When Ernie Herbert married his wife, it was his father-in-law who gave him the best advice: “He said you should start saving for retirement now,” Ernie recalls. Starting with a $1,000 mutual fund investment and investing regularly, the couple built up a solid nest egg.
Now on the cusp of retirement, they find themselves asking a number of questions. Are we going to be okay without a regular paycheck? How do we invest to maximize retirement income? What if we outlive our investments? Fortunately for the Herberts, there are time-tested strategies for generating income that can help them reach their retirement goals.
“The transition from saving for retirement to living off your nest egg may seem difficult at first,” says Rob Williams, Director of Income Planning at the Schwab Center for Financial Research. “But there are steps you can take and strategies you can consider
to help create a sound, long-lasting retirement income plan. Of course, no plan will fit every investor, but there are solid strategies that can help you plan.”
Retirement Income Fundamentals
When it’s time to turn savings into income, start with a big-picture overview of what it takes to help generate retirement income that lasts. Whether you plan to build your own portfolio or have it professionally managed, it helps to start with a close look at your situation, including a retirement budget.
The first thing Ernie and his wife did was review their expenses and cash needs—separating discretionary spending from necessities like housing, food, health care and utilities—in order to establish a rudimentary annual budget. This is an important step toward creating a broader plan because knowing how much you’ll need to cover necessary expenses makes it easier to understand how much income you’ll need to sustain them.
Next, the Herberts determined how much income they’d likely draw from other sources, such as Social Security, rental income, part-time work or pension benefits. The difference between that figure and their annual budget yielded an estimate of how much income they’d need their portfolio to generate each year.
When Ernie and his wife did the math, they realized they’d need their portfolio to generate income to supplement their other sources of income. “We estimated that we would need a 5% yield in retirement to achieve the kind of lifestyle we wanted to lead,” Ernie said.
The Herberts aren’t alone. For many investors, interest and dividends from lifetime savings alone might not be sufficient to fund retirement, Rob says. “Most investors will want a well-balanced portfolio that continues to work for them, even in retirement. This will likely include stocks and bonds.” Once you have a portfolio that’s right for you and that has the potential to keep growing in retirement, you’ll also want to start thinking about income, says Rob. And you have a number of investment options to choose from. Here are three to consider.
1. Build a Bond Ladder
Investors should consider bonds a foundation of their retirement portfolios, Rob says, because they help reduce risk through diversification and have the potential to generate income. That’s where bond ladders come into the picture, providing diversification through staggered maturities and helping to generate a steady stream of predictable income with regular coupon payments.
Ladders are a collection of individual bonds with staggered maturities spread out over time. By staggering (“laddering”) your bonds’ maturities, you’ll have bonds coming due regularly, making the principal available for reinvestment should interest rates rise.
Investors can build ladders to help generate predictable, steady income. For example, an investor can buy one bond that matures in one year, another that matures in two years, the next in three years and so on. When you redeem the one-year bond, you can use the proceeds to buy another bond to keep the ladder going. And the more bonds in your ladder, the more stable your yield and the higher your average yield, all else being equal.
If interest rates move higher, you can reinvest short-term bonds at higher rates when they mature. If rates stay low, you still have some bonds locked in for the longer term at higher yields.
Some investors use this principle to create a ladder with certificates of deposit (CDs) that mature each year to help meet cash flow needs. Investors should price both CDs and bonds for any given time frame to determine which could provide the highest yield.
Be aware that this strategy may not outperform a more targeted strategy and it won’t prevent the bonds from declining in value if interest rates rise. Additionally, bond ladders might not provide as much diversification as would a bond fund, which raises the potential impact a default could have on your portfolio.
However, constructing a bond ladder can help mitigate some of the problems associated with trying to time the market, and also allows you to stay invested throughout the ups and downs of the interest rate cycle.
“A ladder can be a reasonable and effective way to manage your fixed income investments,” Rob says. “It helps manage interest rate and issuer risk while also generating a steady income stream throughout retirement.”
2. Turn to Stocks with Dividends
Relying on interest and dividends as the first sources of income from your portfolio is an easy-to-understand approach that helps keep your savings intact. In this approach, a retiree withdraws interest and dividends as they are generated, drawing down investment principal only if necessary.
For decades, investors have relied on bonds and other fixed income investments to generate interest income. However, interest rates on many traditional investments have fallen to historic lows, and the impact on retirees is significant. For example, in 2007, someone with $1.5 million could have bought five-year US Treasury notes and earned about $51,150 in annual income. At the end of 2012, that same investor would earn about $9,500 annually. Income from bonds is also fixed. When you buy a bond, you get a fixed interest payment. There’s no potential for growth.
“We think that most retirement portfolios should include an allocation to stocks as well as bonds,” says Rob. Historically, dividend-paying stocks not only generate income but also have tended to outperform over the long haul. From 1927 through 2011, high-dividend paying stocks have returned 11% per year, beating the 8% return from nonpayers.
Investing in individual dividend-paying stocks may make sense for some investors. For broader diversification, however, investors may wish to choose from the numerous mutual funds and exchange-traded funds that invest in an array of dividend-paying stocks.
To help hedge against inflation and potentially achieve growth, Rob recommends that retired investors hold some equities; however, stocks should account for no more than 60% of most retirees’ portfolios. And for the majority of retirees, that exposure to stocks should decrease over time as they transition to more conservative allocations in their portfolios.
3. Consider Annuities
Annuities are another option for retirees seeking to turn their savings into income. Unlike the other strategies, annuities can offer a guaranteed income stream that will last as long as you live. Broadly speaking, there are two types of annuities: immediate fixed annuities and deferred variable annuities.
With immediate fixed annuities, investors pay the insurance company a lump sum up front in return for fixed monthly payments for the rest of their lives (or some other specified period of time). These annuities make the most sense for retirees who are willing to give up control in return for not having to worry about fluctuations in capital markets or actively manage their portfolios.
With an immediate fixed annuity, you “buy it, set it and forget it.” As long as the insurance company remains solvent, annuity owners generally get a check for the same amount every month—they can even set up payments to last as long as they live, so that the longer they live, the more valuable the annuity becomes.
A deferred variable annuity allows investors to retain oversight of their money and provides growth potential by allowing them to choose from a selection of investment options called “subaccounts.” At retirement, the contract value can be converted into a stream of lifetime income through a process called “annuitization.”
The amount of income the annuity owner receives may be more or less than the amount paid into the annuity because it is based on how the subaccounts performed during the accumulation phase. That might sound risky, but many annuities also offer an optional feature called a Guaranteed Lifetime Withdrawal Benefit (GLWB) rider, which can be purchased for an additional cost. A variable annuity with a GLWB rider can help protect the income you plan to rely on during retirement from downturns in the market.
“The GLWB is a significant innovation in the annuity business,” Rob says. “It’s an optional rider that can be added for a fee and provides investors with protection.”
A benefit of the GLWB is that investors can enjoy the upside if the value of their annuity assets increases. Here’s how that works. Each year on your contract anniversary, the insurance company takes a look at your account value. If it’s higher than it was the year before, your income base is set to the new amount. When you reach retirement, you get to withdraw a set percentage of that income base annually for the rest of your life.
If the contract value is less than it was the year before, your income base remains as it was, so your income base cannot go down, only up. However, the income base is not a contract value, nor the amount you can expect to receive should you choose to surrender the annuity. Additionally, the income base cannot be accessed like a cash value and will not preserve your account value, which will deplete with each withdrawal until it reaches zero—though payments under the terms of the rider will continue for life. And, any withdrawals in excess of the specified annual amount may permanently reduce future income.
Variable annuity fees erode investment performance over time, so you’ll want to look for low-cost variable annuities, taking into account base fees and the cost of any optional riders.
Variable annuities can be complex. Just ask Ernie, who turned 63 last year and wanted to buy a deferred variable annuity for himself and his wife. “We were attracted to the downside income protection that a variable annuity can provide,” Ernie said. “But the features can be very complicated.” Ernie reviewed the prospectuses of eight different insurers before buying an annuity offered through Schwab.
Rob’s general advice for your entire income strategy is to remain engaged and make sure your investments remain within your comfort zone, irrespective of whether you choose to generate retirement income by dividend stocks, bond ladders or annuities.
“Markets change and so will your investments,” Rob says. “So check in on your portfolios regularly. Make sure you hold investments that have the potential to generate income for you, but also that are in line with your risk tolerance.”
Charles Schwab, onInvesting, Summer 2013