Published by Robert W. Huntley, CFP®, CHFC®, CKA® Founder & Wealth Advisor
We don’t live on lump sums. We live on the income. While it may feel nice having $1,000,000 in your IRA or 401k plan, what really matters is how much income you can reasonably generate on that money because it’s the income that matters.
Over the years, planners have debated this topic. In the 80s it was common for planners to suggest a 6% distribution rate was doable, so $1,000,000 at 6% would be an annual income of $60,000.
More recently, however, the debate has moved to around 4%. The reason is we’re in such low-interest rates these days and many economists believe stocks won’t grow as fast in coming years as we’ve seen the past 30 years. There is also concern about longevity forcing the money to have to last longer.
Let’s split the difference for our purposes here and settle on an assumed income rate of 5%. What might it look like as you consider investment options to generate your desired $50,000 per year of income? This gets tricky because when you retire you are typically nervous about market risk. You know you must make this money last. There are no mulligans when it comes to retirement. So, let’s look at 4 scenarios to frame this up a little for you.
SCENARIO 1: Put the money in your safe deposit box and spend the principal. This sounds silly. If you were earning no return on your $1,000,000 and taking $50,000 each year, the money would only last 20 years. Probably not a good solution. However, these days if you have your money sitting in bank cash so it’s “safe” you are barely doing more than this because cash rates are so low today.
SCENARIO 2: Put the money in a long-term CD or fixed annuity yielding 3%. Your $1,000,000 is earring $30,000 interest but you’re spending $50,000, so the principal is going down, just at a slower pace than Scenario 1. If you factor inflation into the situation, you’re still losing ground rapidly. Problem is you don’t know how long you’re going to live. So again, this isn’t a good option.
SCENARIO 3: You put the money into a quality bond portfolio yielding 5% gross interest. At least now you’re spending interest only, so your principal remains at $1,000,000. The problem here is with inflation. Inflation has averaged close to 3% in the US since the 1920s. If the cost of living is going up by 3% per year, you need a growing income to maintain your standard of living. Although you’re not spending your principal, you are in effect losing ground due to inflation.
SCENARIO 4: You invest in such a way as to have a reasonable expectation of generating a long-term return of 8%. This is ideal because you’re spending 5% while growing your principal and long-term income on average each year by 3% to offset inflation.
It’s important to understand this logic before deciding on your actual investment strategy. Our instinct is often being “safe” with this money. However, if maintaining your income and your long-term purchasing power are both important, you must understand what rate of return you’ll need to do both.
After you know the rate of return you must generate, now you’re ready to look at specific options that give you a shot at the total needed return with the least amount of risk.
Investing for retirement income is part science and part art. This post deals with more the science part of the process. You must know the numbers required.
The art is more about knowing how to structure a diversified portfolio that gives you a reasonable chance of generating the needed 8% with reasonable risk to your principal. That’s a topic for another day but for now, just make sure you understand how much income you need from your nest egg and be realistic about the rate of return that requires after you factor in long term inflation.