. Finally, it’s important to remember that many private-sector pensions do not include an adjustment for increases in the cost of living, so participants can expect the purchasing power of their pension income to decrease over time.
For those fortunate enough to be covered by a pension plan, careful consideration should be given to the distribution options offered by the plan. Most plans will provide participants a variety of annuity payout options that pay a benefit for the life of the retired worker, with some portion of the benefit paid to their surviving spouse. When selecting an option, consider how the current health and lifestyle of each spouse could impact their longevity.
Maximize Social Security retirement benefits
Social Security retirement benefits provide a foundational benefit that covers the vast majority of Americans. In fact, for many, Social Security comprises the majority of their retirement income. Yet, despite this reliance on program benefits, 42 percent of men and 48 percent of women begin collecting their benefits at age 62.
Collecting benefits prior to full retirement age results in a permanent reduction in benefits of 5/9 of 1% per month for up to 36 months, and 5/12 of 1% per month beyond 36 months. For a current retiree with a full retirement age of 66, the result is a 25% lower benefit if you claim at age 62 instead of age 66. This permanent reduction applies to benefits paid to the surviving spouse of a deceased worker. What’s more, the program’s cost of living adjustment is based on the reduced benefit, and income earned prior to full retirement age could cause a further reduction in benefits for those that collect early.
Contrasting this, workers that defer collection of their benefits until full retirement age will receive non-reduced benefits and are not subject to a reduction in benefits based on earned income. And those that defer collection beyond their full retirement age, up to age 70, will receive Delayed Retirement Credits of 2/3 of 1% per month, or 8% per year. Thus, a retiree with a full retirement age of 66 that collects benefits at age 70 will receive a permanent benefit increase of 32% over their full retirement age benefit. This increase is included in the calculation of any future cost of living adjustments and benefits paid to a surviving spouse.
While claiming early may be the best strategy for singles in poor health, or for married couples where neither spouse is expected to live to a normal life expectancy, it should be noted that- absent a specific diagnosis- estimating one’s life expectancy is a notoriously difficult task. Before irrevocably reducing a lifetime income stream with a generous cost of living adjustment, carefully consider the effect this will have if you live longer than expected.
In general, individuals and couples where one or both spouses may live beyond their mid-80s should evaluate deferring benefits beyond full retirement age. In the case of couples, this is especially true when one spouse’s benefit is materially larger, as Delayed Retirement Credits earned by the higher-earning spouse will result in a larger cost of living adjustments, and these increases will be passed on to a surviving spouse. It should be noted that delaying benefits is not always an option, but for those with significant retirement saving research suggests that the deferral of benefits can help reduce the risk of running out of money in retirement.
Filing for Social Security benefits is an important decision with lifetime consequences, so proceed with caution. A good first step is to visit the Social Security Administration website and retrieve your current benefit estimate. The site also contains many useful calculators that can help you make a more informed decision. Click here to learn more about the types of benefits available and some claiming strategies to help maximize them.
This seems really complicated
Retirement income planning is different from traditional financial planning or wealth management in that it is more narrowly and deeply focused on a specific set of issues affecting retirees. Financial planners or wealth managers with a professional focus in this area not only concentrate on providing retirement income (the primary thrust of this article), but on evaluating retirement plan benefits, Social Security and Medicare benefits, the coordination of tax planning with income planning, long-term care and providing for the ongoing needs of people as they age. The best planners will also help clients visualize and clarify their retirement goals, and will work closely with them on managing their plan and updating it as needed. Given the time and specific skills involved, even those individuals with a high level of comfort in managing their own finances may find it helpful to work with a qualified financial planner to help coordinate these decisions and develop a plan of action.
There are many ways to structure a retirement income plan and no one approach is right for everyone. Care should be taken to evaluate anticipated spending and whether this can be comfortably supported by portfolio assets and sources of income in retirement. Adjustments to the plan may be necessary, including increased saving, working longer or part-time in retirement, or reducing lifestyle costs. These are best addressed prior to retirement, while remedies remain available. The deferral of Social Security benefits can dramatically increase retirement income, and, for some, is among the most effective methods available to increase cash flow in retirement and reduce the risk of depleting portfolio assets. Those nearing retirement will grapple with many important and irrevocable decisions. Having a thoughtful plan in place will help facilitate better decisions and increase the likelihood of a worry-free retirement.
John Male CFP®, RICP®
The Gassman Financial Group
G&G Planning Concepts, Inc.
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New York, NY 10016
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