5 Retirement Income Portfolios

Pros and Cons of 5 Different Approaches to Retirement Income

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There are several ways to line up investments in such a way to produce the income or cash flow you'll need in retirement. Choosing the best can be confusing, but there really isn't any one perfect choice. Each has its pros and cons and its suitability can depend on your own personal circumstances. But five approaches have met the test for many retirees.  

Guarantee the Outcome

If you want to be able to count on a certain outcome in retirement, you can have it, but it will probably cost a bit more than a strategy that comes with less of a guarantee.

Creating a certain outcome means using only safe investments to fund your retirement income needs. You might use a bond ladder, which means you would buy a bond that would mature in that year for each year of retirement. You would spend both the interest and principal in the year the bond matured.

This approach has many variations. For example, you could use zero coupon bonds which pay no interest until maturity. You would buy them at a discount and receive all the interest and return of your principal when they mature. You could use treasury inflation protected securities or even CDs for the same result, or you could insure the outcome with the use of annuities.

Advantages of this approach include:

  • Certain outcome
  • Low stress
  • Low maintenance

Some disadvantages include: 

  • Income may not be inflation-adjusted
  • Less flexibility
  • You spend principal as safe investments mature or use principal for the purchase of annuities so this strategy may not leave as much for your heirs
  • It can require more capital than other approaches

Many investments that are guaranteed are also less liquid. What happens if one spouse passes young, or if you want to splurge on a once-in-a-lifetime vacation due to a life-threatening health event? Be aware that certain outcomes can lock up your capital, making it difficult to change course as life happens.

Total Return

With a total return portfolio, you're investing by following a diversified approach with an expected long-term return based on your ratio of stocks to bonds. Using historical returns as a proxy, you can set expectations about future returns with a portfolio of stock and bond index funds.

Stocks have historically averaged about 9 percent as measured by the S&P 500. Bonds have averaged about 8 percent as measured by the Barclays US Aggregate Bond Index. Using a traditional portfolio approach with an allocation of 60 percent stocks and 40 percent bonds would let you set long-term gross rate of return expectations at 8.2 percent. That results in a return of 7 percent net of estimated fees which should run about 1.5 percent a year 

If you expect your portfolio to average a 7-percent return, you might estimate that you can withdraw 5 percent a year and continue to watch your portfolio grow. You would withdraw 5 percent of the starting portfolio value each year even if the account didn't earn 5 percent that year.

You should expect monthly, quarterly, and annual volatility, so there would be times where your investments were worth less than they were the year before. But this volatility is part of the plan if you're investing based on a long-term expected return.

If the portfolio under performs its target return for an extended period of time, you would need to begin withdrawing less.

Advantages of this approach include:

  • This strategy has historically worked if you stick with a disciplined plan
  • Flexibility—you can adjust your withdrawals or spend some principal if necessary 
  • Requires less capital if your expected return is higher than it would be using a guaranteed outcome approach

Some disadvantages include:

  • There's no guarantee that this approach will deliver your expected return
  • You may need to forego inflation raises or reduce withdrawals
  • Requires more management than some other approaches

Interest Only

Many people think that their retirement income plan should entail living off the interest that their investments generate, but this can be difficult in a low interest rate environment.

If a CD is paying just 2 to 3 percent, you could see your income from that asset drop from $6,000 a year down to $2,000 a year if you had $100,000 invested. 

Lower risk interest bearing investments include CDs, government bonds, double A rated or higher corporate and municipal bonds, and blue-chip dividend paying stocks.

If you abandon lower risk interest bearing investments for higher yield investments, you then run the risk that the dividend may be reduced. This would immediately lead to a decrease in the principal value of the income producing investment, and it can happen suddenly, leaving you little time to plan.

Advantages of this approach include:

  • Principal remains intact if safe investments are used
  • Might produce a higher initial yield than other approaches

Some disadvantages include:

  • The income received can vary
  • Requires knowledge of the underlying securities and the factors that affect the amount of income they pay out
  • Principal can fluctuate depending on type of investments chosen

Time Segmentation

This approach involves choosing investments based on the point in time when you'll need them. It's sometimes called a bucketing approach.

Low risk investments are used for money you might need in the first five years of retirement. Slightly more risk can be taken with investments you'll need for years six through 10, and riskier investments are used only for the portion of your portfolio that you wouldn’t anticipate needing until years 11 and beyond.

Advantages of this approach include:

  • Investments are matched to the job they're intended to do
  • It's psychologically satisfying. You know you don’t need higher risk investments anytime soon so any volatility might bother you less

Some disadvantages include: 

  • There's no guarantee that the higher risk investments will achieve the necessary return over their designated time period
  • You must decide when to sell higher risk investments and replenish your shorter term time segments as that portion is used

The Combo Approach

You would strategically choose from these other options if you use a combo approach. You might use the principal and interest from safe investments for the first 10 years, which would be a combination of "Guarantee the Outcome" and "Time Segmentation." Then you would invest longer-term money in a "Total Return Portfolio." If interest rates rise at some point in the future, you might switch to CDs and government bonds and live off the interest.

All these approaches work, but make sure you understand the one you've chosen and be willing to stick with it. It also helps to have predefined guidelines regarding what conditions would warrant a change.