6 Ways to Pay Yourself in Retirement
How to make sure your retirement income will last
(This article appeared previously on MarketWatch.)
Many retired investors — and those approaching retirement — are confused about how to pay themselves from their portfolios.
They generally want three things: enough retirement income to live comfortably, safety from market meltdowns, and the assurance that they won't run out of money. The first item is mostly a function of how much they have saved. The second and third are easily attainable.
Let's look at six common ways that retirees deal with this problem. None of these is perfect; as we go, I'll point out some of the pitfalls of each. Ultimately, you may want to "diversify" your withdrawal strategies among two or more of these.
1. A pension
A pension completely satisfies the second and third objectives. Whatever happens in the market won't matter to you. And you'll have a guaranteed income.
If you don't already have a pension, you can create one yourself by buying an immediate-life annuity (ILA).
The ILA is a contract between you and an insurance company. In general, here's how it works: You pay a lump sum to the insurance company. In return, based on your age and current interest rates, the insurer promises to pay you a guaranteed monthly income no matter how long you live.
That sounds very nice, but this arrangement comes with three major drawbacks.
- Your monthly payments are fixed (unless you pay extra for an inflation adjustment), so the real value of your retirement income will decline over time.
- The money you pay for the annuity is no longer yours. It won't ever be available for health care, family emergencies or leaving to your heirs.
- Finally, because the insurance company is taking all the market risk, it will promise you no more than a relatively modest payout rate. A single-life ILA guarantees payments for the life of one person. When he or she is gone, so are the payments. A joint-life ILA continues the payments (which are smaller because the payout period is likely to be longer) as long as either one of the two people is still living.
Based on a calculator available at www.immediateannuities.com, a 65-year-old male could buy a single-life annuity for $1 million and get guaranteed payments of $5,660 — or $67,920 a year — for life. For a 65-year-old female, the payout would be $5,440 a month, or $65,280 a year.
A joint-life annuity for a man and woman, both 65 years old, would pay $4,798 a month, or $57,576 a year, until they have both died.
These are generic quotes from a site sponsored by an annuities brokerage firm with access to multiple insurance companies. If you're shopping for rates, I suggest you also check out Vanguard and USAA.
2. Bond funds
You can generate income from holding a collection of bond funds. For many years I have recommended a combination of equal parts in four Vanguard bond funds (short-term, intermediate-term GNMA and high-yield).
In the 15 years ending Dec. 31, 2014, this portfolio compounded at a rate of 5.7 percent. The current yield of this portfolio is 2.95 percent. (For those who prefer a single bond fund, the current yield of the Vanguard Total Bond Market Index Fund is 2.14 percent.)
In theory, if interest rates remained unchanged (that won't happen, of course), an investor could withdraw 5 percent from this portfolio every year (including principal) for 31 years before that portfolio was totally gone.
The drawbacks of this approach are obvious: There's no inflation protection. Higher interest rates in the future would likely erode the principal even as that principal was being used for part of the withdrawals. Furthermore, when the principal is used up, there's nothing left of this portfolio.
3. The Vanguard High-Yield Bond Fund
The Vanguard High-Yield Bond Fund has compounded at 6.2 percent over the most recent 15 calendar years. Its current yield is 5.2 percent.
If you withdrew 5 percent a year from this fund, it is possible you would not have to ever dip into principal.
This option has a significant drawback in terms of safety. High-yield bonds were once known as "junk bonds" for a very good reason: Investors have relatively low confidence in the eventual payback of the bond principal. Buying such bonds individually is very risky. But when you buy them by the hundreds, as in a fund, the default risk declines a lot.
Still, this fund's net asset value (NAV) can be expected to rise and fall significantly. In 2008, it was down 21.3 percent. In 2009, it was up 39.1 percent. If your withdrawal is based on the value of the portfolio, you would not have a predictable retirement income.
In addition, this doesn't protect you from inflation.
4. The Diversified Portfolio
If you invest in a well-diversified portfolio of equity funds, the probability is very high that you will be able to withdraw 4 percent a year, plus adjustments every year to keep up with inflation, without running out of money. This column shows at least four combinations of bond funds and equity funds that I expect will hold up well in such a plan.
The weakness here is that your portfolio will be subject to the ups and downs of the stock and bond markets. However, this plan's advantages are great enough, in my opinion, to overcome that weakness for most retired investors.
5. Variable Distribution
If you have saved more than enough to meet your goals, you can invest as described in the previous example, then start taking out 5 percent of your portfolio each year. This "variable" distribution is not tied to inflation; instead it varies according to how well your investments fare.
This is a superb plan for those who can afford it. Its only drawback: It requires you to save significantly more before you retire. I described this plan in detail in an earlier article.
6. Corporate Dividends
I've spoken with many investors who like living on corporate dividends, hoping those dividends gradually increase.
It's not hard to find blue-chip companies with long histories of rising dividends. Some investors find this strategy quite comforting. As you might expect, I don't recommend buying individual stocks for their dividends. It's much less risky and less expensive to let a mutual fund manager do that.
The Vanguard Equity Income Fund invests in companies of this nature. Its current yield is 2.89 percent. Quite a bit of that yield is likely to consist of "qualified" dividends that have favorable income tax treatment.
The drawbacks to this strategy are:
- The comparatively low payout
- The lack of any guarantee that corporate dividends will increase — or even be maintained
- The risks of full exposure to the stock market
- As noted, none of these strategies is perfect. Some investors therefore like to use a combination of two or more of them.
The possibilities are nearly endless. Here's one:
You could put one-third of your money in a life annuity, another third in a high-yield bond fund and the final third in a 50/50 (bond-equity) portfolio with a flexible payout.
For a couple, both age 65, the expected payout of this combination is 5.25 percent. One-third of this portfolio should grow over time, and you remain in possession of two-thirds of your capital.
For more information, I suggest you checkout two podcasts I recorded. One is on the flexible distribution strategy, the other on immediate life annuities. For even more on ILAs, here's a good five-minute video.
Richard Buck contributed to this article.