How does retirement income from investments work? Where does it come from? How much can you get? And how can it help you relax about retirement?
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A great irony in retirement is that it’s easier to save money than to spend it.
That may sound wrong at first, but think about it: You put away 10% or so of your paycheck for savings, and you’ve been doing that for many years. You like checking your balance and watching the account grow over time, and you’ve built up a sum of money that represents hard work over your lifetime.
Now, you’re supposed to draw that money down? Unless you’re working on your golf game, you usually want numbers to go up, not down.
Entering into retirement can feel a little bit like walking into a dark cave—you’ve never been here before and you don’t know what to expect.
Your whole life you can see where your income comes from—you work, and you receive a paycheck from that work. Or, if you’re self-employed, you provide a good or service and get paid for that good or service. There’s a direct correlation between what you do and what you get. Retirement is completely different. You’re not directly working for anything. You already have worked for something.
What if it’s not enough? What if the income runs out? Will it sustain all of the things you want to do? What if something happens and you lose it all?
Retirement doesn’t have to be a dark cave buried in the back of a jungle (unless, of course, your retirement plan includes spelunking). Rather, think of retirement more as a continuation of life than a new beginning—a whole new range of possibilities.
If retirement does feel like a dark cave, my goal is to be the lantern, the map, and the guide by your side.
This post will focus on income from—you guessed it—investments. We’ll first look at what that actually means (we’ll briefly talk about other income strategies, but those will be reserved for other posts).
Then, we’ll answer four questions in relation to retirement income from investments:
- How much income can you get?
- Where should you get that income from?
- What if the market crashes?
- Can you be too old for stocks?
What Is Retirement Income from Investments?
There are about as many approaches to solving retirement income as there are advisors in the world.
There are different strategies—systematic withdrawals, the bucket strategy, or the flooring approach. There are also different types of products to use for retirement income—stocks and mutual funds, insurance products like annuities, or fixed income products like REITs, UITs, or bonds.
There are pros and cons to each strategy, but we recommend using a diversified portfolio of stocks and bonds to generate income in retirement.
Here are the advantages and disadvantages of this strategy for retirement income:
When you maintain a diversified portfolio throughout retirement, you’re not locked into one specific investment. Your money is flexible and diversified, and you can use the academic research on portfolio building.
With diversification, you decrease the risk of any one investment tanking.
Diversification also allows you to take income from the investments in the portfolio that are performing well, and give time for the other investments to catch up. We call this the wells strategy, discussed below.
2. Unrestricted Access to the Principal
With an investment portfolio, you can withdraw any amount, at any time. There might be tax consequences, but your principal is not locked up.
With many other strategies, your principal is either restricted through fees or surrender charges, or you may have to forfeit your entire principal to generate an income stream. Forfeiting your principal means giving up the inheritance you wish to pass on as well.
Also, when your principal is locked up, you lose flexibility with your money. You can’t change strategies based on new needs.
3. Inflation Protection
Stocks protect from inflation.
Inflation is prices going up. Who is raising prices? Companies. What do you own when you own stocks? Companies. When you own stocks, you own the companies raising prices due to inflation. And to confirm that, when you look at historic returns, stocks have generally had higher returns in periods of high inflation.
Most other strategies don’t naturally offer inflation protection.
But the average retirement lasts twenty-five years or more. Think about how much you made twenty-five years ago and whether or not you could live on it now. Inflation is one of the biggest threats to your retirement.
Other products can offer inflation protection, but there is often a significant cost to purchase it, which limits your income.
The Con: Market Fluctuations
The main disadvantage to using stocks in your income portfolio—and the main reason why many are hesitant to choose the strategy—is that the portfolio is subject to market fluctuations.
People fear that the market might crash and they’ll run out of money. This up and down nature of the stock market can be unsettling, causing many to avoid the stock market altogether.
The biggest risk with market fluctuations is that if the market is down and you need income, you may have to sell stocks low to get it. This is called “Sequence of returns risk,” and in bad market conditions, it puts increased strain on the portfolio.
How Much Income Can You Get From Investments?
This is the question everyone wants to know.
But there’s no one single answer to this question. There is no rule of thumb that applies in every situation. There are, however, guides that give us a starting point, and then there are factors that show when to adjust how much income to take.
The rule of thumb you will most often hear is 4%.
This is a great starting point, but don’t take 4% as the absolute rule of retirement income.
The 4% rule can be polarizing. If you research it, you’ll hear some say that it’s dead—it’s too high and you have to use other strategies to support retirement income. Others will say it’s way too low—if you make certain adjustments you can take much more than 4%.
So is the 4% rule dead or is it too low?
The truth is, the 4% rule is a starting point, not a final answer. It sets expectations. It gets us in the right vicinity. It shows us that taking 10% of your portfolio is too much, while taking 1% will probably leave a lot of money on the table.
The final answer for you depends on other factors. For some it may be too low, for others it may be too high.
Nonetheless, the 4% rule is one of the most important pieces of research when it comes to retirement income, so we’re going to analyze it, and then look at what other factors impact how much income you can get from investments.
Understanding the 4% Rule
The research on the 4% rule was done by a financial advisor named William Bengen in his paper Determining Withdrawal Rates Using Historical Data.
His research came at a time when the pension world was declining, and defined contribution plans like 401(k)s were on the rise. Previously, when most people had pensions, getting retirement income from investments was not as important. But as pensions were replaced by personal investments, the income question took the forefront.
In this study, Bengen sought to answer the question: how much income can I take out from my investments and be safe. In other words, how much income can I withdraw without running out of money?
To answer the question, Bengen put together a portfolio of two assets—large US stocks and intermediate government bonds—and he looked at two variables: the withdrawal rate each year and the stock to bond ratio.
He then ran scenarios using historic returns to see when portfolios would run out of money.
For example, he started with a mix of 50% large stocks and 50% bonds, and a withdrawal rate of 3%. Then, he started in 1926 and took 3% of the total portfolio value out. So if it had $100,000 in 1926, he would take $3,000 out that year. After that, he would increase the withdrawal by inflation. If inflation was 2%, he would withdraw $3,060 in 1927 and continue withdrawing money each year, increasing for inflation until the portfolio was out of money.
He would then start in 1901 and do the exact same thing, then 1902, then 1903… Looking at how long the portfolio would last in different periods throughout history. He did the same thing for 4% rate, and a 5% rate, and then for a 50/50 mix (50% bonds 50% stocks), a 60/40, a 75/25, etc.
He was searching for the best combination of withdrawal rate and best asset mix for taking income in retirement.
After looking at many combinations, he came to the conclusion that the best asset mix is between 50% and 75% stocks, and the “safe” withdrawal rate is 4%. A portfolio constructed in this way never ran out of money in less than 35-years. In other words, in every period throughout history, if you took 4% of your portfolio out and increased for inflation each year, you would have lasted at least 35-years.
4% increasing for inflation lasted at least 35-years in every period throughout history; even the absolute worst period.
The worst period in history was from 1966 to 1982 where large US stocks had a 0% return after inflation. This is where having withdrawal rates above 4% started to fail. A 5% withdrawal rate, for example, lasted 19-years if you started in 1966.
Sidenote: Be careful if anyone tells you the S&P 500 is diversified enough. Few people would have come to that conclusion after the 1966–1982 time period (or the dead decade of the 2000s for that matter).
So, 4%, increasing for inflation, means your portfolio would have survived any 30-year period in history. Not only that, but 96% of the time you would have all your principal leftover. You took income over 30-years and you still ended up with what you started with.
Here’s a chart from Bengen’s paper:
The numbers along the bottom represent the year retirement starts, from 1926 through 1975. The numbers in the red circle show how long the portfolio would have lasted if you retired that year. The red line shows the worst period—retiring in 1966.
As you can see, most periods throughout history lasted over 50-years when using the 4% withdrawal method.
What that means is that, in this study, 4% was a minimum.
There were many periods in history where you would have been safe by taking 6% or 7%, but of course, we can’t predict what economic conditions will be in the future, that’s why we assume the worst and hope for the best. Since Bengen, there has been research on retirement income showing that you can increase your chances of success with better diversification (Bengen only used two asset classes), as well as if you adjust spending slightly in down years, among other things.
Each situation is unique, and there are other factors that affect your retirement income than just investments, so it’s important to consider investment income in relation to your overall financial plan.
How Do I Take Income from an Investment Portfolio?—Wells In Your Backyard
We just said we can take 4% of portfolio assets per year, which is great, but where does that income actually come from? From stocks? From bonds? From each asset equally? From a cash account?
The best approach to this is what we call a “Wells” approach. The idea here is to take the income from whatever investment has had the best recent performance.
Think of each asset class in your diversified portfolio like different wells in your backyard. You have large US stocks, small US value stocks, small international, government bonds, etc. Each one is a well. The water in the well represents how much money is in that particular investment. Each well will have a different water level because the investments perform differently each year. Higher performing investments mean a higher water level in that well, while lower returns mean the water level is down.
But each well has a target level of water. This represents the target percentage for each asset class.
How the targets are determined is beyond the scope here, but a properly structured portfolio has targets for each asset class that are determined by correlation relationships, risk tolerances, risk capacities, and other factors driven by ongoing academic research. Then, the portfolio is periodically rebalanced to maintain the targets, which helps reduce risk.
The returns of the different assets will be different every year.
Some years, large US stocks will be up and international small stocks will be down. Other years, bonds will be up and stocks will be down. In any given year, the water levels will be different across all of the wells—some will be higher than their targets, and others will be lower.
So, we take our income from the well that has the highest water level.
One year the wells might look like this, with varying water levels:
In this case, we would take income from Small international stocks and Small US stocks, while leaving the other areas time to grow.
The wells approach has three primary benefits:
- It causes us to sell assets higher. If that asset has had high returns recently, its price will be driven up higher than the target, so it’s a perfect opportunity to sell it off.
- It saves us a transaction cost in rebalancing. Rather than having to rebalance by buying one thing and selling something else, we can eliminate one transaction by only selling.
- It buys time for any investments with low returns to recover without dipping into the principal.
Combined with a diversified portfolio, the 4% rule, and the well approach to taking income, we’re well on our way to maximizing our hard-earned savings. (Sorry, I couldn’t resist.)
What About Market Crashes?
The biggest fear people have with taking income from a portfolio of stocks is that the market might crash.
Here are some of the most common concerns: “What if the market crashes and I lose all my money?” “What if the market has several bad years and I run out of money?” Or, “What if I’m too old for stocks and the volatility that goes with them?”
Each strategy for income has pros and cons.
Don’t let an advisor tell you that there’s only one perfect strategy. But make sure you understand each strategy before choosing one.
Many people hear the words “market crash” and then run to a product that promises safety, like an annuity. Annuities can have their place in retirement planning, but you should fully understand annuities before purchasing one. They are sold because they make some sort of “guarantee” on your money. But think of it this way: the insurance company can’t guarantee you income for free. They have to make up for that guarantee somehow.
With stocks, it’s important to understand the risk of volatility and how it can affect your income. Let’s address the fears mentioned above.
What If the Stock Market Goes down and Never Comes Back?
With a diversified portfolio, you own thousands of companies. For you to lose all your money, thousands of companies would have to go out of business at once.
These companies would have to lose all profit and have no hope of future profits. If that happens, then these companies aren’t paying taxes, and they’re not employing people who are working and paying taxes. But if we don’t have any taxes, we don’t have any government. If we don’t have any government, we probably have bigger problems on our hands than our investments.
So, when you diversify properly, we don’t need to fear permanent crashes in the market.
Still, I often hear people say, “But this time is different!”
Current circumstances always feel different because they affect us now, but it’s important to look at the past to get perspective on the present. How about the great depression? That felt different. There was absolute panic over the stock market. We had a dust bowl. We were worried about our food supply. And then Hitler comes into power. It was a scary time.
How about post-World War II? It was the atomic age and the cold war with Russia. People were saying, “Russia’s got an atomic bomb! Humanity could be destroyed as we know it!” There was panic.
Then there was the energy crisis in the 1970s. Jimmy Carter said we were running out of oil. Oil powered our factories, our automobiles, our transportation, flight; everything was based on oil.
Put yourself into that time.
The entire economy could come to a halt. And then at the same time, scientists were saying we might go into an ice age. Time magazine called it “the big freeze.”
Not only that, but we were running out of food because of the growing population. There was a popular book at the time called “The population bomb” which said that we wouldn’t be able to feed the explosion in population. That felt different. And then you had the tech bubble burst in 1999 and 2000. The NASDAQ fell 78%. Hundreds of companies crumbled. And at the same time, Y2K was going to shut the computers down. Then 9/11 came right after. It was one thing after another.
What do all these downturns have in common? We bounced back every time.
With oil, for example, we were previously limited to drilling straight down. Then we learned how to drill horizontally.
We’re always moving forward and finding solutions.
Am I Too Old for Stocks?
At this point, many investors say something like, “Ok, I know we always bounce back, but what if I’m too old for a downturn? What if I don’t have enough time for the market to recover?”
The truth is, when you look at the numbers, most people have enough time—and assets—to recover from a down market.
To answer the age question, we’ll look at average life expectancies and compare them to downturns throughout history.
Here is a life expectancy table based on age and gender. “Couple” refers to the joint life-expectancy of a couple, and it means how long the last survivor is expected to live.
Keep in mind that these are averages, meaning that there’s a 50% chance to reach the age listed, which also means half live longer and half live shorter.
So, another way to think about it is there’s a 50% chance for a 65-year old male to live longer than age 83. That’s a good chance.
For more on life expectancy, visit the Social Security Life Expectancy Calculator.
How Long Do Downturns Last?
So, how do those life expectancies compare to market downturns?
The average downturn through history has lasted about 121 days. Every one of those life expectancies are longer than it has historically taken the market to recover from a downturn.
If you look at just the big downturns, from a 10% to a 20% drop, the average recovery ranges anywhere from 118 days to 322 days at the worst—all less than one year. We’re talking about just the S&P 500 here, for simplicity, but diversified portfolios—especially retirement portfolios—often recover quicker.
Even looking at the worst downturns in history, recovery has taken less than three years.
In 1973–74, for example, large US stocks went down about 40%. The S&P 500 recovered by the end of 1975. How about the big doozy of a downturn from 2007–2009? The S&P 500 recovered by April of 2011.
Downturns can feel long when you’re going through them.
Especially because you don’t know when they will be over. That’s why you must step back and look at the big picture.
Humans, companies, and markets are great at adapting and responding. And even the worst downturns haven’t lasted as long as it sometimes seems.
Looking at this chart, you can see that most people are not too old for even the worst downturns.
Bonds Help Protect from Downturns
Still, even if you have one year of life left, the wells approach can help us here.
When the market is down, that means your stock wells are low, so we draw from the bond wells. A retirement portfolio has anywhere from 40–60% of its money in bonds. On $500,000, that’s $200,000 in bonds. And remember that the right kind of bonds hold value during downturns, and can often go up.
In most situations, that’s more than enough to sustain someone through a downturn while stocks recover. But each situation does need to be analyzed with care. In some cases, with low life expectancy and low assets, it may make sense to annuitize.
While it’s impossible to eliminate the risk of stock market fluctuations, when you diversify, set up the right mix of stocks to bonds, take the right amount out of your portfolio, from the right places, and coordinate it with your entire financial picture, you can really mitigate that risk.
Investment Income and Freedom in Retirement
Investment income shouldn’t be a stress factor on your life.
It’s meant to create freedom for you. Freedom from needing to work for your money—you’ve already done the hard work. And freedom to live fully for your purpose—because now you have the time and resources. Many times, though, income from investments becomes a stressor. When that happens, it restricts freedom. Instead of being a creator of freedom, it’s a barrier to freedom.
But it doesn’t have to be.
The first step is understanding your financial situation and how investment income fits into it.
A dark cave is scary because it’s unknown. What if there are bats? I hate bats. But we’re not scared of a well-lit room because we know what’s in there—we understand it. So, take time to understand investing and income.
You don’t have to get a degree and start teaching finance at the local university, but a little understanding goes a long way towards peace in retirement.
The next step in your journey to plan well for retirement is to estimate your retirement expenses. Not only do you need to know where your income will come from, but you need to know if it’s enough to meet your expenses.
Keep learning. You can relax about retirement.
If you want a coach to guide you through that journey, you can schedule a free 15-minute, no pressure call with an advisor here: paulwinkler.com/call.
By Michael Sharpnack
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*Advisory services offered through Paul Winkler, Inc. (‘PWI’), an investment advisor registered with the State of Tennessee. PWI does not provide tax or legal advice: please consult your tax or legal advisor regarding your particular situation. This information is provided for informational purposes only and should not be construed to be a solicitation for the purchase of sale of any securities. Information we provide on our website, and in our publications and social media, does not constitute a solicitation or offer to sell securities or investment advisory services, or a solicitation to buy or an offer to sell a security to any person in any jurisdiction where such offer, solicitation, purchase, or sale would be unlawful under the securities laws of such jurisdiction.