Turning Investments into Retirement Income

 

For most people, the ultimate goal of all this planning and investing activity is to set themselves up for a future where they are not working. At some point, the task will be turning investments into retirement income. This is more complicated than saving and investing, requires more precision, and is worthy of a book in its own right.

To be clear, the basic mechanics are not any more difficult: instead of saving and adding money every month or year to your portfolio and doing the rebalancing, you will sell some and live off the proceeds. However, there are a number of factors that you have to consider more carefully in retirement, in part because of the situation, and in part because the particulars do not fade away in the mists of future uncertainty – there is less ability to start off approximately right and correct later.

Young people may not necessarily need outside help from a financial planner or advisor – with what was covered earlier in the book you can invest on your own, and a more detailed plan may not be worth the money when there is so much unavoidable future uncertainty ahead of you [78]. For near-retirees however, a visit to a financial planner or advisor can be well worth the fee. Turning your investments into retirement income carries many special considerations, including:

• Sequence-of-returns risk.
• Longevity risk.
• Tax and benefit considerations, such as when to convert your RRSP to an RRIF, or when to take or defer OAS and CPP.
• Balancing a legacy with optimal spending and whether to buy an annuity.
• Choosing to sell or downsize your house.
• Different spending patterns, and differences between your personal inflation rate and the official inflation averages.
• The strategy and approach for viewing your investment portfolio.
• Whether it is preferable to be conservative with spending and get a steady retirement income, or to spend more but allow market returns to dictate your spending capacity.

Surveys show that most people spend less as retirement goes on – however, the surveys don't tell us whether this is a feature of their plan or a failure [79]. Using a constant, average figure for your income needs makes planning more straightforward, but may not be realistic: even if you don't plan for a gradual tapering in spending as you travel less, there will likely be irregular expenses like repairs, health care, or new cars.

Your personal inflation rate may differ from the official one used by the government and your pension plan to adjust your benefits, known as the consumer price index (CPI). In your working and saving years, you likely have a spending pattern similar to the average person's that makes up the CPI inflation calculation, and your income will likely rise along with inflation. In retirement your spending may be concentrated in certain categories, for instance you may spend most of your money on food and energy, and not spend anything on furniture, having already acquired a lifetime supply. So if what you spend your money on (food & energy) increase in price while what you don't (furniture) decreases, your personal inflation rate may considerably outstrip the official CPI calculation, and so this can be a much larger risk factor in retirement.

Focusing on your investments and getting income out of them, there are several ways to approach your portfolio as you enter retirement.

The simplest is to simply continue as you did in your accumulation years, with a steady shift towards fixed income to reduce the potential volatility; sell what you need and what your plan dictates to get cash each year, and rebalance periodically. There is a common “rule” for how much to withdraw from such an approach, which is to take 4% (less about half the fees) of your starting portfolio to spend, and increase the amount with inflation each year. For example, if you were paying 0.4% in MERs by investing in e-series index funds and had $500,000 on the day you retired, you would withdraw 3.8% of that, or $19,000, to spend in the first year – increasing the amount each year with inflation. Such a simple rule has a lot of appeal, which may explain its popularity, but there are downsides. It's good enough for most historical market conditions, but still particularly sensitive to a big crash right after setting your withdrawal rate – it may be better to use a more responsive strategy right from the beginning. Conversely, to meet the “most market conditions” criteria, it's overly conservative for many scenarios (though that is not such a bad problem to have).

Another popular option is to shift to a portfolio of dividend-paying stocks and “live off the dividends”. I am not fond of this strategy. On the one hand, if you are only living off the dividends then you are being needlessly conservative in your spending, as dividends are just one component of total return. Unless you have a strong desire to leave a large legacy, you should plan to spend a bit of your capital. It is also a strategy that involves too much equity risk, and concentrating to just a few sectors that tend to pay dividends, rather than diversifying broadly. It swings to becoming too risky if there’s a concentration in a small selection of companies paying high (and unsustainable) dividends.

Another method that is worth considering is a “bucket” approach. In this method you split your future years' spending needs into “buckets” that you can fill with different sub-portfolios. For example, you could have a bucket for the current year and following year's spending budget, held in savings accounts and ready to spend as needed. The next few years, say years 2-10, could be held in bond funds and GICs with appropriate maturities. The rest, for ten years out and into the more distant future, could be invested largely in equity funds, or a portfolio appropriate to the time available and your risk tolerance. In future years, depending on the performance of your investments, you can adjust filling the next mid-term spending bucket from your long-term bucket. This lets your budget respond to changes in investment performance, but with a bit of a lag so you have time to ease your spending and lifestyle into it.

At this point you may easily be thinking that things would be so much easier with a defined benefit pension plan: you would have a set level of income – likely adjusted for inflation each year – that would last until you died, taking care of longevity risk. An annuity (specifically a life annuity) is a way to approximate [80] the benefits of a pension yourself. By paying a lump sum near retirement, an insurance company can guarantee a steady stream of payments for the rest of your life, no matter how long you may live. The cost of that assurance is that if you die young, there may be nothing left of that lump sum for your family, friends, or favourite charity to inherit.

 

Footnotes:

78: But when you need help planning, or help budgeting, then an advisor may be worth the cost at any age.

79: Michael Wiener did find one study that suggests indeed, spending reductions are forced on retirees by their circumstances. He discusses it at

http://www.michaeljamesonmoney.com/2014/02/telling-us-what-we-want-to-hear-about.html

80: Inflation protection is less common in annuities.