This article is about managing how you spend your investments. The key concept is your payout strategy: how much to withdraw or spend, given your objectives to live long, live within your means, and, perhaps, leave some for others. While most relevant to those in or near retirement, the article also has good ideas for working people who draw income from their savings.
Don't Be Confused
For something as complex as retirement income, it's no surprise that confusion lurks, ready to sprout like a resilient weed. So let's start by setting the record straight on some key points.
- Required minimum distributions (RMDs) are not a retirement plan. They are tax obligations you owe to the Internal Revenues Service, if you have a traditional IRA or employer's retirement plan (not a Roth plan). You have to withdraw RMDs (except from a Roth plan) and pay taxes on them. But you don't have to spend them. Conversely, if you need to spend more than this year's RMD, you can. Simply withdraw what you need, plus an extra amount to cover the taxes you'll have to pay.
- No single solution works for everyone. Do you need a reserve fund? Does Social Security cover your most critical expenses? What matters most to you? Is it having high income, smoothing your income, or leaving a bequest? How you answer these questions will determine the investment products and payout methods that are best for you.
- Easy may not be better. Sometimes, easy solutions work well. Other times, they may be weak or even risky. The oft-cited "4% Rule," for example, is neither so easy as it may seem, nor as safe. It's actually an "inflated 4%" method, as originally conceived, and the calculations may not be simple for everyone. Significantly, it risks depleting your savings in some circumstances. As another example, payouts based on a flat percentage are often a sensible option, but are rarely the best choice.
- Risks can be reduced, but not eliminated altogether. You can temper the risk of inflation by maximizing your Social Security benefits, supplemented perhaps by the right kind of annuity. Even then, unplanned medical costs or other emergencies could arise that exceed your fixed income. Alternatively, without relying on an annuity or Social Security, if your retirement funds are ample, you could adopt a cautious spending plan that keeps a large balance for emergencies or a bequest. While this plan can be very good, it's not immune to all risks. The risk that you live to be very, very old could mean that despite your prudent intentions, your residual balance could become very, very small.
Planning Your Income
With these points in mind, we at able2pay.com believe every retiree should consider some basic steps to manage payouts taken for retirement income.
First, maximize your Social Security. A common mistake made by many retirees is to start Social Security benefits prematurely. In this case, the simple rules are often best:
Second, save as you spend, even when retired. Already have a reserve fund? Consider adding to it if you have more income than you need. Don't have one? Then start one, first by segregating some of your retirement assets in a separate fund or account for emergencies. Later, if you have excess income, you can redirect it to an after-tax reserve fund. There's more information in a related article. If it gets to be larger than you need, you can safely withdraw and spend about 1% to 3% of the fund, except after a down year.
Third, know where you will turn for large, unplanned expenses. Consider following one of these strategies:
Fourth, in your spendable accounts, adopt a payout method that fits one of three goals. This applies after you've completed the items above. If you then have additional retirement or investment assets from which you can spend, use them to round out your budget. You'll have to pick one of the following goals as your top priority, because no single method can accomplish all of them:
Fifth, seek advice twice. Just as you would get a second medical opinion on a life-critical decision about your health, it makes sense to get alternative advice about retirement income from independent sources. If you have an adviser at your investment firm, you could compare that person's recommendations with ones from software such as ESPlanner Basic or from websites with articles by financial professionals. Or you could split your assets between two firms with different incentives, perhaps one that sells insurance products and another that doesn't. Or you could seek a financial planner who will write a one-time plan for you for a fixed fee, not a percentage of your assets or a recurring charge. Be aware of any and all fees you may be incurring, and know how to find the costs of your accounts.
Sixth, revisit your plan every year. You'll have to do this anyway, when you handle RMDs or update your budget. It's the perfect time to revisit the five items above,
First, maximize your Social Security. A common mistake made by many retirees is to start Social Security benefits prematurely. In this case, the simple rules are often best:
- Work at least 35 years, if you can, at jobs that withhold Social Security taxes from your paycheck. Each additional year increases your eventual benefit.
- Unless you absolutely need the income, postpone Social Security benefits to age 70, or at least to your full retirement age (66 or 67, depending on your year of birth).
Second, save as you spend, even when retired. Already have a reserve fund? Consider adding to it if you have more income than you need. Don't have one? Then start one, first by segregating some of your retirement assets in a separate fund or account for emergencies. Later, if you have excess income, you can redirect it to an after-tax reserve fund. There's more information in a related article. If it gets to be larger than you need, you can safely withdraw and spend about 1% to 3% of the fund, except after a down year.
Third, know where you will turn for large, unplanned expenses. Consider following one of these strategies:
- Use the reserve fund. If it's intended for big expenses, such as long-term care in a nursing home, the fund will have to be larger. Do the research to know how much is necessary. Our article on retiree reserves may help.
- Use the residual balance in your retirement and investment accounts. To keep a large balance, you'll need to pick the right strategy for spending from those accounts. See the fourth point, below.
- Sell your home and use the proceeds. If this is really your plan, procrastination could be your undoing. Wouldn't it make sense to be sure your home is ready to sell now, even if you won't list it for a while? Or plan a date certain when you will sell it and move to less expensive ownership or a rental. It's going to be hard on you or your guardians to exercise this option after an emergency has already begun. See this related article on your home as a financial asset.
Fourth, in your spendable accounts, adopt a payout method that fits one of three goals. This applies after you've completed the items above. If you then have additional retirement or investment assets from which you can spend, use them to round out your budget. You'll have to pick one of the following goals as your top priority, because no single method can accomplish all of them:
- High payouts. Suppose you aim to spend as much as you safely can, leaving just enough cushion to cover the possibility of living to a very old age. You accept that in good years you will be able to spend more, and in bad years, less. Then Life+6 is your best method for taking payouts that you plan to spend. Historically, this method has tended to keep up with inflation, and often to better it, provided you have at least 20% invested in stocks. It's trivially easy to calculate: Find your life expectancy according to Social Security. Add six. Divide the value of your spendable retirement and investment accounts by that number. The result is what you can safely spend this year. Do it again next year, with your new life expectancy and account values. Or use our safe payout calculator, which finds your longevity and does all the math.
- Smooth payouts. In this case, your aim is to spend a consistent amount each year, adjusted for inflation. You accept that to protect against depleting your funds, there will be some limits, which may cause your income to lose some ground to inflation, temporarily, when inflation runs well above the historical norm. And you know that an unpredictable amount of your savings may be left unspent, often a large portion if history can be taken as a guide, but sometimes very little. In this case, Collared Inflation is your best method. Our safe payout calculator will get you started. ESPlanner Basic, as reviewed in a related article, is an alternative way to estimate smooth payouts. Be aware, however, that it assumes a constant future rate of inflation. The reality is that inflation will vary from year to year, and deflation might occur instead.
- Predictable bequest. Your goal in this case is to maintain, if possible, the entire principal of your accounts as gifts for charities or inheritances for your loved ones. Our safe payout calculator does all the complex calculations, which depend on your age and your mix of investments. In all 40-year retirements since 1924, this method (as implemented in our calculator) would have paid steady income every year while retaining, on average, 134% of the principal, adjusted for inflation, in a portfolio 65% in stocks, and 98% of the principal when 35% was invested in stocks. A second option, easy to compute by hand but somewhat less stellar in its results, is to spend a flat 4% of the account value each year, not adjusted for inflation.
Fifth, seek advice twice. Just as you would get a second medical opinion on a life-critical decision about your health, it makes sense to get alternative advice about retirement income from independent sources. If you have an adviser at your investment firm, you could compare that person's recommendations with ones from software such as ESPlanner Basic or from websites with articles by financial professionals. Or you could split your assets between two firms with different incentives, perhaps one that sells insurance products and another that doesn't. Or you could seek a financial planner who will write a one-time plan for you for a fixed fee, not a percentage of your assets or a recurring charge. Be aware of any and all fees you may be incurring, and know how to find the costs of your accounts.
Sixth, revisit your plan every year. You'll have to do this anyway, when you handle RMDs or update your budget. It's the perfect time to revisit the five items above,
Disclaimer: Historical data cannot guarantee future results. Although a mixture of bonds, stocks, and other investments may be safer than investing exclusively in one class of assets, diversification cannot guarantee a positive return. Losses are always possible with any investment strategy. Nothing here is intended as an endorsement, offer, or solicitation for any particular investment, security, firm, or type of insurance. You are responsible for your own investment decisions. Please read our full disclosures and Fiduciary Oath.