After a lifetime of working and saving, retirement is the light at the end of the tunnel. Most of us envision it as a time of rest and relaxation, where we enjoy the fruits of our labor. We envision a steady source of income without the need to go to work each day.
It's a great vision, but generating income without going to work tends to be a murky concept during our working years. We know what we want, but aren't totally sure how it will happen. So, how exactly will you turn your nest egg into a steady flow of cash during your retirement years? These concrete strategies can help.
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Purchasing an immediate annuity is an easy way to convert a lump sum into an ongoing income stream that you can't outlive. Retirees often take the money they saved up during their working years and use it to purchase an immediate annuity contract because the income stream starts immediately, is predictable and is unaffected by falling stock prices or declining interest rates. (For related reading, see Immediate Payment Annuity.)
In exchange for the cash flow and security, an immediate annuity buyer accepts that the income payment will never increase. The greater concern for most immediate annuity purchasers is that once you buy one, you cannot change your mind. Your principal is locked in forever, and upon your death, the insurance company keeps the balance remaining in your account.
Annuities are complicated products that come in a variety of forms. Before you rush out and buy one, do your homework. (Read Getting the Whole Story on Variable Annuities for insight into several types of annuities.)
Even if you've got millions of dollars sitting in your bank account, taking it all out at once and stuffing it in your mattress is not a strategic method of maximizing and safeguarding your income stream. Regardless of the size of your nest egg, taking out only the amount of money that you need and letting the rest continue to work for you is the smart strategy. Figuring out your cash flow needs and taking out only that amount of money on a regular basis is the essence of a systematic withdrawal strategy. Sure, taking out the same amount of money each week or month can also be categorized as systematic, but if you don't match your withdrawals to your needs, it sure isn't strategic.
One way or another, most people implement a systematic withdrawal program, liquidating their assets over time. Equity holdings, such as mutual funds and stock in 401(k) plans are often the largest pools of money tapped in this manner, but bonds, bank accounts and other assets should all be considered as well. A properly implemented drawdown strategy can help ensure that your income stream lasts as long as you need it.
“For retirees who are pulling retirement money out of traditional IRAs (not Roth IRAs), 401(k)s and 403(b)s, the ‘right withdrawal amount’ is not their decision – rather, it is determined by the RMD (required minimum distribution) starting at age 70½,” says Craig Israelsen, Ph.D., designer of 7Twelve Portfolio, in Springville, Utah. “In general, the RMD requires smaller withdrawals during the first five to six years (roughly through age 76). After that, annual RMD-based withdrawals will be significantly larger for the remainder of the retiree’s life.”
Bond ladders are created through the purchase of multiple bonds that mature at staggered intervals. This structure provides consistent returns, low risk of loss and protection from call risk, since the staggered maturities eliminate the risk of all of the bonds being called at the same time. Bonds generally make interest payments twice a year, so a six-bond portfolio would generate a steady monthly cash flow. Since the interest rate paid by the bonds is locked in at the time of purchase, the periodic interest payments are predictable and unchanging. (For more information on setting up this strategy, read Boost Bond Returns with Laddering.)
When each bond matures, another is purchased, and the ladder is extended as the maturity date of the new purchase occurs further in the future than the maturity date of the other bonds in the portfolio. The variety of bonds available in the marketplace provides considerable flexibility in creating a bond ladder as issues of varying credit quality can be used to construct the portfolio.
“Individual bonds – laddered across different sectors, asset classes and time periods – can provide a guaranteed return of principal (based on the viability of the issuing company) and a competitive interest rate,” says Dave Anthony, CFP®, president and portfolio manager, Anthony Capital, LLC, in Broomfield, Colo. “I recently had a client who, when presented with this strategy, decided to take her company’s $378k lump sum pension buy-out offer and purchase 50 different individual bonds, from 50 different companies, not risking any more than 2% in any one company, spread out over the next seven years. Her cash flow yield was 6% per year, more than her pension or an individual annuity.”
The construction of a certificate of deposit (CD) ladder mirrors the technique for building a bond ladder. Multiple CDs with varying maturity dates are purchased, with each CD maturing later than its predecessor. For example, one CD might mature in six months, with the next maturing in one year and the next maturing in 18 months. As each CD matures, a new one is purchased and the ladder is extended as the maturity date of the new purchase occurs further in the future than the maturity date of the previously purchased CDs.
This strategy is more conservative than the laddered bond strategy because CDs are sold through banks and are insured by the Federal Deposit Insurance Corporation (FDIC). (To learn more about the how the FDIC is helping you keep your money in your pocket, read Are Your Bank Deposits Insured?) CD ladders are often used for short-term income needs, but may be used for longer-term needs if interest rates are attractive and provide the desired level of income.
The interest earned on CDs is only paid when the CDs reach maturity so proper structuring of the ladder is important to ensure that maturity dates coincide with income needs. Note that some CDs have an automatic reinvestment feature, which could prevent you from receiving the investment's income. Make sure that any CDs you use to generate a retirement income stream do not include this feature.(For additional insight into this strategy, read How to Create a Laddered CD Portfolio)
For many people, retirement funding does not rely on a single source of income. Instead, their cash flow comes from a combination of sources, which may include a pension, Social Security benefits, an inheritance, real estate or other income-generating investments. Having multiple sources of income – including a portfolio structured to include an immediate annuity, a systematic withdrawal program, a bond ladder, a CD ladder or a combination of these investments – can help to safeguard your income in the event that interest rates fall or one of your investments delivers returns that are less than you expected to receive.
A steady source of income during retirement is possible, but it takes planning. Save diligently, invest conscientiously and determine the best payout option for you when it comes time to draw down your funds.