Imagine your last day at work. While the psychological impacts of retirement are real and deserve a column of their own, it’s the finances that first get retirees tripped up. You’ve been saving for this day for thirty years, but you have to wonder how the mechanics of getting paid are actually going to work.
Defined benefit pensions were more commonplace when the last generation retired. You looked up a chart and using your recent salary, years of service, and age, you could compute your guaranteed fixed payment per month. In most cases, this monthly pension would increase on occasion for inflation. When combined with Social Security (at least for private sector employees), defined benefit pensioners received a fairly high percentage of their pre-retirement income.
These pensions were very comforting for new retirees. You were still getting a regular paycheck, albeit coming from a different source. Sure pension funds suffered through the calamity of 2008 like the rest of us, but pensioners still received their monthly payments seemingly impervious to the violent market swings.
Pensions have largely disappeared from the private sector, and new public sector employees seem to receive a less generous offer with each new generation. Now we must do this on our own. But how?
The easiest method is to purchase an immediate annuity. For a lump sum provided to an insurance company, you receive a regular payment to you and your survivor every month for the rest of your lives. If you live beyond your life expectancy, then the insurance company still pays you for the rest of your lives. Unless you buy so-called riders, if you die soon after purchasing an immediate annuity, your heirs are out the money.
It was also simpler in the days of 6 percent Treasury Bond rates. You put your savings entirely in what many call the safest investment on the planet. You collect biannual interest payments that are exempt from state tax, and then live on the interest. You weren’t worried about the income continuing because you never had to “invade principal.” You were never forced to sell anything as you lived off the interest of your hard earned dollars.
But now the 10 year Treasury pays well under 3 percent. You cannot live on 2.5 percent of your savings per year. Even with retirement savings of $1 million, the $25,000 a year that is generated seems paltry.
The trick is using your entire Portfolio, made up of taxable, IRAs, Roth IRAs, and other accounts saved for the long-term. Your Portfolio has an optimized mix of bonds and equity mutual funds designed to grow with less risk than an all-stock portfolio. Every year you sell a percentage of your Portfolio (let’s say 5 percent) in a tax-efficient manner. The proceeds then go to a Working account that pays at least some interest.
Every month you transfer a fixed amount from the Working to your Spending account. This Spending account is a checking account that receives your monthly “paycheck.” While some may state that having three separate categories of accounts is nothing more than a parlor trick, it does help retirees when the market is dropping. After all, if it drops for a few months, that doesn’t affect your Working or Spending accounts.
You feel an extra level of security if you have 50 percent of your Portfolio in high quality bonds. Now you have enough in stable investments to fund your Working account for ten years outlasting all but the worst historic bear markets. We don’t know what direction the stock markets will move over the next year, but we have a pretty good idea what direction it will take over the next ten years.