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 when we enjoy the fruits of our labors. 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? Developing a concrete strategy based on these income sources can help.
- Annuities give you a steady income stream for life.
- The amount you receive from your annuity may go down in value due to inflation.
- Strategic systematic withdrawals need to be based on your cash-flow requirements.
- Bond and CD ladders can create a consistent income stream while being low-risk.
- Many investors rely on other sources of income during retirement, including Social Security and real estate holdings.
1. Immediate Annuities
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.
In exchange for the cash flow and security, an immediate annuity buyer accepts that the income payment will never increase, which means that it actually decreases in value over time due to inflation. 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.
2. Strategic Systematic Withdrawals
Even if you've got millions sitting in your bank account, taking it all out at once and stuffing it under your mattress is not a strategic method of maximizing or safeguarding your income stream. Regardless of the size of your nest egg, taking out only the amount of money you need and letting the rest continue to work for you is the wise 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 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 required minimum distribution (RMD) starting at age 70½," says Craig L. Israelsen, Ph.D., designer of 7Twelve Portfolio, based in Springville, Utah. "In general," Israelsen adds, "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."
The age requirement for RMDs was increased to age 72 from age 70½ in late 2019 under the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019. The age was raised again to 73 for anyone turning that age on or after Jan. 1, 2023, after the SECURE Act 2.0 was passed in December 2022.
You are subject to penalties if you don't take the RMD as scheduled. According to the SECURE Act 2.0, you are charged 25% of the value of the missed distribution. That fine is reduced to 10% of the withdrawal's value if you fix it during the correction window, which is the date on which the fine is imposed.
3. Laddered Bonds
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, as the staggered maturities eliminate the risk of all 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. As the interest rate paid by the bonds is locked in at the time of purchase, the periodic interest payments are predictable and unchanging.
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 David Anthony, CFP®, president and portfolio manager at Anthony Capital LLC, of Broomfield, Colo.
"I recently had a client who, when presented with this strategy, decided to take her company's $378,000 lump-sum pension buyout 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."
4. Laddered Certificates of Deposit
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.
One CD might mature in six months, for example, with the next maturing in one year, and the next maturing in 18 months. As each CD matures, you purchase a new one, and the ladder is extended since the maturity date of the new purchase is farther 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). CD ladders are often used for short-term income needs, but they 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 to ensure that maturity dates coincide with income needs, it's important to structure the ladder properly. 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.
Having diverse sources of retirement income safeguards against underperforming investments.
Other Income Sources
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 safeguard your income if interest rates fall or one of your investments delivers less-than-expected returns.
The Bottom Line
A steady source of income during retirement is possible, but it takes planning. Save diligently, invest conscientiously, and determine the best payout options when the time comes to draw down your funds.