Making an Income For Yourself, Part 2

In Part 1 of this series, we talked about the initial steps you need to take as you plan your income stream, especially in retirement.  In this second section we’ll talk about how to develop an income stream from your assets.

But first, we need to get an understanding of just how much income we’ll need.  In the example that we started with in Part 1, the expenses totaled at $2,975 per month, and our income from pension, Social Security, an annuity, and rental income totaled $2,000, leaving us with an unmet need of $975 per month, $11,700 per year.

Also, earlier in Part 1, we totaled up all of our investment accounts: IRAs, 401(k)s, taxable accounts, savings accounts, and the like.  Time to put those calculations to work.  As a general rule, which we can address further at another time, you can usually count on being able to withdraw up to 4% of your portfolio per year, and as long as the investments are properly diversified, this rate of withdrawal should sustain over your lifetime.  (Keep in mind that this is only a general rule of thumb and each individual’s situation is different, requiring review of risk tolerance and year-by-year investment experience.)

Sustainable Withdrawals

So if we use a 4% rate of withdrawal, we need to have approximately $292,500 in investments in order to generate the additional income stream that we calculated earlier ($11,700/year).  We get this number by dividing the needed income by the withdrawal rate ($11,700/4% = $292,500).  Simple enough, right?

Let’s say you indeed have a total of $300,000 in your accounts.  For now, we won’t get into which account to draw from first, let’s assume that you’re over age 59½, and that all funds are available to you for withdrawal.  Furthermore, we’ll assume that none of your funds are in Roth-designated accounts (but taxes are not considered in this example).

The Portfolio

How does one concoct a portfolio that will provide the required income stream, while at the same time generates growth and protects the principle?  Start with the amount required in income – this amount goes into a money market account with checking privileges.  Secondly, a similar amount, representing the following year’s income needs, is invested in short-term Treasury bonds of 1-3 year duration.  This has covered the investment of a total of $23,400 of your portfolio.

The remainder of your funds, $276,600, should be invested in a broadly-diversified portfolio, approximating no more than a 50% exposure to equities, and including domestic and foreign debt instruments, commercial property (in the form of REITs), and various commodities, in order to ensure that the portfolio is well rounded and contains enough non-correlated asset classes to protect your capital.

Each year, as you need the funds, you draw from the money market account.  At the end of the year, you replenish that account with the proper amount for the coming year – if necessary from the short-term Treasury holdings, but most likely from income/dividends generated by the remainder of the portfolio.  In years of lean growth, more will need to be drawn from the short-term portfolio, but in years with more growth, the “investment” portion of your portfolio will grow and should outpace inflation.

But There’s Not Enough!

The question comes up though – what if you didn’t have a portfolio of $300,000 (from our example)?  What if the portfolio only amounts to $100,000?  The sad truth is that you’ve got some tough decisions to make… Maybe you will need to delay retirement for several years in order to build up your portfolio.  Another option would be to take a part-time job that pays at least your “unmet” amount after tax for several years, in order to make up the difference.

You may have to look long and hard at your expenses and make some dramatic cuts to your lifestyle goals.  Maybe it would make sense to downsize your home, assuming that you have equity built up, and thereby use some of the excess cash to bolster your investment funds.

Oooh, but not an annuity!

There is one option that may sound very tempting at this point, especially if you’re much closer to the full amount required from your calculations, but still just a bit short – an immediate annuity.  Under one of these plans, you are trading flexibility and a considerable amount of expense for a guarantee that you’ll always have an income stream – even if it’s a little less than you had planned for originally.  The expense amounts to anywhere from 2% to 3% of your portfolio, and the flexibility is huge: if you decided that instead of the lifetime income you’d prefer to make a large charitable gift (perhaps a health issue has developed) – you’ve pretty much lost that option if you’re stuck in an annuity.

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Jim Blankenship, CFP®, EA, is an expert in personal retirement, IRAs, and tax issues, with more than 20 years of experience in the industry.  . Read more from this author