Four of the many possible strategies for the “Collection” phase of your financial life.
I like choosing the right word for the situation.
The headline for this article uses the term “retirement income” because that is more recognizable. But with more people (me included) not all that interested in retirement as it’s usually understood, I felt a need to find a better word for my financial practice. Most of us have two big phases to our financial lives: the period where we spend a lot of time earning our living and finding some cash leftover to save. Later, we dial back the work effort and start receiving benefits we’ve paid for over those decades. Borrowing lightly from the terminology used for annuities, I like to call these phases Accumulation phase and Collection phase Traditionally, they have been considered distinct from each other. You retire from your career, and you enter Collection phase the next day. We all can see that transition is much fuzzier for a lot more people, compared to last century.
Social Security & Pensions
The first part of any professional financial planning is to discuss collection-phase goals and make plans to meet them. The first income sources to lock down are Social Security benefits and pension plans. These are truly “fixed-income”. You have paid taxes and funded your company or union pension—probably for decades—and there are fixed benefits associated. For Social Security, you can check the most recent statement you’ve received in the mail or go to https://www.ssa.gov/myaccount/ to see the latest. For Social Security, we can choose when to begin receiving retirement benefits—sometime between ages 62 and 70 in most cases. Like many financial planners, I suggest putting off receiving benefits as long as possible for most clients. There are exceptions of course.
Pensions often have options for collecting benefits, the main choices being to 1) take a lump sum or 2) to turn on an income stream. There is also a choice of turning on the stream for one person, or for the lives of the beneficiary and spouse. A financial advisor can be of great assistance in analyzing these choices for your situation.
Four Collection Phase Strategies for Your Investment Portfolio
Here are four of the more common strategies financial advisors may use as a starting framework with clients. Each demands a good deal of discussion. In this space, I’ll list them with just a little commentary to help the reader begin considering them.
4% of capital balance approach
- Each year in Collection Phase, plan to draw down about 4% of your investment portfolio as income.
Three Bucket Strategy – Divide your investment assets into 3 “buckets”:
- For income needed in the next 2 years: money market/CDs
- For income needed between 2-7 years: invest in bonds or perhaps deferred annuities
- For income after that: invest in income stocks with some growth stocks added in. You have time for this part of your portfolio to weather some ups and downs.
Combo Strategy – This is a way to use annuities and a growth-oriented portfolio. It’s a 6-step process:
- Estimate full income needs
- Find your Social Security income; Find out your pension lump-sum values
- Calculate the budget shortfall between your income needs and Social Security
- Convert pensions to lump sums, fill budget shortfall with the best value A-rated annuity available
- Remaining assets are devoted to a growth-oriented portfolio. Your life expenses are covered with Social Security and annuity
- Tap portfolio only when necessary. Rebalance more conservative as time goes on
Money for Life Approach -This is an extension of the Three Bucket Strategy into six buckets. With a 30-year life expectancy, use six tranches as defined below. As time gets shorter, go to five, and four, and so on
- Tranche 1 (years 1-5): Put funds into a money market vehicle or CDs
- Tranche 2 (years 6-10): Invest funds that will grow into your money market tranche in US Treasuries. A financial advisor will help figure how much this is (in this environment, consider a deferred annuity instead)
- Tranche 3 (years 11-15): Invest in corporate bonds (consider deferred annuity), that will grow into your US Treasuries investment.
- Tranche 4 (years 16-20): Invest in a balanced fund that will grow into your corporate bonds tranche
- Tranche 5 (years 21-25): Invest in large cap stocks that will grow into your balanced fund tranche
Tranche 6 (years 26-30): Invest in small cap stocks that will grow into your large cap stocks tranche
Rebalance every 5 years or so as your money market funds are used up.
The Strengthening Role of Annuities in This Low Interest Rate Environment
Interest rates are near zero at this writing (December 2020). Bonds are yielding practically no return, and so the traditional way of securing reliable income during Collect phase is, well, not so reliable. Annuities have always been a strong alternative to a bond portfolio for those people who are more risk averse. Surveys indicate that annuities often lead to less anxiety and therefore more happiness for the people who choose them. The price for that security is that it closes down other options for the money spent. Investment portfolio assets can always be adjusted as things change. This freedom of action has a certain amount of value. There are some degrees of freedom with annuities. You can select investment options during the accumulation phase of an annuity. Similar to pensions, you can select the length of time for the annuity payments. You often can choose to annuitize a deferred annuity into a lump sum! But income taxes must be paid on that sum immediately, making it a very inefficient choice.
A particularly important part of the choice in selecting an annuity is to honestly estimate your own life span. If you’re healthy and have a family history of long life, an annuity can be a fantastic option. If it’s the opposite in your case, you should be very reluctant to enter into any new annuity contracts. But even then, you can often choose a “period certain” that will benefit your heirs, if not yourself. I think these 3 bullet points are a great start for thinking about annuities:
The longer your expected lifespan, the better annuities look
- Annuity pay-outs are based on expected lifespans of a large group. Your payments will be funded by those who died earlier
- Decide as soon as possible (allows for maximum growth & return on deferred annuities)
Get as little annuity as necessary (keep other options alive)
- Like cooking with salt–you can always add more later
The best way to use this information, if it’s new to you, may be to use it to guide your next conversation with your professional financial advisor.