Answering the retirement income question
April 02, 2014
Whether you're years away from retirement or already living in it, how to maintain an income stream that lasts throughout your life once you're no longer working is a question you've likely considered. We asked Fran Kinniry, an investment expert in Vanguard's Investment Strategy Group, to share some strategies that can help you manage the retirement income issue. Here's what he had to say.
How should you determine the amount to withdraw from your portfolio once you retire?
A good approach to determining how much money to withdraw from your portfolio over the course of your retirement is one that has some flexibility. We all have unique asset levels, financial situations, and income needs. We can't predict a number of things, such as market performance, surprise expenses like healthcare, or even inflation rates over the long term.
Highlights from a recent Vanguard webcast on spending in retirement:
Our research suggests using a "dynamic" approach to spending in retirement can make sense. With this method, you calculate your annual spending as a percentage of your portfolio's balance at the end of the previous year and then apply a top and bottom limit. This "ceiling and floor" approach adjusts your withdrawals for spending up or down, based on market performance, but keeps them in a range that moderates fluctuations in the amount you'd take from your portfolio each year.
Be careful that you don't take out so much that you jeopardize your portfolio's ability to continue to meet your future income needs. (Vanguard has a retirement-income worksheet, along with additional resources, that can help you determine some reasonable spending and withdrawal targets.)
There are three things to consider as you determine your spending plan: how long you expect to be retired (your life expectancy), how probable it is you could run out of money based on your spending and investing patterns, and your asset allocation. Other things to keep in mind are investing costs and taxes.
Depending on how complex your situation is, it might make sense for you to seek help from an experienced advisor or even have a professional do it for you. (We have a range of advice services that can help you.) This type of support can pay for itself just from the help you receive.
How should someone who's been focused on saving for retirement approach tapping into those savings effectively?
If you've been focused on saving for retirement, you're probably already comfortable making regular, systematic contributions to your retirement accounts. One way to transition from saving for retirement to using your savings while you're retired is to reverse what you've been doing. Instead of putting money into your accounts, you can take it out through what's called a systematic withdrawal plan or SWP.
One way to establish an SWP is by setting up an automatic asset transfer from an investment account into a spending account. You can choose to take the withdrawal from your full portfolio or select a specific fund. With this approach, you have the option of staying in the same investments you've already chosen, instead of opening a new type of investment account, so you have the comfort of sticking with the familiar.
"There are three things to consider as you determine your spending plan: how long you expect to be retired (your life expectancy), how probable it is you could run out of money based on your spending and investing patterns, and your asset allocation. Other things to keep in mind are investing costs and taxes."
If you already invest in a target-date fund, such as the Vanguard Target Retirement Fund series, taking your automatic withdrawal from this investment could make sense. The fund series' design moves you along an allocation glide path that becomes more conservative as you get closer to your retirement year. The automatic adjustment of the asset mix pairs nicely with the SWP approach. Another good option for the SWP is a balanced fund.
The goal is to create an income stream that can last through your life in retirement, using the investment portfolio you've built over the years, combined with Social Security and any pension or other payments you may receive.
If you have more than one investment account, which one should you use?
One thing to keep in mind when you're taking any type of withdrawal from an investment account is tax efficiency. Taxes are another cost of investing, so minimizing the bite they take from the net return of your investments is a good idea.
One way to help reduce that bite's size is through a tax-efficient withdrawal plan. Generally, if you have tax-deferred retirement accounts and you've reached age 70½, you need to take required minimum distributions (RMDs). So if this applies to you, it makes sense to start your withdrawals from tax-deferred accounts. Next, you'd look to spend the assets you have in taxable accounts; some examples include interest, dividends, and capital-gains distributions. You want to tap your taxable accounts in a way that minimizes capital gains. Once you've depleted your taxable portfolio, you'll start withdrawing from your tax-advantaged accounts.
Your tax bracket—now and your expected one in the future—will play a role in whether you draw first on your tax-advantaged account (Roth IRAs or 401(k)s are examples) or tax-deferred one (such as traditional IRAs or 401(k)s).
The goal is to spend the money in your tax-deferred accounts when you expect your tax rate to be at its lowest. For example, if you ease into retirement and have some part-time income that causes you to be in a higher tax bracket now than the one you're likely to be in later, consider spending from your tax-advantaged account (maybe a Roth IRA if you have one) and hold off using your tax-deferred accounts until later.
You may want to consult with a tax or financial planning professional for guidance on which account to select for withdrawals and when.
What if you want a more "turnkey" option for retirement income?
One option to consider is the Vanguard Managed Payout Fund.* Here, the SWP is set up for you. You get a regular payment each month, calculated each January based on your balance in the fund over a three-year rolling period and using the 4% rate many financial planners suggest. You can access your investment balance at any time, so it gives you flexibility if you need to withdraw more than your regular payment.
Something to keep in mind with this option is that it's a mutual fund and, just like any other fund, it may increase or decrease in value, depending on market conditions. Depending on performance, your yearly payout could go down or you may end up receiving some principal in a monthly payment if the market drops after the payout amount for the year is set.
Another option to consider is an annuity, especially if you're looking for stable payments over a contract term. There are a few things to consider before deciding on an annuity.
First, does your desire for a regular monthly check outweigh your potential need to tap into the assets you invest in the annuity? An income annuity pays you a predictable amount each month, but because you turn over a lump sum to an issuer (generally an insurance company) in order to get those guaranteed payments, you typically can't get the sum you invest back in its entirety. It's a good idea to have an emergency fund or other assets you can tap in case unexpected spending needs arise.
Another type of annuity—a deferred variable annuity—is often used as a tax-deferred savings vehicle, but can also provide guaranteed retirement income in many cases. For these types of annuities, you'll want to consider the associated costs for the guarantee. If you're already invested in a variable annuity, this calculator can help you evaluate your costs and learn about any applicable surrender charges.
No matter which approach you use, it's a good idea to revisit it regularly—perhaps once a year—to verify it fits your current situation and to make any adjustments if you need them.
- All investing is subject to risk, including the possible loss of the money you invest.
- Investments in Target Retirement Funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the Fund would retire and leave the work force. The Fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in the Target Retirement Fund is not guaranteed at any time, including on or after the target date.
- The Managed Payout Fund is not guaranteed to achieve its investment objective, is subject to loss, and some of its distributions may be treated in part as a return of capital. The dollar amount of the fund's monthly cash distributions could go up or down substantially from one year to the next and over time. It is also possible for the fund to suffer substantial investment losses and simultaneously experience additional asset reductions as a result of its distributions to shareholders under its managed distribution policy. An investment in the fund could lose money over short, intermediate, or even long periods of time because each fund allocates its assets worldwide across different asset classes and investments with specific risk and return characteristics. Diversification does not necessarily ensure a profit or protect against a loss in a declining market. The fund is proportionately subject to the risks associated with its underlying funds, which may invest in stocks (including stocks issued by REITs), bonds, cash, inflation-linked investments, commodity-linked investments, long/short market neutral investments, and leveraged absolute return investments.
- The Managed Payout Fund may not be appropriate for all investors. For example, depending on the time horizon, retirement income needs, and tax bracket, an investment in the fund might not be appropriate for younger investors not currently in retirement, for investors under age 59½ who may hold the fund in an IRA or other tax-advantaged account, or for participants in employer-sponsored plans. Investors who hold the fund within a tax-advantaged retirement account should consult their tax advisors to discuss tax consequences that could result if payments are distributed from their account prior to age 59½ or if they plan to use the fund, in whole or in part, to meet their required minimum distribution (RMD) obligations. Distributions from the fund are unlikely to precisely match an investor's IRA RMD obligations. In addition, use of the fund may be restricted in employer-sponsored plans by the terms of the governing plan documents and/or at the discretion of the plan administrator. Review the information carefully with your financial advisor before deciding whether the fund is right for you.
- Deferred annuities are long-term vehicles designed for retirement purposes and contain underlying investment portfolios that are subject to market fluctuation investment risk, and possible loss of principal. If you take withdrawals from a variable annuity prior to age 59-1/2, you may have to pay ordinary income tax plus a 10% federal penalty tax.
- *U.S. Pat. No. 8,180,695 and 8,185,464