Much has been written about the importance of saving for retirement. However, people pay less attention to an equally important subject – how to take income once you do retire. As we noted in a previous article on the phases of retirement investing, the third phase is less about saving and more about spending. In other words, how to efficiently spend the money you’ve saved during your working years. The term professionals use for this process is “capital distribution.”
The goal of capital distribution is NOT to outlive your retirement nest egg, but to maintain the desired lifestyle for you and your loved ones through your non-working years. Capital distribution (not to be confused with capital gains distribution) is about spending your retirement savings the best way for your unique situation. Here are three common strategies:
One way to generate income during your retirement is with an immediate annuity, sometimes called an income annuity. This is not the same as a fixed or variable annuity. An immediate annuity is similar to a self-funded pension. You deposit a chunk of cash with an insurance company and they pay you a certain dollar amount over a period of time. There are different distribution options related to spousal benefits, number of payments to be made, immediate or deferred payments, etc. No matter the options chosen, the mechanism is the same: give an insurance company some money, and they pay you back every month until you and/or your spouse die.
The risks of this approach can relate to your life span, market risks, performance risk, and whether the insurance company stays solvent. Also, if you die after receiving the first payment, your family may lose the majority of your initial deposit if you did not cover that contingency in the annuity contract.
In addition, a typical annuity payment is fixed even if the market goes up. You may find you have given up some potential opportunities for growth. Finally, you must consider the risk that the insurance company may go bankrupt and will no longer make good on their end of the contract. Annuities can be an effective capital distribution method, but they’re not appropriate in all situations.
2) Systematic Withdrawals
Another way to finance your retirement is through systematic withdrawals. There are two main methods: constant dollar and constant percentage. Just as you once saved money systematically and let dollar cost averaging work for you, so also you can systematically pull money from your retirement account on a monthly, quarterly, semi-annual, or annual basis. The constant dollar withdrawal plan has the benefits of convenience and consistency.
However, there can be a major risk with constant dollar withdrawals. When you withdraw money from your retirement account during a bear market, you’re locking in a permanent loss to your portfolio. Some advisors suggest that this method, known as “reverse dollar cost averaging,” can be a great detriment to your portfolio when you make withdrawals during a bear market – which you almost certainly will if you live long enough. So beware of the additional risks associated with constant dollar withdrawals.
Another systematic withdrawal option is the constant percentage method. Instead of consistently taking out the same dollar amount, regardless of economic climate, you take out a constant percentage, thereby limiting your realized losses in a falling market and not compounding the losses to your nest egg. The risk is that very few people want their retirement budget to be a slave to the market. Less consistency in income streams means less ability to plan future life events.
3) Strategic Withdrawals
The final type of capital distribution is a strategic withdrawal of retirement savings. There are several ways to implement this method. For instance, you can categorize your savings in buckets: low-risk, medium-risk, and higher-risk investments. A strategic withdrawal would be pulling funds from a lower-risk investment regardless of where the market is. This reduces the negative effects of market risk on your retirement savings. The risk is that this strategy requires some sort of market-timing plan. It takes more time and expertise and is far from full proof.
Building a retirement income plan is one of the most important investment decisions that you’ll consider. While these are three conventional methods used, they certainly aren’t the only ones. Like most things in life, generally one size does NOT fit all. Mixing a few of these methods or others may be the optimal blend for your income plan. Also, often the right method is dependent on the type of assets you’ve saved: individual securities, pooled investments, employee pensions, or a mixture. All have benefits, but all have risks as well.
Before implementing any of these strategies, discuss your situation with a qualified investment advisor. A professional can guide you through different ways to distribute your assets during retirement so you don’t outlive your savings.