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Managing Cash Flow in Retirement
- By Travis Echols
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- 25 May, 2018
Updated on January 7, 2020.
Managing cash flow in retirement when you are no longer earning a regular paycheck may sound tricky.
Social Security, pensions, rental income, etc. can be viewed as annuity-type payments, in that they pay you a regular fixed amount for as long as you live. A person who is planning ahead can affect what these payments will be in the future to some degree; but once certain decisions are made, and payments start, the choices are often limited. See How to Maximize Your Future Social Security Payments.
The other major source of income for retirees is investments. How should investments be structured to supplement Social Security and any other income streams one may have?
Retirement specialists propose different methods.
Annuitizing a Lump Sum
One method is the annuity approach, in which the owner pays an insurance company to convert a lump sum into an income stream for life. The resulting payments are similar to Social Security and defined pension payments. This can work out great if you live a long time, don’t care if you leave an inheritance, and have other resources for spending shocks.
But this method does not work out so great for your heirs if you die early. Depending on how the annuity is structured, non-spouse beneficiaries normally receive nothing upon the early death of the annuitant(s).
Another negative is locking in a low life-time payment, as the insurance company that guarantees your payments are limited to the interest rate conditions at the time you purchase the annuity. A low-returning payout with no inflation adjustment can expose you to significant purchasing power risk over time.
The annuitized lump sum is also no longer available for large unexpected spending needs in retirement, since this part of your nest egg has been replaced by a promise of regular monthly payments from annuity insurance company.
While the annuity approach has the advantage of reducing longevity risk by guaranteeing a lifetime income stream, the biggest potential problems with the annuitizing approach is legacy risk (nothing for heirs), inflation risk (payment doesn’t keep pace with inflation), and liquidity risk (no access to cash if needed). See Annuities: The Good, the Bad, and the Ugly.
For those who want to grow their capital while still maintaining access to it, there are three major methods retirement specialists propose.
Income investing
Income investing is a retirement cash flow strategy that attempts to maximize dividends and interest to cover as much of the owner’s income needs as feasible. Theoretically, if a $1 million stock/bond portfolio can regularly pay out an average of 4.5% in stock dividends and bond interest, the owner doesn’t have to sell investments to generate income (they would still have to sell investments for unexpected spending shocks, Required Minimum Distributions (RMDs) from IRAs, and for rebalancing and tax harvesting.)
Stocks generally pay a lower income than bonds so a mixed portfolio of high dividend-paying stocks and investment-grade bonds generally comes short of matching a withdrawal rate above 3% (in today’s yield environment). When selling is needed to cover income shortages, it can be done when the portfolio is rebalanced. This method can normally avoid having different buckets for different dedicated time frames. Rather the entire portfolio is at work generating a sufficiently high enough income stream to meet most of the client’s portfolio income goals.
The benefit of this approach is that all the portfolio is working, yet with less overall market risk. However to get more income, you typically have to buy lower quality bonds and bonds with longer maturities. The primary risks are credit risk and duration risk.
Total Return Bucket Approach
The total return bucket approach is where you keep five or more years’ worth of income in low-yielding, low-risk investments (such as money market, CDs, or short-term government bonds) and the rest of your retirement nest-egg in long-term growth assets such as stocks. The idea here is that the war chest of safer investments is available to draw from in retirement when the markets experience prolonged or severe downturns. Using a farm analogy, when the cattle are healthy, eat the cows from the field. But when they are unhealthy eat the meat stored in the freezer until the cows in the field fatten up again.
This approach helps investors dedicate and time-segment their investments. Safer investments are dedicated for short-term needs and stocks are dedicated for long-term needs. The safe bucket gets depleted during market downdrafts and filled back up during strong market periods. Bucket strategists figure five years will get you through most economic crises. For retirees needing $45,000/year from their $1 million portfolio, they would keep at least $225,000 in the safe bucket and the remainder in the growth bucket. It is called the total return approach because there is no need to orient the investments toward high dividends and interest. The growth bucket may have no bonds at all. This approach requires selling stocks when they’ve grown and spending down cash-like assets when stocks decline. Since stocks’ growth consist of price appreciation plus dividends, investors using this approach aren’t necessarily attracted to high-dividend paying stocks but can focus on total return only.
One advantage to this approach is the ability to seek investments that don’t necessarily pay high dividends or high interest. Having a war chest of cash also makes it easier for retirees to weather bad market performance and avoid selling assets when they are down in price. The disadvantages are the potential opportunity cost of a five-year bucket of guaranteed, low-returning assets and the market risk of the growth bucket if it is wholly invested in stocks. There is also the risk that a situation arise in which five years may not be enough time for market values to rebound; and when the five-year bucket is depleted, you would then be forced to sell assets when they are down to provide for your living expenses.
A Hybrid Approach
With these
pros and cons considered above, some retirement planners have combined the Total Return Bucket
Approach and the Income Investing Approach to form a hybrid model as
illustrated below.
Notice above that the two buckets are Cash and Retirement Investments. Ideally, you hold one to two years’ worth of investment income in cash or cash equivalents. The remainder of retirement assets (often in IRAs anyway) you fully invest for long-term growth and income. So, with a $1 million liquid net worth, ideally $45,000 to $90,000 would be in cash reserves with the remainder in a broadly diversified portfolio of bonds and stock funds.
After age 72, when Required Minimum Distributions (RMDs) are due annually (from traditional, SEP, and Simple IRAs and qualified plans), any excess RMDs (above the calculated sustainable withdrawal amount--counting any QCD) would go back into retirement investments, albeit in taxable accounts.
The dynamic distribution method (i.e., retirement income guardrails) controls the flow of income from the retirement investments bucket to the cash bucket. The portfolio is tilted toward higher income investments to minimize the need for constant trading, while periodic rebalancing provides opportunity to fill income shortfalls if the portfolio yield is less than the withdrawal rate. See Three Steps to Safely Maximize Your Portfolio Income.
This hybrid approach also employs a war chest, albeit with cash and bonds, which allows time for market disruptions to resolve, while in the interim producing a steady flow of dividends from stocks and income from bonds. This method also mitigates liquidity risk, in that there are one to two years of cash reserves available in the bank--which also has an emotionally settling psychological effect, according to studies.
I think this hybrid method is the best of all worlds, balancing the longevity, lifestyle, legacy, and liquidity needs of the majority of retirees. See Investing for Income in Retirement.
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- Liquidity--Retirement assets are not being locked up or annuitized such that capital is not available for emergencies.
- Income—Using an optimized withdrawal rate, an increasing income is produced to combat inflation (unlike many pensions, bank and insurance strategies that are not inflation-adjusted).
- Growth--assets that can combat inflation over a 20 to 30-year period, giving the retiree more income and upside potential under normal and good economic times.
- Safety--manages the myriad of investment risks like market risk, inflation risk, and credit risk. Under worst-case scenarios, if withdrawal amounts are adjusted by using guardrails, the portfolio can still provide a lifetime income.
Here is an executive summary of how to build up a portfolio for retirement in seven steps.
1. Values clarification and goal-setting . Figure out the income objective and capability of your retirement assets in lifestyle terms, then financial terms. In other words, set realistic, specific, financial goals based on your core life values.
2. Asset allocation glide path . Figure out how to diversify your retirement assets among stocks, bonds, and cash, based on your age, risk tolerance, retirement goals, and changing market values.
3. Valuation-dependent efficient frontier . Figure out which areas of the markets are historically inexpensive, and which are historically expensive. Don’t take on more volatility than you need to for the growth you need or desire.
4. Multi-asset class approach . Diversify one more step for more growth and less volatility. Put more money in the specific market areas that are less expensive and less money in the specific market areas that are more expensive.
5. Tax-aware asset location and distribution . Save as much on taxes as possible by figuring out which type of investments should be held in which types of accounts. If you are drawing an income from your assets, figure out the least-costly order for making withdrawals.
6. Investment selection based on account type (qualified, nonqualified) and asset-class propensity and magnitude of outperformance (passive, factor, managed, etc. ). Figure out what kind of investment to use (index mutual fund, factor mutual fund, actively managed mutual fund, single factor ETF, multifactor ETF, passive ETF, individual stocks, individual bonds, Unit Investment Trust, closed-end fund, etc.) based on the account type, asset class, and growth and income needs.
7. Rules-guided rebalancing based on retirement glide path and multi-asset-class approach . Readjust the investment mix based on your changing personal situation and changing market values.
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Here is a summary of the details backing this approach. Also, click here for more background information regarding my investment philosophy.
1. Values clarification and goal-setting
Investment planning for (or in) retirement starts with retirement planning. You start with thinking about your life goals...your dreams...your ideal life in retirement. It could involve doing no work, working part-time, or doing seasonal work. Your ideal life could be going back to school, spending more time with family, traveling, ministry, etc.
Ask yourself questions like, "What would I want to do if I
didn't need to work for money?" or "What are the most important
dangers, opportunities, and strengths I need to address?" or“Ten years from now, if I am looking back on a successful
ten years, what will I have achieved?”
This conversation allows you to create specific
goals around your most cherished values. And your goals will be unique to you.
You then design an investment plan to help you live your ideal life.
This kind of goal-focused, plan-driven approach minimizes the
chances of making bad investment choices based on current events and emotions.
Instead, you can choose and maintain the
specific mix of investments that can best deliver the results you need--using a
disciplined, research-driven approach.
2. Asset allocation glide path
The next major question is what kind of investments do you need to meet your goals. All investments have risk. Even "safe" investments over long periods have inflation risk. No single investment delivers growth, high income, and safety of principal. The key is designing a portfolio that balances them in a way that supports your retirement objectives.
And this mix may change over time. For example, for most people, it makes sense to gradually decrease their exposure to high-growth, high-volatility assets like stocks (i.e., equities) as they approach retirement. In retirement, it is usually best to maintain a flat equity glide path, dynamically adjusted for valuation. This approach protects you from the retirement-danger-zone risks of portfolio size effect and sequence risk, while allowing you to take advantage of bear markets and market corrections. See How to Navigate the Retirement Danger Zone .
Protecting your lifetime retirement savings from excessive taxes is a crucial part of holistic financial planning. This involves protecting your IRA, 401k, lump sum pension rollover, Social Security, and any other type of retirement account or income stream from crushing tax rates.
So let's be sure to differentiate tax preparation
from tax planning
.
Tax preparation , also called tax return preparation, looks backward, one year at a time, to get the numbers right to accurately calculate your tax liability (and how much you owe or overpaid).
Tax planning on the other hand looks at taxes in the context of your overall financial picture. A tax planner not only looks in the rear-view mirror but will look forward 20 to 30 years at your projected tax liability and ask what can be done to lower your lifetime tax bill.
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If you have savings outside of pretax retirement accounts invested in capital assets (like stocks, bonds, ETFs, mutual funds, precious metals, jewelry, and real estate) which have large unrealized capital gains, this article is for you. You may be missing the opportunity to pay zero taxes NOW instead of 15% or higher rates in the future. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Originally written on Aug 2, 2018 and updated for tax law changes.
If you are no longer working and have reached the age of 72,
you probably know about Uncle Sam’s rule for you to take a Required Minimum Distribution
(RMD) from your traditional and rollover IRA(s) each year for the rest of your life. You can always withdraw more,
but this requirement is the minimum
you must take or be severely penalized. Fortunately,
this rule does not apply to Roth IRAs. (The SECURE Act of 2019 changed the starting RMD age from 70½ to 72 starting in 2020, but fortunately you can still make a Qualified Charitable Distribution (QCD) starting the year you turn 70½.)
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If you have delayed paying taxes in your pretax IRA, 401(k), or 403(b), etc, there comes a time when the IRS wants their taxes. And if you don’t give them their taxes based on their required withdrawal schedule, you'll get hit with a 50% penalty on top of what you owed.
Along with Social Security and other retirement income, this RMD can significantly raise your tax rate. Also read How to Dodge the Social Security Tax Torpedo . There are not many ways to reduce this tax burden. In the past, retirees have used various deductions including charitable cash contributions and gifting of highly appreciated assets to charities. (The latter not only gives you, the donor, a deduction but also avoids a long-term capital gains tax bill.)
However, with the passing of the Tax Cuts and Jobs Act of 2017 (TCJA) , with its almost doubling of the standard deduction, itemizing deductions won’t make sense for near as many retirees. Ah, but there is still a strategy. But first let’s better understand the RMD.
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The latest book I am reading is “ The Psychology of Money ” by Morgan Housel. Chapter 3 is entitled “Never Enough”. In this chapter, Housel talks about when rich people do crazy things. He tells stories of wealthy people who never had a sense of enough and wrecked their reputations, families, freedom, and happiness because of it. I have also talked to older couples who tell me they once had a much better retirement in view, but the quest for more led them to make unwise investment decisions that left them financially crippled in retirement. The importance of knowing when you have enough is not only vital to when you retire but also how you retire. It can affect how you invest, how you withdraw, and your overall satisfaction before and during retirement. Be sure to read to the end where I summarize a few key takeaways. Housel makes the four following observations in chapter 3 of his book. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Whether you do mini-Roth conversions over several years or big Roth conversions in a few strategic years, the Roth conversion strategy could save you tens if not hundreds of thousands of dollars over your retirement. This article will get deep into the issues of Roth conversions for retirees and the ten steps to take to be sure it is done properly. Be sure to scan or read to the end where I will give you the simple answer to getting your Roth conversion questions answered. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Making big financial decisions immediately following the death of a close family member can be dangerous. It is often best to allow some time before tackling big financial decisions. On the other hand, some people find getting immersed in the finances is helpful in coping with the loss. Whatever way is best for you, you will need to give it your
careful attention to avoid big financial mistakes. The different types of accounts have different rules. I'll address the most common types. In the case of the death of a parent or anyone other than your spouse in which you are a non-spouse beneficiary, there are many rules that you must know to make the best decision for you and your family. (In this article, I use the common parent-child inheritance, but the planning strategies can apply to other non-spouse situations.) Your decisions can have major tax and investment consequences, both now and in the future. And some of these decisions have time deadlines keyed to your parent’s date of death. Also, some of these decisions are irreversible. You can download my free Estate Planning Survivor Checklist here
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So, you don’t want to rush in and make decisions without knowing the rules, and you don’t want to wait too long and be stuck with fewer options. (In this article, I am not addressing estate taxes. As of 2021, only estates valued at $11.70 million or more are subject to federal estate tax. But there are plenty of other tax pitfalls to navigate around. I am also going to focus on liquid savings like investment and retirement accounts, versus real estate which will be for another time.) Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Delaying Social Security makes a lot of sense for many retirees; but there are common pitfalls that can cost you a bundle. As you know, the longer you delay your Social Security Retirement benefit, the higher your lifetime monthly payments are figured to be. This increase in delaying continues until age 70, after which there are no further increases for delaying. This increase for each month that you delay filing is not small, especially considering the current low interest rates. Even after full Social Security age, your payment goes up by 8% per year until age 70. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation . Here are the five big mistakes of delaying your Social Security retirement benefit. |
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Are you wondering about the impact of the
2020 election results on your retirement? If so, you are not alone. The two political parties are greatly polarized. While the Democrat party has moved further toward ethno-centric socialism, the Republican party has moved further toward nationalistic populism. The difference in the two parties’ goals for our country is wider than ever. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation . |
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Investment Advisory Services offered through JT Stratford, LLC. JT Stratford, LLC and Echols Financial Services, LLC are separate entities.
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