Retirement planning expert Wade Pfau has spent countless hours researching the different types of retirement income planning tools available. In a recent article for Forbes magazine, “Understanding The Tools In Your Retirement Income Toolbox,” he summarized the important facts about your income choices. Your first option is the Total Return Investment Portfolio. This is where you make systematic withdrawals from your investment portfolio. The benefit is that your money has the potential for significant growth if markets perform well and there is a good chance you will leave money for your heirs. There are many downsides to this retirement income approach though. It doesn’t account for longevity risk or sequence of returns risk and it only accounts for inflation risk if markets keep up with inflation. You also have to make important decisions throughout your life regarding your investments, something that would be difficult if your cognitive ability declines later in life.
Another option for creating income is to use bonds along with total return investments. Short and medium term bonds can be held to maturity and used for spending. Long term money can be kept in a portfolio where returns may be higher. This strategy accounts for sequence of returns risk, but still does not account for longevity risk. You have to worry about inflation with traditional bonds, but not with TIPS. You still have to worry about declining cognition later in life, but you’ll protect yourself from panicking and selling off in a market downturn when you hold bonds to maturity. Retirees are typically able to better understand asset allocation when they use bond income for a fixed number of years.
Income annuities are the next income option that Pfau discusses. While income annuities make up only a small percentage of all annuities sold, they are arguably the most important annuity for retirement income planning. They protect against longevity risk as well as sequence of returns risk. Some annuities protect against inflation risk, but it is often at an added cost. SPIAs are immediate annuities that pay your income right away, while DIAs allow you to defer your income payments until you need it. There are a few important decisions to make in regards to your income annuity, including whether or not to annuitize, what age to annuitize at, and whether or not you should build a ladder with your annuities. Another benefit of using income annuities is that they protect against cognitive declines later in life. One Harvard professor refers to them as “dementia insurance“. You won’t have to make any additional financial decisions in regards to your annuity as you age and you will continue to receive income until you die. While income annuities account for many risks, they don’t offer growth potential, may not leave an inheritance, and are not liquid. Combining income annuities with investments is often a successful retirement income strategy.
In addition to income annuities, there are many other annuity types that can meet income planning needs. Traditional fixed annuities are an alternative to CDs and investment-only variable annuities allow your money to grow tax-deferred during the accumulation phase. Fixed indexed annuities and variable annuities can both include riders that provide income guarantees, potential growth if markets perform well, and even liquidity. Each annuity type has its own benefits and drawbacks, so you have to research which annuity will work for your retirement income planning.
Social Security is the best type of income annuity available. It protects against all of the earlier mentioned risks and also leaves money to beneficiaries at your death. The longer you delay receiving Social Security, the higher your benefits will be. Social Security is not liquid, however, you have to wait until your payments come in monthly to get your income. Your housing wealth is something else to account for when planning for retirement. Some people use a reverse mortgage on their paid-off home to pay for long term care in their old age. Long term care is one of the largest expenses in retirement, so you have to plan for it before it negatively impacts your long term finances. Some other sources of potential income include part time work, rental property income, life insurance and business income. There are many different sources available to provide retirement income. Aside from Social Security, income annuities account for the most types of risks and provide guaranteed lifetime retirement income.
Written by Rachel Summit