Lifetime Income Sources
There are many sources of income in retirement. Any asset that can be sold is a potential source of income that can be used to support retiree spending, as of course, are the more traditional streams of future payments. Retirement experts, however, tend to focus on lifetime income sources. These are generally streams of payments that are designed to last as long as the retiree (and in some cases, the retiree’s spouse) lives. These lifetime income sources include “guaranteed” streams of payments and non-guaranteed streams of payments. These lifetime payment streams may be paid in constant real dollars or in constant nominal dollars. Traditional guaranteed sources of income include payments from Social Security, pensions and life annuity products. Technically, however, even these guaranteed lifetime payment streams may not be 100% guaranteed.
Many retirement experts argue that lifetime income sources also include non-guaranteed streams of payments that may be withdrawn from a portfolio of invested assets using a pre-determined withdrawal algorithm. This source of lifetime income is generally referred to as a systematic (or structured) withdrawal plan (SWP). There are no guarantees, however, that either the SWP withdrawals will actually last for the retirees’ lifetimes or that future withdrawals will not decrease. There are numerous SWPs, ranging from approaches that employ simply withdrawing interest and dividends earned on investments, to approaches that consider withdrawing some of the investment portfolio principal. See our posts of December 21, 2016 and January 12, 2017 for discussion of why SWPs may work well in certain limited situations, but may not work well if the retiree’s total income sources are not expected to be paid linearly in constant real dollars throughout retirement. This may occur, for example, if:
- The retiree has lifetime income source(s) that are not indexed to inflation
- The retiree has lifetime income source(s) that are not paid for the entire period of retirement,
- The retiree has significant non-lifetime income sources (see below), or
- The retiree spending goals are not consistent with constant real dollar spending in retirement
Any expected future single payment or stream of payments, even if not designed to last for a retiree’s lifetime, can also be used to support retiree spending. These sources can include temporary loan repayments from family members or business associates, temporary part-time employment income, proceeds from future sales of assets, etc.
While lifetime income sources generally pay as long as a retiree lives, the stream of payments may not cover the retiree’s entire period of retirement. In some cases, payments from these sources may commence long after the individual retires. Examples of such deferred sources of income are deferring commencement of Social Security benefits and deferred annuities (such as QLACs).
Another significant source of income for many retirees today is home equity. Home equity can be tapped in several ways, including selling the house, downsizing or taking out a reverse mortgage. The payments under a reverse mortgage can be structured as a stream of payments to be paid for as long as at least one borrower continues to live in the property, as a stream for a shorter period of time, as a line of credit, or as a single lump sum payment. Thus, this source of income may not always be a lifetime income source.
When comparing spending strategies, many retirement researchers make simplifying assumptions that individuals have Social Security and maybe one or two other lifetime income sources that are not deferred and, in total, are expected to be received linearly in constant real dollars over a retiree’s lifetime planning period. They also assume that individuals will determine their annual spending by summing these individual sources of income and will spend exactly this amount each year. In the next section, we will look at the potential problem with making such simplifying assumptions.
Summing Up Individual Sources of Income to Develop a Spending Budget
The primary problem with summing individual sources of income to determine how much one can spend in a year is that it increases the odds that a retiree’s spending strategy will be inconsistent with the retiree’s spending goals. While each of us has potentially different spending goals in retirement, typical goals include:
- Assets should last a lifetime, but retirees generally don’t want to significantly underspend and leave more assets to heirs than desired
- Assets should cover essential expenses now and in the future, and desired level of non-essential expenses
- Assets should cover non-recurring as well as recurring expenses
- Spending budgets should be relatively stable from year to year, and relatively linear over the retiree’s lifetime planning period (but not necessarily linear in constant real dollars).
Budgeting and Determining Withdrawals from an Investment Portfolio under the Actuarial Approach
An SWP approach prescribes an algorithm for spreading investment portfolio assets over a retiree’s lifetime and anticipates adding that amount to income from other sources to determine the retiree’s spending budget. The Actuarial Approach, on the other hand:
- first develops a spending budget for the current year that is consistent with the retiree’s spending objectives, and
- subtracts income from other sources for that year from that spending budget
We at How Much Can You Afford to Spend are big supporters of using lifetime income sources to manage longevity and investment risks. We are not big fans, however, of SWPs or of summing sources of retirement income to determine a retiree’s spending budget. We believe that developing a reasonable spending budget using the more holistic Actuarial Approach is a better way for you to accomplish your spending goals in retirement.