In retirement, income, not wealth, determines the standard of living.
You’ve determined your desired retirement lifestyle, figured out how much it will cost, and hopefully set aside enough savings to pay for it. But frequently overlooked in planning for retirement is choosing a strategy to convert those savings into income. An income distribution strategy will help generate lifetime retirement income, prevent spending too much or too little, increase income efficiency (higher spending and/or increased legacy values), and mitigate the most significant retirement risks (inflation, timing, and longevity).
Having accumulated enough savings is a tall order, but an equally towering challenge is turning those savings into reliable retirement income. Failing to select the right income distribution strategy (or one at all) can prematurely wipe out decades of savings and undo the best planning. It’s one area in retirement planning you can ill afford to make a mistake.Here are a few things to remember to help choose an income distribution strategy.
What Are The Options?
While there are many approaches to creating retirement income, there are 4 main income strategies, largely defined by how each aligns with the 4 retirement income styles: safety-first, probability-based, commitment, and optionality.
- Total Return (probability-based & optionality) produces income by spending systematically from a diversified investment portfolio focused on total returns (think: the 4% rule).
- Income Protection (safety-first & commitment) builds a lifetime income floor with secure income sources such as Social Security and simple income annuities to support spending.
- Risk Wrap (probability & commitment) pairs secure income sources to create an income floor wrapped around a diversified investment portfolio to generate retirement income.
- Time Segmentation (safety-first & optionality) matches short-term spending needs with secure assets and long-term spending needs with less secure assets to generate income.
What’s The Best Strategy?
This largely depends on how you feel about the various retirement income styles. Those with a strong preference for retirement income with the lowest risk and growth potential will opt for the Income Protection strategy. A Total Returns strategy will appeal to those comfortable relying on market returns (greatest risk and return) to source retirement income. Those willing to sacrifice some upside growth for increased downside protection to income will prefer a Risk Wrap strategy. And a Time Segmentation strategy will resonate with those seeking safety and some growth income potential from market returns. There are many approaches to creating retirement. The best strategy provides a steady income most compatible with your retirement income style.
A New Twist
Even the best strategy can be improved. One such improvement is adding an annuity to the time segmentation strategy. This is known as the Hybrid Time Segmentation (HTS) strategy. Adding an annuity, typically one that begins making future payments to the income stream, all but eliminates the risk of outliving income through contractual guarantees of lifetime payments. This strategy also protects against inflation and timing risk (such as experiencing poor market returns early in retirement). It does this by allocating safe assets to fund spending early in retirement and deploying a portion of assets in the markets to produce returns to outpace inflation potentially.
Retirement can be a formidable proposition. You have to do two things very well. First, you must build a base of assets to support future spending goals and convert those assets into lifetime income. Spending in retirement is arguably the more complex of the two because the stakes are much higher. This underscores the importance of having an income distribution strategy to turn savings into a steady stream of lifetime income. Don’t mistake choosing the wrong strategy, or worse, choosing no strategy at all. You’ll want to choose a strategy amenable to you to generate the income for a financially secure retirement while protecting the income from retirement risks.