When building your retirement income plan, you first need to have a good understanding of your goals, particularly your needs versus wants. An example might be: “I need $2,000 per month in income from my investments, and I want to leave $250,000 to my kids.” Second, you need to understand how investments pay you. While it would be ideal to go back to college and major in finance, it’s too late for most of you who come to our site seeking guidance.
What it isn’t too late to do is grasp the key concept of creating an income stream. For many of you, your savings have come through growth-oriented investments made in your TSP, 401(k), or 403(b). The biggest mistake you may make is looking at your percentage rate of return in these accounts during the later years of your life and assuming this rate will be the income “yield” produced to pay you during retirement.
At this stage in life, growth and income should be defined differently in your financial plan. Growth represents risk, while income represents security. Growth at this stage in a retiree’s financial life cycle represents “sequence of returns risk,” which can be devastating.
Sequence of returns risk is a significant concern for retirees because it can drastically impact the sustainability of their retirement portfolio. Here’s why retirees need to avoid it:
1. Impact on Portfolio Sustainability:
- Definition: Sequence of returns risk refers to the risk that the order of investment returns can negatively affect a portfolio, especially when withdrawals are being made. Even if average returns are the same over a period, a retiree who experiences poor returns early in retirement while drawing down their portfolio may deplete their savings more quickly than someone who experiences those poor returns later.
- Example: Consider two retirees with identical portfolios. If one retires during a market downturn and starts withdrawing funds, they may have to sell assets at lower prices, locking in losses. This reduces the amount of capital remaining in the portfolio, making it harder for the portfolio to recover when the market eventually improves. Conversely, a retiree who experiences strong returns early on can better withstand later downturns because their portfolio has had a chance to grow.
To further illustrate this point: at the turn of the century in 2000, a $500,000 portfolio invested in the S&P 500 and withdrawing $20,000 annually (or 4%) would be worth only about half by December 2013, with the retiree likely still having many more years to live.
To build a sound retirement income plan, you don’t need to go back to college, but you do need to understand the concept of yield versus distribution rate.
Yield and distribution rate are both important financial metrics, particularly in the context of building a retirement income plan using investments like bonds, mutual funds, REITs, and certain annuities. However, they refer to different aspects of return and income.
1. Yield:
- Definition: Yield refers to the income return on an investment, typically expressed as an annual percentage. It can be calculated based on the investment’s current price or its original cost. To keep things relatively simple, let’s define yield as the current yield as we begin thinking about how to structure your portfolio.
- Current Yield: This is the annual income (interest or dividends) divided by the current price of the investment. For example, if a CD pays $5,000 annually and is currently priced at $100,000, the current yield is 5%.
When considering making an investment decision, an assumption that should be made and verified is the return of the initial principal invested. In the above example, this would mean ensuring that the investment includes a return of the $100,000 to you or your family after receiving all of the $5,000 annual interest payments.
A distribution rate, on the other hand, may not only include interest and dividends but also a portion of your initial principal invested.
2. Distribution Rate:
- Definition: The distribution rate refers to the percentage of income (typically in the form of dividends or interest) distributed to shareholders or investors. It’s usually expressed as an annualized percentage of a fund’s or REIT’s net asset value (NAV) or market price.
Often, a distribution rate might include a portion of your initial investment. This is a key concept to understand when you are gauging the longevity of your investment. If you’re expecting an investment to last throughout your retirement, but you’re receiving a portion of your principal back in each payment and you’re spending that entire distribution check, you might eventually deplete your entire investment ahead of schedule. This could be incredibly troubling, as in many cases, due to health care costs, one’s expenses tend to rise later in retirement.
- Calculation: The distribution rate is calculated by taking the total distributions paid out over a period (usually a year) and dividing it by the investment’s current price. However, in many sophisticated investments, a piece of that distribution could be principal.
For our clients, the concept of simplicity always overrides more sophisticated structures.
How Do Needs and Wants Find Balance?
As in the above example, we start with needs first. We look at the current universe of yield-based investments given the current income environment. We aim to preserve a client’s principal first and generate a sufficient amount of current income. If the current interest rate environment is 5%, a client would need a portfolio of income-producing investments of $480,000 in order to not spend any of their principal and receive $2,000/month or $24,000 a year, perhaps to supplement their Social Security.
If we don’t have the $480,000 to commit to the strategy, that’s okay. The “need” was $2,000/month, and the “want” was to leave $250,000 to the kids. At this point, we have only considered the 5% current yield needed; we have not explored investments that carry a higher “distribution” rate.
Let’s assume we had an option with an 8% lifetime distribution rate. Yes, by “lifetime,” we mean that the income stream will last for the rest of your life, even if you live to 150 years old. The capital needed to fund your need drops from $480,000 to $300,000. The trade-off is that if you live long enough, there will be no legacy assets left for the family.
As you can see, there needs to be a lot of attention paid to planning. The trade-offs all need to be considered. First, a mindset shift is needed from growth to income to avoid sequence of returns risk. Then, a realistic assessment of needs versus wants should be conducted. Lastly, the vast number of options and potential combinations of different strategies should be evaluated. These are all key to how we help our clients at RCP.
Ready to Take the Next Step in Your Retirement Planning?
Building a sound retirement income plan requires careful consideration of your needs, goals, and the right strategies to avoid unnecessary risks. Let us help you navigate this journey with confidence. Fill out the contact form below to schedule a complimentary consultation and learn how we can help secure your financial future.