Weave Your Own Retirement Safety Net
Baby boomers planning for their retirement face unprecedented financial challenges. Unlike retirees of past generations who could rely on Social Security and employer pension plans for guaranteed income, baby boomers will likely be on their own when it comes to income generation and must rely on their savings to provide much of their retirement income. Prior to retirement, the focus is on wealth accumulation, but when retirement rolls around a fool-proof plan must be devised to ensure accumulated wealth is effectively managed to finance the entire retirement.
In this article we'll explore how traditional, safe income generating strategies may not be enough for the latest crop of retirees, and we'll look at some alternative methods to help baby boomers generate sufficient income throughout retirement.
How Much Is Enough?
With the lack in traditional sources of guaranteed retirement income, boomers find themselves with the need to turn their savings into income that lasts throughout retirement. To accomplish this goal, boomers must determine the answers to two key questions:
How Much Income Will You Need?
It would be easy to answer this question if you could see into the future to learn how long you will live, your health status for the rest of your life and how the economy and inflation will behave during your retirement. Unfortunately, there is no way to answer these questions with absolute certainty. As such, you must implement a plan based on assumptions and suppositions. Many financial planners estimate that you will need retirement income of about 75% to 100% of your pre-retirement income to maintain your pre-retirement standard of living . This, coupled with longer life expectancies, means that you will need more than previous generations to finance your retirement. For instance, In you and your spouse both retire at age 65 and need your retirement savings to pay $50,000 per year for roughly 20 years. You will need $1 million at retirement to provide sufficient income over the 20-year period.
How Can You Generate This Income?
One key step is to work with a financial planner to determine your projected retirement income needs. Social Security and pension plans used to provide a base level of retirement income that you could count on. Boomers are the first generation to see these safety nets fade away, and new creative solutions need to be found, which could include devoting more of your retirement portfolio to stocks or establishing an annuity. Another factor to consider is inflation, which can erode the purchasing power of your savings over time. Let's say you retire on an income $50,000 per year. If the rate of inflation averages only 3% per year, after 20 years, you will need $90,500 to buy what $50,000 buys today. If inflation averages 5%, the number increases to $132,500. As such, any practical financial plan for retirement must take inflation into consideration.
Implementing Your Plan
While it may be tempting to allocate all of your savings toward providing your projected retirement income needed for each year, you should designate some of your savings to cover contingencies. Throughout your lifetime, there will be circumstances, both expected and unexpected, that require funds over and above your usual income needs. Some of your savings should be earmarked to cover such expenses, so as not to stifle the flow of your regular income needs.
Your retirement income program should consider the following:
How to Maximize Your Income
Maximizing income from your savings will help to ensure that you are able to finance your retirement needs and wants. Contrary to popular belief, retirement is not a period where you should eliminate risk within your investments. Investing all of your savings in low-return vehicles such as money market accounts and certificates of deposit (CD) minimizes risk to principal, but there are two things to consider:
Income from these "safe" assets may not keep pace with inflation.
- You may begin to spend principal too early during your retirement, and outlive your assets if insufficient income is generated.
Stocks have historically outpaced inflation by a significant margin and have provided the strongest return on investment over the long term, so consider keeping a portion of your savings invested in stocks and stock mutual funds throughout your retirement. Also, think about adding (or keeping) preferred stock, which almost always carries a dividend to provide income.
Investing some of your savings in an annuity may also be beneficial. Many insurance companies offer variable and equity-indexed annuities with an income rider that provides a guaranteed lifetime income withdrawal benefit and the opportunity to grow your remaining principal within the annuity. In addition, you can make withdrawals from the principal if needed.
Investments with the potential for high returns usually have high risk of loss. If these assets, such as stocks, are included in your portfolio, it is important that you minimize the risk of losing your savings. One way to do so is to diversify your investment portfolio so that it includes a reasonable amount of growth and income producing assets to balance your investments among high-, medium- and low-risk investments. Your financial planner may recommend different strategies, depending on your investment profile.
Taxes can eat into your income and cause your net income to be much less than anticipated. While your retirement projections must include provisions for taxes, you can take steps to reduce the amount you will owe. Here are few ideas to help minimize tax and its impact.
- Avoid putting most of your savings in low-paying fixed-interest vehicles such as money market accounts and certificates of deposit (CD), as they're not very efficient income producing investments. If you need the interest from these investments for income, you can probably get a better rate of return from other investments. Unless the investments are held in tax-deferred accounts, you will pay taxes the year the interest is earned, reducing your net earnings. Consider that the after-tax return on a CD paying 5% interest is essentially cut to 4.25% if you're in the 15% income tax bracket and 3.75% if you're in the 25% tax bracket.
Consider an immediate annuity as an income producing alternative. Say you have $100,000 that you want to invest for income. If you invest it in a CD paying 5%, your net after-tax return is only $3,650, presuming you're in the 27% income tax bracket ($100,000 x 5% = $5,000 x 27% = $3,650). Instead, you could invest the money in an immediate annuity, which would pay you $7,545 per year for the rest of your life ($100,000 = $7,870/year - $6,666 exclusion = $1,204 taxable income x 27% income tax = $7,545 net income/year).
Take small distributions from your individual retirement account (IRA). If you are like most people, you have two types of savings: one type that has already been taxed (after-tax money) and another that has not yet been taxed (pretax money). Some financial advisors may recommend spending your pretax money first and preserving the after-tax savings. This recommendation is usually made if you will be in your lowest tax bracket during the years the distributions occur; however, if the bulk of your saving will be spent during the earlier years of your retirement, it may make sense to withdraw the after-tax amounts during those periods so as to reduce the tax impact. In other cases, a financial advisor may recommend that you withdraw a little from each. The key is to ensure that your withdrawal strategy is one that will result in the lowest possible tax liability.
- Consider converting some of your Traditional IRA assets to a Roth IRA if you are eligible to do so. Earnings on Roth IRA assets are tax-free if qualified, and there is no required minimum distribution (RMD) amounts.
|Example: Traditional IRA vs. Roth IRA
Suppose you own a $300,000 Traditional IRA and you also have $90,000 in regular savings. Let\'s assume everything grows at exactly 10% per year, and your tax bracket is at the 30% rate.
Thus, the $300,000 Roth IRA generates $30,000 net income while the $300,000 Traditional IRA coupled with an additional $90,000 from savings provides an income, net after taxes, of $27,300.
The Bottom Line
Baby boomers planning for retirement will be confronted with financial challenges that are much different than those of their predecessors. With the shift from defined-benefit plans to defined-contribution plans, and the uncertain future of social security, boomers are on their own when it comes to financing retirement. As such, they must generate more of the income they will need in retirement from their own savings.
Additionally, with the increase in life expectancy, assets used to finance retirement will need to last longer than ever before. Finding ways to minimize expenses, preserve savings, account for inflation and reduce taxes is of paramount importance for this new generation of retirees.