Retirement Investor

The Ideal Income Strategy for the Optimistic Pessimist


In my September 2021 article, I wrote about the importance of determining if a retiree is a “constrained investor.” In a nutshell, constrained investors reach retirement with savings. That’s great. However, the amount of savings they’ve accumulated is not high relative to the level of monthly income they need to generate. As a practical matter, this constraint signals caution. Constrained investors must rely upon their savings to produce part of their essential retirement income. Because there’s no wiggle room here, their chief investing priority is to mitigate risks that can damage their ability to generate income. Otherwise, constrained investors face the possibility of a permanently depressed standard of living.

You can view constrained investors as optimistic pessimists. In the hope of realizing capital growth in their investment portfolios, a key to generating inflation-adjusted income, they are optimistically willing to expose some of their savings to investment risk. At the same time, however, constrained investors also pessimistically express their unequivocal demand that at least a portion of their monthly income is guaranteed to be paid to them for as long as they live. Are you an optimistic pessimist? A constrained investor? 

A Thought Experiment

Here’s a thought experiment. You’ve reached retirement with accumulated savings of $1,000,000. You’re healthy and you believe that you’re likely to need income in retirement for at least 25 years. To enjoy your desired standard of living, you wish to have a total monthly income of $6,500. After determining that you’ll receive $2,600 per month from Social Security, you calculate that you must rely upon your savings to fill the gap of $3,900 per month.

Inflation is in the news. Its appearance is obvious to you when you shop. You’re sensitive to the fact that your long-range income must keep pace with rising prices. You appreciate the fact that your Social Security retirement benefits will be inflation-adjusted. However, you also want your savings to generate inflation-adjusted income. You conclude that this aim will require your savings to be invested somewhat aggressively in a portfolio that includes stocks. 

You accept the fact that you will need to assume risk. At the same time, you understand that there’s no guarantee that your investments will grow. You are aware that in Japan, the NIKKEI stock index reached its all-time high in 1989. Over the succeeding 32 years, Japanese stocks have never once clawed their way back to what they were worth in 1989. 

While you feel it extremely unlikely that the same scenario will play out in the U.S., you really can’t be certain. To sleep at night, you want protection against the risk that your savings could be depleted by investment losses, thereby reducing if not eliminating your income entirely. You ask yourself, “If I scale down some of my expenses, what is the minimum monthly income I need to still have an acceptable lifestyle?” Your answer is $5,000 per month. 

This brings you to the rational conclusion that you have conflicting objectives. On the one hand, you want income that grows as a result of investing your savings in risky assets. On the other hand, you want protection against risk in the form of an assurance that you’ll always have at least a nominal monthly income of $5,000. 

What do you do?

The Hybrid Retirement Income Strategy

After many years of working in the field of retirement income planning, I believe the hybrid retirement income strategy is the best choice for the constrained investor. Why? It addresses both of the needs that the optimistic pessimist expresses. The hybrid strategy is a combination of two methods of generating retirement income. The first is the optimistic component- time-segmentation, commonly known as “bucketing.” Bucketing involves allocating retirement savings to discrete accounts that hold investment assets earmarked for providing income during specific phases of your retirement. In a typical example, a retiree might set up five “buckets.” Bucket one will provide income for the first five years of retirement Bucket two, will provide income in years 6-10. Bucket 3, in years 11-15. Bucket 4, in years 16-10. And bucket 5, in years 21-25. 

Importantly,  non-equity (safer) assets are used to fund buckets one and two. The reason for choosing safe money vehicles is to introduce protection against timing risk. Timing risk is a serious threat to one’s capacity to generate income. If it strikes, it can mean even total depletion of your savings. By making sure we take withdrawals only from safe investments during the first ten years of retirement, we make a strong stand against timing risk. 

Buckets 3, 4 and 5 are invested more aggressively. The buckets that are held for the longest periods of time hold the most aggressive assets. However, these buckets are also receiving the smallest share of your savings. The hope is that a relatively small investment, invested aggressively, will produce strong gains over 15-25 year holding periods. Then again, there is no guarantee. That’s where the pessimistic part of the strategy comes in: protected lifetime income from an annuity. Typically, the annuity income would commence beginning in year 11. Why year 11? It’s because we placed safe assets in buckets one and two that will provide 10 years of income we can count on. There is negligible risk in the strategy during the first 10 years.

Beginning in year 11, we’d take the money that has been accumulating for ten years in bucket 3 and use it to produce a safe monthly income in years 11-15. However, because bucket 3 included an allocation to stocks, we can’t know in advance how much it will have grown to by the time we will use it to produce income. This means we can’t know in advance how much income bucket 3 will produce. By starting the annuity payout in year 11, we hedge the possibility that bucket 3 (and the future buckets) may underperform. Here’s the key point: the combination of the income from the annuity plus your Social Security produces the minimum $5,000 monthly income that is required…no matter what. Constrained investors are typically attracted to this substantial level of downside protection. 

Designing and implementing a hybrid income strategy is not an ideal task for the do-it-yourself investor. You would be well-served by calling upon a financial advisor who specializes in income distribution planning. The advisor will help you choose rate-of-return targets for each of the five buckets as well as an assumption for long-range inflation. In order to achieve your “no matter what” income requirement, he or she will also calculate the share of your savings that should be invested in an income annuity. 

The advisor will use specialty software that creates your personal income plan. This is a formal, written plan that includes projections of both optimistic and pessimistic scenarios that could play out over the course of your retirement. One of these scenarios illustrates what would happen to your income plan if your investments never grew at all. While 25 years of zero investment growth is highly unlikely, this scenario would nonetheless demonstrate the plan’s ability to still provide you $5,000 per month for life. 

A second scenario would show the plan’s results assuming that the targeted rates-of-return were realized. Under this scenario, you would see your income increasing annually, eventually about doubling,  based upon the assumed rate of inflation. 

I can’t advocate strongly enough for any retiree having a thoughtful, well-designed and transparent plan for generating monthly income. The income plan gives you a defined path toward financial security in retirement. Entering retirement, that creates confidence that’s simply priceless.

David Macchia

David Macchia is Founder of Wealth2k, Inc. He is an author and entrepreneur focused on retirement security. David is the developer of the widely used retirement income solution The Income for Life Model® as well as the recently introduced Women And Income™, the first retirement income solution developed for women investors.

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