IRAs and 401k: How to Generate Retirement Income with Managed Payouts

Last Updated Oct 1, 2010 6:18 PM EDT

This post continues my series that advocates using IRAs, 401k plans, and other retirement savings to generate a lifetime monthly paycheck. The kickoff post summarized three ways to generate retirement income:
  1. Invest your savings, and spend just the interest and dividends.
  2. Invest your savings, but draw down principal cautiously so you don't outlive your assets.
  3. Buy an immediate annuity from an insurance company.
I covered option No. 1 in my second post, and in this post, I'll explore the second method in greater detail -- drawing down principal and investment earnings. With this option, you invest in IRAs, 401k accounts, and retirement savings, and then set up periodic withdrawals -- typically monthly or quarterly -- to generate retirement income. For the sake of this post, let's call this approach "managed payouts."

You might have seen articles or advertisements for financial products that provide retirement income. They go by various names, such as managed payout funds, monthly income funds, or income replacement funds, and big institutions such as Fidelity, Vanguard, and Schwab all offer them. But before you decide to invest in such a product, you'll need to look under the hood and kick the tires. And you might find you'd be better off setting up your own managed payout retirement income generator. It's not too hard to do that. Let's take a look.

Whether you invest in a product or do it yourself, you'll need to make two very important decisions:
  1. How to invest your retirement savings, including your asset allocation, and
  2. How much to withdraw to cover your retirement living expenses.
If you invest in one of the products mentioned above, the investment firm will make both of these decisions for you. But those decisions might not be best for you. I recommend that you first think about what best meets your situation, taking into account your expected longevity, tolerance for investment risk, and other sources of retirement income. Then investigate how well the firms' products match your situation and profile. This is consistent with my general advice regarding investment products: Go shopping - don't be sold! If you're not satisfied with the products these companies have to offer, then it's time to see how you can do it yourself.

Many large mutual fund companies and other financial institutions will allow you to set up periodic, automatic withdrawals from your IRAs and retirement savings to your checking account. All you need to do is specify the following items:
  • the amount of each transfer,
  • the frequency -- monthly, quarterly, etc., and
  • the specific investments or funds that the transfers will come from.
To keep it very simple, you could invest all your retirement savings in a target date fund or a balanced fund, both of which invest in a mix of stocks, bonds, and cash.

Check to see if your 401k plan also offers this automatic payment service; if they do and you like your plan's investment funds, there's no need to roll your 401k accounts into an IRA. Most 401k plans, however, don't provide these services, so if that's your situation, you'll need to roll your money into an IRA with an institution that allows for periodic payouts.

Here's how managed payouts meet the criteria for evaluating retirement income generators that I introduced in my previous post on this topic. As you can see, using managed payouts has the potential for high ongoing monitoring and maintenance.
  • Amount of initial income: Moderate
  • Potential for growth in income: Depends on your asset allocation
  • Access to/preservation of principal: Yes, although you're subject to investment risk
  • Protection against investment risk: Depends on your asset allocation
  • Protection against longevity risk: No; your level of risk depends on the amount of periodic withdrawals
  • Effort to set up: High -- you need to select appropriate investments, calculate the amount of your withdrawals, and the payout mechanism
  • Ongoing maintenance: Moderate to high -- periodically, you need to monitor investment performance and check to see if you're depleting your assets too rapidly
  • Ability to change to other methods: Yes
It's important to note that with managed payouts, there's no guarantee you won't outlive your money. The other two methods of generating retirement income -- using just interest and dividends, and buying an immediate annuity -- provide much better protection against outliving your money.

With managed payouts, the likelihood of outliving your money depends on your asset allocation and the amount of your periodic withdrawals -- the two important decisions I mentioned above. The financial literature is quite robust on this topic, and I'll summarize the considerations and strategies in future posts. I'll also look at how various managed payout or income replacement funds measure up to the analyses in the financial literature and show you how to look under the hood.

Is it really worth this time and effort? Consider this: Most of us have spent years in school and getting on-the-job training that enabled us to generate income for 30 or more working years. Now we're in training for generating another type of income -- our retirement income -- and we might need it to last for 20 or 30 years as well. You won't be spending nearly as much time as you did your previous schooling and on-the-job training, but I'd say it's equally as valuable.

More on CBS MoneyWatch
IRAs and 401k: 3 Ways to Generate Lifetime Retirement Income
IRAs and 401k: Generate Retirement Income with Just Interest and Dividends
The Best Target Date Funds Part 1
The Best Target Date Funds Part 2
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    Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck and Recession-Proof Your Retirement Years.

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