Creating a Retirement Paycheck
Barbara O’Neill, Ph.D., CFP®, Rutgers Cooperative Extension, oneill@aesop.rutgers.edu
As baby boomers (i.e. people born between 1946 and 1964) continue to reach retirement age, increasing attention is being paid in the financial services industry to the concept of creating a “retirement paycheck.” What exactly is a “retirement paycheck?” It is income received on a regular basis after someone stops working. A “retirement paycheck” makes it easy to pay monthly bills, which provides financial security and peace of mind. It also continues a money management system that many people are used to before retiring where they received income in regular payments.
Another benefit of a “retirement paycheck” is that it can be structured to provide a “safe” withdrawal rate to reduce the risk of outliving your assets. Given increased life expectancies in recent years, this is a big concern. Second to out-of-pocket medical expenses, outliving savings is retirees’ biggest worry about retirement security according to a 2008 survey by the Charles Schwab Corporation.
Researchers have found that an inflation-adjusted withdrawal rate of 4% of a retiree’s portfolio balance will generally last for 30 years when the portfolio consists of 50% stocks and 50% bonds. For example, with $500,000 of savings, you would withdraw $20,000 ($500,000 x .04) during your first year of retirement and $20,600 ($20,000 + $20,000 x .03) and $21,218 ($20,600 + $20,600 x .03) in years 2 and 3, assuming a 3% annual inflation rate increase. Recently, researchers have been advising investors to skip the annual inflation increase during severe market downturns such as 2008-2009.
So how does someone create a “retirement paycheck”? There are a number of available products or strategies that can be used to arrange regular income deposits at regular time intervals. Following are eight common “retirement paycheck” income distribution methods:
• Automatic Withdrawal Plans– Available through mutual funds, this account feature allows investors to designate a dollar amount and a date (e.g., $500 on the 15th of the month) to receive regular income withdrawals, generally by direct deposit into a bank account. The withdrawals are automated and occur systematically regardless of market conditions. Payments are made by the investment company until the account balance is depleted.
• Income Replacement (Managed Payout) Mutual Funds– These are a new type of actively managed mutual fund, with a choice of maturity dates (e.g., 2048) that investors select to match their projected life expectancy. The further away the maturity date, the less money investors will receive (as a percentage of the account balance) because their account has to last longer. Managed payout funds pay a monthly income that is adjusted annually for inflation and economic conditions and monthly payments continue until assets are exhausted. They contain a diverse portfolio of securities and are similar in operation to target date mutual funds except that the time deadline is based on investors’ life expectancy instead of their anticipated year of retirement.
• Bond or Certificate of Deposit (CD) “Ladder”- An investment “ladder” can be visualized as an actual ladder with a series of rungs (steps). It is a staggered portfolio of bonds or certificates of deposit (CDs) with different maturities (e.g., 6, 12, 24, 36, 48, and 60 months). As each bond or CD matures, the proceeds are reinvested at the longest time interval to maintain the ladder. With a fixed-income investment ladder, investors can “hedge their bets.” Instead of placing all their investment principal in one bond or CD with one maturity date, the money is spread around. If interest rates rise, they’ll be more frequent opportunities for investments to mature and to reinvest the proceeds at higher market interest rates. If interest rates decline, investors will still have some longer-term investments in the ladder that are paying higher interest than what is currently available.
• Regular Withdrawals from Cash Assets– Many financial advisors recommend setting aside enough money in cash assets (e.g., money market funds, CDs, and bank or credit union savings accounts) to provide 3 to 5 year’s worth of income that is not provided by Social Security or other sources (e.g., post-retirement jobs and pensions). The purpose of this money is to “ride out” recessions and bear markets so that investments like stocks and growth mutual funds don’t have to be sold at a loss to provide money for daily living expenses. The remainder of a retiree’s assets would be placed in stocks, bonds, or mutual funds. For example, if a couple plans a $40,000 annual income in retirement and expects to receive $25,000 from Social Security and employment, their income “gap” is $15,000 and 3 to 5 year’s worth of cash assets is $45,000 to $75,000. Income can be withdrawn monthly or quarterly, as needed. The cash balance should be replenished regularly, starting with income from bonds and dividends and capital gains from stock when market conditions are favorable.
• Post-Retirement Income– Several research studies have found that many people want to continue working past the traditional retirement age of 65, either because they have to (i.e., economic need) or because work provides a sense of satisfaction and daily structure. Income earned in later life (e.g., from a job or home-based business) can also be an important part of one’s “retirement paycheck.” In addition to providing money for daily living expenses, continued employment provides an opportunity to keep depositing money into retirement savings plans (e.g., 401(k)s), earn a higher Social Security and/or pension benefit, and postpone withdrawals from retirement assets. Earning $40,000 a year is the equivalent of withdrawing 4% from a $1 million portfolio.
• Annuities– An annuity is a contract with an insurance company where an investor deposits a sum of money in one lump sum or over time and the insurance company makes regular payments for the investor’s life (or a joint life expectancy with a spouse) or for a fixed time period. Annuity payments are generally based on factors such as age and gender. Investors should shop around for annuities with low expenses that are sold by insurance companies with high ratings for financial stability.
• Reverse Mortgages– A reverse mortgage gives older adults the ability to remain in their homes while receiving cash based on their home equity. The homeowner must be 62 years of age or older and the home must be their principal residence. Any existing mortgage must be paid off, (this is typically done from the money received from the reverse mortgage). There is no minimum credit or income requirement to qualify for a reverse mortgage and borrowers can use the money for whatever purpose they choose. Money can be received from the loan as a lump sum, in cash installments, as a line of credit, or any combination of these options. The amount received is based primarily on a borrower’s age, the value of the home, and prevailing interest rates.
• Monthly Income Payments– Regular income payments, such as rent collected from rental real estate or monthly mortgage payments (e.g., if a retiree provides a mortgage for others upon the sale of a house) are another way to create a retirement paycheck. Some people also rent out land, garages, or part of their primary residence as a source of additional income in retirement,
There are many ways to create a “retirement paycheck.” It’s fair to say that retirement in the 21st century will be quite different than that of previous generations. First, the “three-legged stool” analogy of a pension, Social Security, and personal savings as sources of retirement income is being replaced by a “four-legged chair” that also incorporates earnings from employment. In addition, the increasing cost of health care and long-term care will continue to be a major concern as life expectancies increase and retirements increasingly last 20 to 40 years. New financial products and strategies will continue to be developed to help people manage cash withdrawals for daily living expenses during later life.