Introduction As retirement approaches, you might begin wondering whether the "golden nest egg" you've accumulated is enough to provide the retirement lifestyle you envision. To answer that question, you must determine how much annual income you'll need in retirement. After you've made that calculation, the next step is to develop a plan to turn your nest egg into an income stream that will be sufficient to meet your retirement needs and goals.
Retirement income planning is a very individual matter, and no single strategy or investment is right for everyone. The strategies and investments you choose should be based, at least in part, on your desired lifestyle, risk tolerance, life expectancy, potential return on your investments and their degree of volatility, as well as other available sources of fixed income such as Social Security and pensions.
There are many different types of investments available. Understanding how they work individually and in combination with other choices can help you decide which investment options will work for you.
Annuities Annuities are a common investment for retirement income planning primarily because they guarantee a stream of income for the rest of your life. Most annuities offer you the option to take regular or intermittent withdrawals as well. These types of annuities are called "deferred annuities." Deferred annuities allow your investment to grow during a period called the "accumulation" or "investment phase". During the accumulation phase, earnings accrue tax-deferred (i.e., earnings are not subject to income taxes until they are withdrawn). Most deferred annuities allow you to periodically withdraw some of the earnings (or some of the earnings and principal) from the annuity, or you can withdraw all of the earnings and principal from the annuity (this is referred to as full surrender). Another withdrawal option found in most deferred annuities is called "annuitization. "
With annuitization, you receive a guaranteed income stream from the annuity. The annuity issuer promises to pay you an amount of money on a periodic basis (monthly, quarterly, yearly, etc.). You can elect to receive either a fixed amount for each payment period (called a "fixed annuity payout"), or a variable amount for each period (called a "variable annuity payout"). You can receive the income stream for your entire lifetime (no matter how long you live), or you can receive the income stream for a specific time period (10 years, for example). You can also elect to receive the annuity payments over your lifetime and the lifetime of another person (called a "joint and survivor annuity").
Immediate annuities offer the same payment options as an annuitized deferred annuity. However, immediate annuities differ from deferred annuities in a few ways. While you can make a single payment or many separate payments for most deferred annuities, immediate annuities are usually funded with a single, lump-sum payment. Immediate annuities do not have an accumulation phase; rather, payments begin within one year from your investment in the annuity. And, unlike deferred annuities, most immediate annuities do not allow for partial withdrawals, although there are some exceptions.
Immediate annuities pay a steady income for a fixed period of time, or for the rest of your life, or for the joint lives of you and another. Often, if you have an immediate need for income, and you don't own a deferred annuity, you may be able to sell stock or mutual funds and use the cash to buy an immediate annuity. Immediate annuity payment guarantees are based on the claims-paying ability of the immediate annuity issuer.
Caution: Annuity guarantees are based on the claims-paying ability of the annuity issuer. Also, withdrawals made prior to age 59½ may be subject to a 10 percent federal income tax penalty.
Fixed versus variable deferred annuities There are two basic types of deferred annuities: fixed and variable. The issuer (an insurance company) of a fixed annuity guarantees the return of principal at the end of the surrender period. The issuer also guarantees that a minimum rate of interest will be paid on the annuity, but the actual rate of interest credited to the annuity is typically higher than the guaranteed rate. Fixed annuities can provide a source of income by allowing you to withdraw interest earnings, often as frequently as monthly, and the annuity contract may also let you withdraw a stated percentage of the annuity's account value, usually ten percent each year, without incurring surrender or withdrawal charges.
Variable annuities have a variety of investment options called "subaccounts" available for your selection. The investment choices may include general equity stocks, balanced portfolios, bonds, and other specialty investments such as international stocks. Unlike a fixed annuity in which the issuer guarantees that a minimum rate of interest will be paid on your investment, the issuer of a variable annuity does not guarantee or project any rate of return on the underlying investment portfolios. You assume all risk on the underlying performance of the variable annuity's subaccounts. However, earnings from the variable annuity can be withdrawn in the same fashion as a fixed annuity. Also, like fixed annuities, most variable annuities allow for withdrawal of a stated percentage of the annuity's account value without incurring withdrawal charges.
Caution: Variable annuities are long-term investments suitable for retirement funding and are subject to market fluctuations and investment risk, including the possibility of loss of principal. Variable annuities contain fees and charges including, but not limited to, mortality and expense risk charges, sales and surrender (early withdrawal) charges, administrative fees, and charges for optional benefits and riders.
Caution: Variable annuities are sold by prospectus. You should consider the investment objectives, risk, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the variable annuity, can be obtained from the insurance company issuing the variable annuity, or from your financial professional. You should read the prospectus carefully before you invest.
Annuity advantages One of the main advantages of a deferred annuity is that any earnings accrue tax deferred until they're withdrawn. Over a long period of time, your investment in an annuity may grow substantially larger than if you had invested money in a comparable taxable investment.
Another advantage of an annuity is that you can choose to receive payments from the annuity for your entire lifetime. Even if you live to the age of 100 or beyond, the annuity issuer must continue making the payments to you.
There is no limit on how much you can invest in an annuity. Also, in recent years, there has been a huge increase in the number and variety of annuities available in the marketplace, including fixed annuities, variable annuities, and equity-indexed annuities. In addition, most annuities have options available through riders, usually for a fee or charge, which add benefits to the basic annuity contract, such as an enhanced death benefit, guaranteed income without annuitization, and penalty-free access to annuity proceeds due to a terminal illness or disability affecting the annuity owner.
There is no age limit at which you must begin receiving payments or taking withdrawals. If you do not need the money from the annuity, you can continue to have the earnings accrue tax deferred.
If you die before the distribution period begins, the annuity proceeds will go directly to the beneficiary (or beneficiaries) you have named in the contract, bypassing probate. This can be advantageous because of the potential time delays and costs that are associated with probate.
Annuity tradeoffs Annuities normally come with higher fees and expenses when compared to other types of investments such as mutual funds and bank deposits. Almost all issuers of annuities, particularly variable annuities, charge a variety of fees for the administration and management of an annuity account. Because variable annuities have more features than fixed annuities, variable annuity fees are generally higher, but in either case, fees can be costly. In addition, many deferred annuities have surrender charges that apply if you withdraw your money from the annuity within the first few years.
Investments in an annuity are not tax deductible. You generally use after-tax dollars to purchase an annuity.
Another concern is that the tax code imposes a 10 percent penalty (in addition to any other taxes owed on the payments) on withdrawals of any earnings made before you reach the age of 59½, though there are certain exceptions.
While there are some exceptions, once you elect a specific distribution plan, annuitize the annuity, or buy an immediate annuity and begin receiving payments, there's usually no turning back. For example, you are not allowed to change from an election to receive annuity payments for a five-year period to an election to receive payments over your whole life.
Another tradeoff with certain types of annuities (specifically fixed annuities) is that the income from the annuity may not keep pace with inflation over the long term.
If you choose to annuitize your deferred annuity or purchase an immediate annuity, and select a "life only" payment option, annuity payments will stop at the death of the annuitant. It is possible that the annuitant can die without receiving at least the return of the investment in the annuity.
Assets that generate income When it comes to retirement income planning, the challenge is trying to figure out how to a generate a steady and reliable payout from your investment portfolio without running out of money too soon. While your plan should involve an asset allocation personalized to meet your particular retirement needs, it is often necessary to combine assets oriented toward growth with investments that favor income.
Investments that generate a regular, steady stream of income give you a spending base you can rely on, and may help offset some of the ups and downs of the stock market. There are many investments that provide income, including Certificates of Deposit, Treasury securities, bonds, dividend-paying stocks, and real estate investment trusts. Income may be in the form of interest, dividends, or earnings.
Caution: Yields on income-oriented assets may not be enough to meet your retirement income needs. Also, inflation tends to increase expenses over time, and some fixed-income investments may not keep up with these increasing costs. As a result, you may need to combine income-producing assets with growth-oriented assets.
Certificates of Deposit (CDs) CDs, which can be purchased from banks and brokerage firms, can be used to provide regular income. CDs pay a fixed interest for a fixed period of time, usually from three months to five years. They usually pay higher interest than a savings account, and a penalty is charged for cashing in the CD before its maturity date. Typically, you can have the interest earned from the CD paid to you as income, sometimes as frequently as monthly. Bank-issued CDs are insured by the federal government up to $250,000 per account through December 31, 2013. After that, the standard coverage limit will return to $100,000 for all deposit categories except IRAs and certain retirement accounts, which will continue to be insured up to $250,000 per owner.
Caution: A brokered CD is a bit different from a bank-issued CD. It may have a much longer term--up to 20 years--and a longer-term brokered CD may pay interest at designated intervals rather than at maturity. It also may have a call feature that permits the issuer to redeem it before maturity. Also, if a brokered CD is traded in the secondary market, the price you get if you sell it before maturity may be more or less than your original investment. Finally, if a brokered CD is issued through a bank or thrift where you already have an account, the $250,000 FDIC insurance covers both your CD and that account; anything over the $250,000 limit is not insured.
Higher yields are usually offered on CDs with longer maturities. However, to avoid the early surrender charge, you'll have to keep the CD invested until its maturity. In order to obtain higher CD yields and still maintain some liquidity, you can buy CDs of varying maturities (this is referred to as laddering). This strategy allows you to take advantage of interest rates spread over several maturities without sacrificing liquidity.
Dividend-paying stock Some companies share their profits with their investors by paying shareholders a dividend. Companies that have regular profits and do not need to reinvest all of them back into the company will issue dividends regularly. Stocks that regularly pay dividends may supply a steady source of income. Dividends are taxed either as ordinary income or as qualified dividends. In order to be taxed as a qualified dividend, you must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date, and the dividends must be paid by a domestic corporation or a qualified foreign corporation. Qualified dividends are generally taxed at the rates applicable to long-term capital gains.
Caution: Because dividends on common stock are subject to the company's performance and a decision by its board of directors, they may not be as predictable as income from a bond.
Tip: The special tax treatment accorded qualified dividends is set to expire after 2010 barring additional legislation.
Another source of dividend income can be found in dividend-paying or income mutual funds. Often called income funds, growth-and- income funds, or equity-income funds, these mutual funds invest in companies with a history of steady growth and excellent dividends. Income funds usually include not only stocks, but a strong bond component, as do balanced funds.
Preferred stock Preferred stock may be used to generate income because it pays a fixed rate of return in the form of dividends. Dividends on preferred stock are paid before the common stockholders receive a dividend. Additionally, preferred shares usually pay a much higher rate of income than common shares. Also, while most preferred stockholders do not have voting rights in the company, their claims on the company's assets will be satisfied before those of common stockholders if the company experiences financial difficulties. Almost all preferred stocks have a provision allowing the company to call in their preferred shares at a set time or at a predetermined future date.
Mortgage-related securities Mortgage-related securities are fixed-income investments that generate interest revenue from pools of home loan mortgages. Mortgage-related securities represent an ownership interest in mortgage loans made by financial institutions such as savings and loans, commercial banks, or mortgage companies used to finance borrowers' purchases of homes or other real estate. Examples include Government National Mortgage Association securities (GNMA or Ginnie Mae), Federal Home Loan Mortgage Corporation securities (FHLMC or Freddie Mac), and Federal National Mortgage Association securities (FNMA or Fannie Mae).
Corporate bonds Corporations issue bonds to help pay for expansion, equipment, or operating expenses. Corporate bonds are a company's IOU for the money you're lending to the company through the purchase of the bond. Corporate bonds provide a steady and predictable stream of income through interest payments. Though they are not risk-free (e.g., a bond issuer could default on a payment or even fail to repay the principal), bonds as a whole are considered somewhat less risky than stocks because a corporation must pay interest to bondholders before it pays its stockholders. If a company declares bankruptcy or dissolves, bondholders are compensated before stockholders.
If you're considering using bonds primarily to provide current income, buying bonds at their face values and holding them to maturity provides a stable stream of income and the assurance that, unless a bond issuer defaults, you'll receive your entire investment back.
In some cases, the issuer of the bond may exercise its right to call the bond--that is, to repay the debt evidenced by the bond before it is due. Each bond's agreement specifies whether it is callable and how soon. Typically, a bond is called when interest rates drop and the issuer can refinance the loan at a more favorable rate. The higher the interest rate, the more likely the bond will be called.
The variety of bonds available offers you the flexibility to tailor your portfolio to your individual needs and investing style. Strategies for bonds can range from something as basic as buying a bond and holding it to maturity, or earmarking the bond proceeds for a specific need, to strategies such as laddering maturities and bonds swapping to achieve a higher yield or tax advantage.
Municipal bonds Municipal (muni) bonds are issued by state and local governments. Most state and local governments do not tax muni bond interest from that state, though regulations vary from state to state. Also, muni bond interest is usually (but not always) exempt from federal tax as well. Whether muni bond interest is taxable at the federal level depends on how the issuing government uses the money raised by the bonds. If the project that the bond is funding is deemed to have primarily a private rather than a public interest, the bond's interest may be taxable at the federal level. Because of their tax-advantaged status, tax-free bonds almost always yield less than corporate bonds with the same maturity date.
Caution: Income from municipal bonds may be included in the calculation of the alternative minimum tax. Be sure to consult with your tax professional about municipal bond income.
Treasury securities Treasury securities are sold on the open market by the Department of the Treasury and are backed by the full faith and credit of the U.S. government, making them a relatively safe investment. The most commonly used Treasury securities are Treasury bills (T-bills), Treasury notes, Treasury bonds, and Treasury inflation-protected securities (TIPS). Interest earned on these Treasury securities is not taxed at the state or municipal level, but is subject to federal income tax.
Treasury notes (usually issued in 2-year to 10-year maturities) and Treasury bonds (issued in 30-year maturities) pay interest semi-annually until maturity.
TIPS are designed to adjust both your initial investment (principal) and the interest paid every six months to reflect changes in the Consumer Price Index (CPI), a widely-used measure of inflation. If the CPI increases, the Treasury recalculates your principal to reflect the change. The interest rate is fixed; however, it also will change with inflation because it is applied to the adjusted principal amount. If the CPI figure rises, the principal will be adjusted upward with the interest paid based on the increased principal; if deflation occurs, your principal could actually drop, correspondingly decreasing the interest paid. When the TIPS matures, you will receive either the inflation-adjusted principal or your original investment, whichever is greater. TIPS are available in 5-, 10- or 20-year maturities.
Real estate investment trust (REIT) A REIT is a company that buys, develops, manages, and/or sells real estate such as skyscrapers, shopping malls, apartment complexes, office buildings, or housing developments. Rather than investing directly in real estate, investors in REITs invest in a professionally-managed portfolio of real estate. REITs trade on the major exchanges, just like stocks. REITs may make money from rental income, profits from the sale of property, and other services provided to tenants. REITs also receive special tax considerations; they do not pay taxes as long as they pay out at least 90 percent of their net income to their investors. There are many types of REITs, so before you invest, be sure you understand how the one you choose functions.
Growth-oriented investments Some retirees put all of their investments into bonds or other fixed-income investments when they retire, only to find that they haven't accounted for the impact of inflation or potentially decreasing bond yields. Keeping a portion of your portfolio invested in assets oriented toward growth gives you the potential for returns that can outpace inflation and spending needs. Historically, stocks have provided the most common hedge against inflation. Keeping part of your portfolio invested for growth gives you potential for higher returns, albeit with increased risk associated with market volitility.
Stocks What role should stocks play in your retirement income plan? Conventional wisdom had been that as you approach retirement, you should convert most of your stocks and equity investments to fixed-income assets such as bonds and cash. However, several factors have evolved which heightens the importance of stocks as part of your retirement portfolio. First, retirees are living longer than ever before, which means that your income will have to last longer. While past performance is no guarantee of future results, stocks historically have had better long-term returns than bonds or cash.
Second, as inflation rises, interest rates also tend to rise. Because newer bonds would offer those higher rates, older bonds with lower returns are worth less on the secondary market. If you needed to sell a bond before maturity when its price was down, you could lose money.
Finally, payments from bonds that are based on fixed interest rates lose purchasing power to inflation over time. Stocks, however, have historically outpaced inflation over time.
Mutual funds Mutual funds provide a good way for retirees to conveniently obtain the benefit of owning a diversified and professionally-managed portfolio. Each fund invests in numerous securities and this diversification reduces the impact of a loss on any individual security. A mutual fund spreads your investment dollars among several individual securities more efficiently than you might be able to on your own. Diversity usually results in less volitility, because gains from some investments can offset losses from others.
Tip: A new type of offering has emerged in the mutual fund market which is designed to help retirees strike a balance between current income and future growth. Generically referred to as distribution funds, they are also known as managed payout funds and retirement income funds. These funds attempt to provide income while maintaining some equity for savings.
Caution: Before investing in a mutual fund, carefully consider the investment objectives, risks, charges, and expenses of the fund. This information, which you should carefully read before investing, is available in the prospectus, which can be obtained from the fund.
If you have any questions, please do not hesitate to conact Dwayne K Dowell, CPA/PFS at
dkdowell@dkdcpa.com