We frequently read articles encouraging retired individuals and couples to cobble together different sources of retirement income (or “design their retirement paycheck”) to meet spending needs in retirement. We call this approach the “Sum of Income Sources” (SOIS) approach. The theory behind this approach is that the sum of the income sources will replace some or all of the paychecks individuals and couples received while working; theoretically making it easier for them to manage their finances in retirement. And while this approach can work well in fairly simple situations, and in fact is promoted as a simpler alternative to other approaches (like the Actuarial Approach advocated in this website), it can fall short in many real-world situations unless it is properly modified. In this post, we will demonstrate the potential shortcomings of this approach and discuss how non-linear sources of income can be modified to make the SOIS approach work somewhat better.
Sum of Income Sources Approach
The SOIS approach generally develops a spending budget by adding current year income from sources other than accumulated savings to an annual withdrawal amount from accumulated savings calculated using a specific Strategic Withdrawal Plan (SWP). There are many different SWPs that may be used to determine withdrawals from accumulated savings (or invested assets) under this generic approach. SWP approaches include “Maintain your principal” (by withdrawing only investment earnings), static drawdown rules like the 4% Rule and dynamic drawdown rules like the IRS RMD approach. The SOIS Approach is a relatively simple approach that can work reasonably well as a budgeting tool when sources of income and retirement expenses are reasonably stable from year to year in real-dollar terms. Since SWPs don’t generally coordinate withdrawal amounts with income from other sources, SOIS approaches tend to be less effective when income during retirement is not reasonably stable in real dollar terms (i.e., non-linear) from year to year.
Examples of non-linear sources income in retirement include:
- Deferred Social Security benefits (you or your spouse)
- Deferred pension benefits (you or your spouse)
- Fixed dollar pension or annuity income
- Part-time employment income
- Inheritance
- Alimony
- Sales of assets (including homes, businesses, boats, art, etc.)
- Loan repayments from family members
- Installment payments from defined contribution plans
- Deferred annuities (QLACs, etc.)
- Payments after first death within a couple, including Social Security survival benefits
- Life insurance payouts, etc.
In our post of June 4, 2020, we also listed examples of non-linear expenditures that may not be adequately reflected in SOIS approach calculations.
There are many real-world situations where the SOIS approach can produce undesirable spending budget results. In the example that follows, we will focus on just one of the non-linear income sources outlined above and, for simplicity purposes, ignore the issues presented by non-linear expenses. We will look at how we believe part-time employment income should be reflected in a reasonable spending budget.
Part-Time Employment Income During Retirement
Research tells us that many workers plan to work for pay during their retirement, but a smaller percentage will probably actually end up doing so. For example, when asked, “Do you plan to work after you retire?”, Baby Boomers participating in the 20th Annual Transamerica Retirement Survey of Workers published in May, 2020 answered:
- Yes, Full-time: 12%
- Yes, Part-time: 42%
- No, I do not plan to work: 29%
- Not sure: 17%
By comparison, the 2019 Society of Actuaries (SOA) Risks and Processes of Retirement Survey indicated that “once retired, a little more than one-third work again, and when they do, it tends to be in more flexible roles with less responsibility that those they retired from.”
Thus, while more than half of the Baby Boomer workers in the Transamerica survey indicated that they plan to work some during retirement, the percentage of retirees in the SOA survey (not necessarily Baby Boomers) who actually worked during retirement was closer to one-third. Still, it appears that a fair number of individuals actually do work during retirement, and we can reasonably expect this to continue in the future, especially in light of the many recent early retirements resulting from the pandemic crisis
Since work during retirement generally tends to last for only a limited period of time, this begs the question of how such employment income should be considered when developing a retirement spending budget. Should the expected take home pay from employment income for the year simply be added to a retiree’s otherwise-determined current annual retirement spending budget as the SOIS approach suggests, or should a portion of this employment income be saved for future spending? The example below will address this question.
Hypothetical Simplified Example
Let’s assume that we have a single male retiree, Bill, who is currently age 66 years old. For purposes of determining his recurring annual spending budget, he has only $100 of accumulated savings and is currently receiving a Social Security benefit of $20,000 per annum. In order to supplement his retirement income, Bill anticipates working in part-time employment until he reaches age 70 earning $35,000 per annum, increasing with assumed inflation of 2% per annum.
Using the default assumptions and our Actuarial Budget Calculator (ABC) for Single Retired, Bill develops a current year recurring expense budget of $25,789 per annum. If the default assumptions are exactly realized in the future, Bill expects his future recurring expense budgets to remain constant at this annual amount throughout his retirement. A screenshot showing the results of Bill’s calculations is shown below.
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By comparison, under the SOIS approach, Bill’s spending budget under the same assumptions for the future would be approximately $55,000 ($20,000 Social Security plus $35,000 employment income) for the next four years and $20,000 (Social Security only) thereafter.
The graph below shows the expected spending pattern under these two approaches.
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The graph illustrates the problem associated with simply adding various sources of income together to develop a reasonable spending budget when one or more of the sources of income is non-linear. Clearly, if Bill desires a more stable spending pattern in retirement, he should save a significant portion of his part-time employment to use after age 70. The next section discusses a way to address this problem.
Proposed Modification of Non-Linear Sources of Income—Average Lifetime Real-Dollar Income
It should come as no surprise that we believe our Actuarial Approach produces a more reasonable spending budget than the SOIS approach in situations involving non-linear sources of income or non-linear spending. However, for those more comfortable with the SOIS approach, we recommend that non-linear sources of income be adjusted prior to adding them to linear sources of income designed to last a lifetime.
The modification we suggest using is to calculate the average of the real expected income over the individual’s or couple’s lifetime planning period. In Bill’s case, the average of part-time employment income would be determined by multiplying the $35,000 per year by 4, adding the product of $0 times 23 years, with the result divided by 27, Bill’s assumed lifetime planning period. The result in this case would be $5,185 ([(=$35,000 x 4) + ($0 x 23)] / 27) average of part-time employment earnings. When this amount is added to Bill’s linear Social Security income of $20,000 and the withdrawal of Bill’s negligible accumulated savings, the result is very close to the real-dollar result produced under the Actuarial Approach ($25,789).
The same “average lifetime real-dollar” modification could be used for the other non-linear sources of income noted above. In situations involving significant back-loaded sources of income, care should be taken under this modification (as well as under the Actuarial Approach) to make sure that cash flow during retirement is not anticipated to become negative.
Summary
As discussed in many of our prior posts (including our posts of December 1, 2020 and December 3, 2020), we believe the Actuarial Approach advocated in this website is superior to SWPs and SOIS approaches, particularly in real world situations involving non-linear sources of income or non-linear anticipated expenses in retirement. However, we realize that it may be easier for some to understand the “paycheck replacement concepts” in the SOIS approach. Since our mission is to help individuals make better financial decisions in retirement, we suggest that DIYers and financial advisors who use the SOIS approach use caution when dealing with situations involving non-linear sources of income and consider adopting the “average lifetime real-dollar” modification outlined above to produce a more reasonable spending budget.
