One of the biggest challenges facing retiring boomers is how to generate a reliable income from your savings that will last the rest of your life, no matter how long you live. Many people struggle with this challenge; they draw down their saving too quickly and end up broke with many good years of life remaining.
The good news is there are many ways to generate retirement income, each with their own advantages and disadvantages. And you'll find different opinions among financial professionals, depending on their training and how they are paid, about which ways are best.
As an actuary, I've studied mathematical and statistical techniques that analyze how to address this longevity problem. Also, I don't sell investments or insurance, so my opinions aren't influenced by how I make my living. With that being said, here are my favorite ways to generate a retirement income that will last the rest of your life, no matter how long that is. And remember, if you're married or have a partner, the income needs to last as long as you're both alive.
1. Use just interest and dividends
Your first option is to invest in a no-load, low-cost mutual fund and use just the interest and dividends to pay your living expenses. You can make it easy by having the dividends deposited electronically in your checking account.
This method virtually guarantees that you won't outlive your money, since you aren't dipping into your principal. It also offers maximum flexibility and control over managing your retirement resources, with the potential to leave a monetary legacy to children or charities.
The downside? This method produces the lowest amount of retirement income compared to the other methods described in this post.
If you choose this method and can tolerate the risk of drops in your income stream and the value of your retirement savings due to market downturns, consider a mutual fund that invests in dividend-paying stocks with the potential for growth in income to protect against inflation. Examples of low-cost, dividend-paying funds that have a four- or five-star rating from Morningstar include:
-- Vanguard's Dividend Growth (VDGIX) or Equity Income (VEIPX), and
-- T. Rowe Price's Dividend Growth (PRDGX) or Equity Income (PRFDX)
If you want more protection against market volatility with a little higher income, consider a mutual fund balanced between stocks and bonds. Examples of such funds that have been rated four or five stars by Morningstar include:
-- Vanguard's Wellesley Income (VWINX), Wellington (VWELX), or Target Retirement Income (VTINX),
-- T. Rowe Price's Balanced (RPBAX) or Retirement 2005 (TRRFX), and
-- Fidelity's Strategic Dividend and Income (FSDIX) or Puritan (FPURX).
Lastly, if you want to diversify your retirement income stream, consider investing a portion of your retirement savings in mutual fund REITs that have low costs and a meaningful dividend payout, such as Vanguard's REIT Index (VGSIX) or T. Rowe's Price Real Estate (TRREX). Both have been rated three stars by Morningstar.
In today's low-interest rate environment, I'd be wary of investing exclusively in bond income funds; if interest rates rise, the value of your retirement savings could drop.
For the purpose of generating retirement income, I'd avoid CDs and bank savings accounts - the interest rates are just too low. And I'd also resist the temptation to maximize your income by chasing the highest dividend or bond yields - these investments often contain too much risk and are headed for a drop.
2. Invest and draw down principal cautiously
If you need more income than what you'd get just from interest and dividends, consider drawing down your principal cautiously through a method the experts call "managed payouts." By conservatively tapping into your principal, you'll generate more income but hopefully avoid outliving your money (but that's not guaranteed). The "safe" principal withdrawal rate is the subject of much debate and analysis, but you should consider the popular "four percent rule" a starting point for your investigation. I recommend that you think long and hard about the withdrawal rate that is most appropriate for your age and circumstances.
One downside of this method is that it requires the most attention from you -- you need to decide which assets to sell, and you should periodically revisit your withdrawal rate as you age and to analyze the investment performance of your savings.
The investments mentioned above that are appropriate for using just your interest and dividends are also appropriate for this purpose. In addition, you might also want to consider low-cost index funds offered by the same mutual fund families mentioned above. If you don't want to manage the withdrawal process, you can use mutual funds that invest and make periodic withdrawals for you, such as Vanguard's Managed Payout Funds, Schwab's Monthly Income funds, and Fidelity's Income Replacement Funds.
3. Buy an immediate annuity
Many commentators long for the days of traditional pension plans offered by employers, where you're paid a monthly income for the rest of your life, no matter how long you live. While most of these plans have been killed off, you can create a "do it yourself" pension by buying an immediate annuity from an insurance company. With this method, you hand over a portion of your retirement savings to the insurance company, and they pay you a monthly benefit for the rest of your life. (Don't confuse an immediate annuity with a deferred annuity, which is an investment vehicle that can have high expenses and poor investment performance).
You can buy an immediate annuity where the monthly income is fixed at a specific dollar amount or, if you want to spend more, your income can be increased at a fixed annual rate, say three percent, or can be adjusted for inflation. An inflation-adjusted annuity neatly takes care of two significant risks that you face in retirement -- the risk of inflation and the risk of outliving your retirement savings.
You can also protect your spouse or partner with a joint and survivor annuity, which pays a monthly income as long as either one of you is alive.
Compared to the other two methods of generating retirement income, an annuity often provides the highest amount of monthly retirement income. The downside? Your decision is usually irrevocable; once you give control of your money to the insurance company, usually you can't change your mind and get your money back or access your savings.
My favorite source for buying an annuity is an online shopping service that searches for the best rate among a select group of insurance companies, such as Vanguard's Annuity Access program, or at Immediate Annuities.com.
Vanguard also offers an immediate variable annuity, which still provides longevity protection, but adjusts your monthly income according to the performance of an underlying portfolio of Vanguard mutual funds. This option gives your income the potential for growth, but it does expose you to some market risk.
4. Choose a hybrid strategy
There are good reasons why you might consider blending the above strategies. To enjoy the advantages of each type of method, for instance, you could invest part of your retirement savings and use the remainder to buy an immediate annuity. Or you could phase-in the purchase of annuities by buying an annuity with a chunk of your savings every five years or so. This averages your annuity purchases and gradually releases control over your assets as you age, so you still have access to your principal for many years.
Take the time to learn about the various ways to generate retirement income. And don't just listen to me; others might have viable, realistic strategies as well, and you can learn from them. The consequences of your decisions will last for the rest of your life and deserve your time and effort. Don't reach your 80s and 90s broke, forcing you to move in with your kids.
Look for a future post that provides a scorecard comparing how much retirement income you might receive under each of the methods described here. And if you're looking for more information now, visit my retirement planning website, Money for Life, which contains a free tutorial that goes into detail on the methods described in this post.