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How to make better decisions about retirement income

(MoneyWatch) One of the most important and complex retirement planning decisions you'll make is how to generate reliable, lifetime retirement income from your IRA, 401(k), and retirement savings. This post suggests a methodical approach for sorting out which retirement income generator (RIG) or combination of RIGs might work best for you.

As background for this post, you may want to review my recent post, "3 ways to turn your IRA and 401(k) into a lifetime retirement paycheck," which summarized the three methods of generating retirement income:

  • RIG #1: Invest your savings, and spend just the investment earnings, which typically consist of interest and dividends. Don't touch the principal.
  • RIG #2: Invest your savings, and draw down the principal cautiously so you don't outlive your assets. (In my posts, I call this method "systematic withdrawals.")
  • RIG #3: Buy an immediate annuity from an insurance company, and live off the monthly benefit the insurance company pays you.

Each RIG has its pros and cons, and each RIG generates a significantly different amount of retirement income. As a result, when deciding how to generate your retirement paycheck, it's essential to understand the important tradeoffs you'll face when choosing your specific RIG or combination of RIGs. Some of these tradeoffs focus on the degree of control you want over your retirement savings vs. the certainty that your retirement paycheck will last the rest of your life, no matter how long you live and no matter what happens in the economy.

When deciding how to use your money to generate retirement income, it's important to understand two cold, hard truths: You'll most likely need to make some tradeoffs between the goals described below. And these tradeoffs will have a significant impact on the amount of retirement income you'll receive.

Some people will opt for a retirement income with lifetime guarantees that aren't subject to the risk of poor investment performance. Others might be willing to live with some uncertainty about their investments in exchange for the ability to have some control over and access to their retirement savings, and for the potential to leave a legacy to their children or charities.

Let's look a little deeper at the possible goals you'll set when it comes to your RIGs. I call these the LIFE goals:

  • Longevity protection: Is your retirement income guaranteed to last for the rest of your life, no matter how long you live?
  • Inflation protection: Does your retirement income have the potential to grow so it can keep up with inflation?
  • Flexibility and the potential for a financial legacy: Can you withdraw your savings in case of emergencies or for special spending needs, or to be able to make changes in the way you generate retirement income? When you pass away, are unused funds available for a legacy to your children or charities? While these may appear to be two different goals, with most RIGs, these goals go hand in hand and deliver the same outcome. So for simplicity's sake, I've combined them into one goal.
  • Exposure to market risk is minimized: Is your income protected from stock market crashes or increases in long-term interest rates?

Most people want to maximize the amount of their retirement income and satisfy as many of these goals as possible with their RIGs. Unfortunately, you get what you pay for when it comes to addressing these goals. What I mean is, the more of these goals you want to meet, the lower your initial retirement income will be.

When selecting a specific RIG, you'll need to make a trade-off between the LIFE goals and the amount of retirement income you need. For example, a 65-year-old with $500,000 in retirement savings can reasonably expect to generate an annual retirement income of between $15,000 and $30,000, depending on the RIG(s) they use and how many goals they want to address. These net figures correspond to initial annual retirement incomes equaling 3 percent and 6 percent of savings, respectively -- these percentages are often called the "payout rates."

The $15,000 amount meets the most number of LIFE goals and gives you maximum control over your retirement investments. The $30,000 amount addresses the fewest number of LIFE goals and gives you the least control over your retirement investments, but it also maximizes the certainty of your retirement income.

Here's a slide from one of the retirement planning workshops that I show participants to help them rate how important each of the LIFE goals are for them.

Deciding which goals are most important to you will help you develop your strategy for generating retirement income. Many people may decide that a combination of RIGs might best meet their circumstances, giving them the advantages of each while mitigating the disadvantages of each.

Stay tuned for my next post, which describes how the various RIGs meet the different LIFE goals.

This post is an edited excerpt from my recent book, Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck.