Retirement is a personally transformative time in life. For most, rather than having the majority of your waking hours occupied by your job, you suddenly have a lot more free time on your hands. Because the concept of retirement is commonly intertwined with the sense of purpose in life that is drawn from work or a career, retirees who find the greatest happiness tend to be those who can recalibrate that purpose in this new chapter.
Similarly, retirement is also a financially transformative time in life. For most, rather than having your income needs met with employment earnings, you suddenly have to pay yourself from a variety of new sources. Navigating that transition looks different for everyone, but regardless of individual distinctions, retirement income planning plays a big role in how the transition unfolds.
For those who are not prepared for it, retirement can be a disorienting time in many ways. Proper planning can help prepare you to meet the challenges of this life change—during those moments that feel like the ground beneath you is moving, and you no longer have solid footing or a clear path forward. In this blog post, we’ll explore the process of retirement income planning so you can make the most of your golden years.
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Aligning Your Money With Your Vision: The Case For Retirement Income Planning
Planning is critical to making a smooth financial transition to retirement, but this planning doesn’t always start with the numbers, and it doesn’t always stop on the day that you retire.
A key facet of retirement income planning involves thinking about what a day in your life will look like once you’re no longer working. Close your eyes and picture it, from the moment you wake up to the moment you turn in for bed. How are you spending your time? What are you doing to find purpose and enjoyment? Your answers may surprise you.
Oftentimes, retirees have more time on their hands than they anticipated. This is why it’s important to consider your leisure time. When you first retire, every night can feel like Friday night and every next day is Saturday. That’s great for a while, but so often the novelty wears off.
As our team at Bay Point Wealth sometimes likes to say, leisure in and of itself can have diminishing returns. However, it’s difficult for many people to think beyond the desire for leisure time because the demands of their working life have never left room for that kind of ideation. But a day in the life, and a vision of the life you want to lead in retirement, will begin to define how your lifestyle and expenses may change—and how your income needs align with your lifestyle.
So give yourself lots of time and space to build—and change—your vision for retirement as this will guide your retirement income plan, and over time, your goals may look different than they did when you first retired. In addition, keep an eye on any financial risks that could jeopardize your retirement, like inflation or potential long-term care needs. As you can likely see now, retirement planning is a consistent process of evaluating your situation and priorities.
What is retirement income?
Retirement income refers to the funds that will support you when you’re no longer working. After all, you need income to accomplish your goals and realize your purpose.
Working with a financial advisor on retirement income planning is a smart move for many people. While an advisor’s main role isn’t to help you define the specifics of your vision and purpose in retirement, they will ask you to think proactively about what you want to achieve in your golden years, in order to best understand if there may be a financial component associated with your objectives.
When most people enter retirement, they are transitioning from receiving a paycheck to not receiving one. They’re shifting from working, earning money, saving money, and accumulating assets to not working, not earning, and consuming what they have saved. This change can be very difficult. If you’ve been saving and have dedicated yourself to the discipline of doing so, it’s hard to flip a switch and start spending what you’ve saved. This is why many people are afraid to spend money in retirement. They worry, with good reason, what if my money doesn’t last?
The key to financial security is to fit the pieces of the retirement income puzzle together with your vision. Everyone’s puzzle looks different. High net worth individuals have certain concerns, while other folks might be focused on something else entirely. Creating your personal retirement plan is the best way to set yourself up for success.
The Retirement Income Planning Process
Step 1: Understand Your Expenses
The first step in the retirement income planning process is to estimate your living expenses, such as your mortgage, health care expenses, travel expenses, taxes, and car payments. Once you know what your total expenses per year will likely amount to in retirement, and you’ve anticipated larger special expenses, you’ll be able to broadly estimate how much money you’ll need each year.
It’s imperative to account for inflation in the retirement income planning process. Your financial advisor should do an inflation calculation to get a sense of what your expenses will look like in the future. For instance, a 3% inflation rate means that the cost of all goods and services will double in 24 years.
Step 2: Assess Your Income Sources
Now it’s time to review and categorize where your income is coming from. At the highest level, there are two main categories to look at: guaranteed income and portfolio income.
Guaranteed income refers to consistent streams of income, such as Social Security, your pension, and annuity payments. (There is an important caveat to note here: Nothing in life is truly guaranteed. You can, however, have a high degree of confidence that guaranteed income sources will pay you over an extended period of time). These are the sources that form the base layer of your income needs, but increasingly, for most retirees today, these sources alone are not enough to cover all of their expenses.
Portfolio income, on the other hand, refers to income from other assets you have accumulated - whether its retirement accounts, brokerage accounts, individual stocks, investment real estate, closely held business interests, etc. The income you receive from your investment portfolio is subject to fluctuation based on market conditions. However, if you invest prudently, your portfolio income will be an important and consistent source to draw from in your post-working years.
Example: If you estimate that you’ll have $100,000 in expenses per year during retirement and $60,000 of income from guaranteed sources, that means your portfolio will need to generate $40,000. Let’s say your portfolio contains $1 million. You’ll need to withdraw 4% per year to total $40,000. In order to do this effectively and not deplete your investments too quickly, you must understand how your portfolio is invested and confirm that it is balanced (i.e., diversified). If so, then it’s likely reasonable to take out 4% per year.
Step 3: Make A Plan
This stage of the retirement planning process is more nuanced. It is the intersection between your vision and your resources. You’ll need to review the sources of retirement income for your specific situation, evaluate them, and put together the right mix for you.
It is also at this point in the planning process that the management responsibilities and the decisions in and around the investment portfolio become increasingly important. For many investors who have been saving and accumulating assets during their working years, their confidence in markets can be shaken when they retire. Navigating the volatility of your investments is never an easy task, and the volatility becomes very pronounced when it directly impacts the amount of income you may be able to reliably take from your portfolio in the immediate future.
For every retiree who has a need to draw from their portfolio of investments, it is essential to have a roadmap in place. It is necessary to consider what types of investments you own, how the investments are allocated, what risks these investments have, how those risks are managed, what types of accounts you own, the tax treatment of your different accounts, and how all of this aligns with your plans. Each of these moving pieces adds complexity to the planning. Working with the right kind of advisor can bring clarity, organization, and confidence to managing a retirement portfolio.
With the portfolio of other assets there to provide income above what your guaranteed sources deliver, it's essential to understand the details of the guaranteed income that you may expect to receive. Let’s look, for example, at some common guaranteed income sources so you can see how they might impact your retirement income plan.
1. Social Security Benefits
If eligible, you can start receiving Social Security benefits as early as age 62, or delay receiving as late as age 70. Of course, this means that if you retire at age 60, you won’t be able to access these benefits for two years. Once benefits start, they will be paid out for the rest of your life and adjusted for inflation, but the age at which you start your benefits will have a direct impact on the amount that you receive.
If you file at your Social Security designated full retirement age or FRA (age 67 for those born after 1960), you will receive your full, unreduced monthly benefit for the rest of your life. If you file earlier than your FRA, your monthly benefit amount is reduced, and the reduced amount is then paid for the rest of your life. Alternatively, if you wait to start taking Social Security after your FRA, your monthly benefit amount increases and the increased amount is then paid for the rest of your life.
The differences in your benefit amounts at different filing ages create flexibility as well as an important set of decisions for retirees. Social Security is designed this way so that in theory, a retiree would receive the same total amount of benefits during their life if they lived exactly to the average life expectancy that Social Security calculates. This concept is known as actuarial fairness.
However, if you assume for your own planning purposes a different life expectancy than Social Security estimates, there could be a potential advantage to filing either earlier or later than your FRA. For example, if you (or both you and your spouse) want to guard against the financial risk of living longer than average, then it becomes increasingly important for at least one spouse to consider delayed filing so that the highest possible benefit amount is attained and paid out for your lifetime. Alternatively, if a retiree has a legitimate reason to assume a life expectancy lower than average, then it may be appropriate to consider filing at an earlier age.
Ultimately, careful planning is needed to navigate the Social Security filing decision. For example, if you are planning to retire, and also planning to delay filing then for a period of time you may have more pressure on your portfolio to provide the income that you need. A financial advisor can help you navigate this gap by monitoring your investments and conducting tax planning to help you select the right account types to withdraw funds from, and manage your investments within each account to make sure they're in a position to generate the income you need.
2. Pensions And Employee Benefits
If you’re fortunate enough to have a pension from your employer, you may be able to start drawing from it right away in retirement—or not, depending on the rules specific to your pension. There is a lot to consider depending on your personal situation. For example, you might be able to lean on the income from your investment portfolio until you can access your pension.
In addition, if your pension offers a lump sum option, it's crucial to understand the benefits and drawbacks of taking the lump sum vs. opting for an ongoing stream of income. The puzzle analogy comes into play again here: You must understand the pieces you have and what course of action best fits your unique circumstances.
On top of your pension, it’s also essential to review your employee benefits. For example, you could have a deferred compensation plan that will pay you either in a lump sum or over the next five or 10 years. This will impact your retirement plan.
3. Required Minimum Distributions
When you reach age 72, you have to start withdrawing a certain amount of money from your individual retirement account (IRA) or workplace plan, such as a 401(k). For some folks, the amount they must withdraw is greater than the amount of portfolio income they need to fund their lifestyle in retirement. When this is the case, planning in advance can often be useful to minimize the total amount of your RMDs once they begin.
Pro Tip: Since required minimum distributions (RMDs) come out of your accounts as taxable income, tax planning can and should be done to minimize your tax bill. Planning strategies such as Qualified Charitable Distributions or Roth Conversions can be used to reduce RMDs.
In contrast, if your RMDs are less than the total amount of income you need from your portfolio, a good financial advisor will have their eye on your RMDs years in advance of when you actually retire, so you can plan accordingly.
Annuities offer a fixed stream of income, which is appealing to many people. If you’ve purchased a defined annuity in your working years, you can decide when and if it makes sense to convert the lump sum into a stream of income. Oftentimes, people will do this as soon as they retire.
Annuities can provide a high degree of confidence that you’ll have a certain amount of income during retirement because you’ve transferred the investment management risk to the insurance company from which you purchased the annuity. This can relieve a lot of pressure. Despite this benefit, at Bay Point Wealth we often observe that, as we help clients gain a clear understanding of how various types of investments can pay them over time, they often lose interest in annuities.
If you’re considering maintaining a permanent life insurance policy in retirement, it's important to clearly understand and accept the reasons why you’re maintaining the coverage. For most people, the main function of life insurance is income replacement. Thus, many people don’t have a compelling reason to continue carrying the coverage once they conclude their working years.
However, other folks may plan to protect a surviving spouse in the event that a certain amount of the other spouse’s income ceases when they die. For example, this could be a relevant choice if a 0% survivor benefit was selected on a pension. The bottom line is to make sure you understand the reasons for and against carrying insurance, as well as the alternative options available to you.
6. Earned Income
Emerging research exists regarding the mental benefits of a gradual phase-out into retirement, as opposed to putting a hard stop to your work. It’s worthwhile to ask yourself the following questions: Do I really want a “hard stop” retirement? Do I have options to phase out of working more gradually?
If earned income is factored into your retirement plan as a necessity, you’re not really dealing with a full retirement situation. (Wondering if you’re financially prepared to retire? Here are four factors to consider.) However, if it’s a choice, that’s a great scenario to be in.
Trusted Retirement Income Planning Advice
At Bay Point Wealth, one of the most common questions we get from clients concerns how they can best pay themselves from their investment portfolio during retirement. While this can be a confusing concept, we strive to make it simple. From our perspective, by and large, it’s critical to know the appropriate mix of stocks and bonds for your specific portfolio in order to generate the income you require.
We’ll work with you to manage your portfolio in a disciplined way over time, and avoid responding reactively to events in the market that would lead you to make significant changes. We’ll ensure your money is invested in a way that enables you to navigate volatility, so you can best align your income with your vision of retirement and for decades to come.
The core of the work we do every day is not only to help our clients get on track for retirement, but also to help them navigate the transition with confidence. If you’re looking for expert retirement income planning guidance, schedule a call with us today.