5 Steps To Build A Retirement Investment System is adapted from Keep It Simple, Make It Big.
Finance is a lot like fitness. No matter what you read, hear, or are pitched, there is no single solution, no silver bullet to getting in shape. Likewise, there’s no one solution for retirement investment.
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Rather, you need a system. With a system of exercise and diet, applied consistently over many years, you can attain your health goals. In the same way, to reach your financial goals and live a comfortable retirement, you need a system of investment.
Universal Steps For Building A Retirement Investment System
Everyone needs a system. Without a system, your retirement dream could quickly turn to a nightmare, as you struggle to make ends meet. While each individual’s system will vary according to their needs, there are five steps that are universal.
Step #1: Establish Your Goal
The first requirement in your system is a goal. Life is like that. If you don’t care where you are going, any road will do. That should not be the case for your financial plan.
Start by thinking about what money means to you. It could be freedom, security, time with family, power, control, or something else. Whatever it is, it will affect your goal.
Then think about what your ideal retirement looks like. Where are you living? What are you doing? How much money do you need each month to have that ideal?
Here’s an example of a goal: based on a detailed expense projection, with family vacations factored in, a couple needs to generate $8,000 a month in pre-tax income. That’s the need.
Step #2: Evaluate Your Resources
After establishing your goal, you next need to evaluate your resources. Start with what you already have available, and then calculate what you still need to reach your goal.
For our example couple, let’s assume they receive $4,500 in Social Security each month and do not have a pension. Therefore, they need to generate $3,500 from investments.
The first thing to figure out is the size of the portfolio required to generate this income. Most people do not want to invade principal, and it takes a lot of assets to generate enough income through interest.
So how much income can safely be withdrawn from a portfolio?
The widely, although not universally accepted, answer to this question is 4 percent a year. Pessimists on financial markets claim this may be too high. Other researchers relying on historical data show that a rate could be higher if careful systems are followed.
For the purposes of this example, we will use 4 percent. It has been tested relentlessly with both real-world returns and academic laboratory modeling, and I consider it safe in my practice.
Using 4 percent, this couple would need a portfolio of $1,050,000. ($1,050,000 x .04 = $42,000 a year, or $3,500 a month.)
Let’s assume that they have $1,200,000 among retirement plans, bank cash, and non-qualified investments. If they didn’t have enough, they’d have to reevaluate their goals or go to a more aggressive withdrawal plan that would rely on using principal.
Step #3: Create an Income Reservoir
Safety needs to come first, and the first piece of safety here is to create an income reservoir. I often call this the operating account. This mandatory account is a pool of money that will protect principal and be liquid when needed.
I usually suggest three to five years of income. In this example, the couple needs $42,000 of income a year, so they need $126,000 to $210,000 for their income reservoir.
How these monies are invested will depend on options available in employer plans—many have attractive stable value funds that can’t be replicated in IRAs—and the interest-rate environment. The key is that this is an expected income reserve, not emergency reserve, so each $42,000 needs to be available at the start of the year. Laddered CDs can therefore be used if the rates are attractive.
For this example, let’s put $160,000 or roughly four years of expected income into this account. We now have $1,040,000 of the original amount left.
Step #4: Create a Retirement Account
The next account to consider is what I call a retirement account. This is an annuity, typically a variable annuity with an income rider, although it could be a fixed-indexed annuity with an income rider.
There are two reasons to use annuities.
First, because they are expected over time to use both principal and returns to generate income, they can generate income at a rate greater than 4 percent, and in some instances, as high as 7 percent. This income will generally not inflate over time, but it will initially relieve pressure on the investment portfolio.
Second, they are hybrid accounts that combine liquidity and guaranteed income. Unlike an immediate annuity that requires people to give up substantial sums to “purchase” a lifetime stream of income, these products allow people to retain access to the principal, subject to the terms of the contract. Typically, there are surrender charges that limit full access to investment values for a number of years.
It’s important to be clear on the structure of the account. Money used to generate the income can’t be removed in lump sums without affecting the amount of income. This is true of investment accounts as well, but it’s more pronounced with annuities as the income guarantees are often greater than the account value.
For our example, let’s move $200,000 into a variable annuity with a 6 percent income rider. This will generate $12,000 a year or $1,000 a month of income.
Since this income is initially guaranteed, it reduces our target need from non-guaranteed investments from $3,500 a month to $2,500, or $30,000 a year. Our income reservoir now covers more than five years of withdrawal needs.
Step #5: Create a Capital Account
The remaining $840,000 is invested in a total return investment portfolio consistent with the couple’s tolerance for long-term volatility. I call this the capital account.
If we assume a moderate risk tolerance, it will be between 60 to 70 percent equity. In years of positive market returns, this account will supply $30,000 a year of income. This is 3.6 percent of the account’s value, which is in the safety range of the 4 percent rule.
Many years, this account will earn far more than its target, and this money can be redeployed into the reservoir for future safety or to replace past withdrawals, used for one-time purchases, such as once-in-a-lifetime vacations, or left in the account to compound. In flat and down years, withdrawals can be stopped and taken instead from the reservoir account.
Customize the System
Any retirement system you choose must fit your personality. Fortunately, this five-step system is modular and easily customized for each person, depending on asset levels and tolerance for risk.
More aggressive investors, for example, might forego the variable annuity. Or couples who do not care about having money left over after they’re gone might choose to take greater income early in retirement, when they’re both around to enjoy it.
By customizing this five-step system to your needs, you can better manage your assets and generate reliable inflation-adjusted income in retirement.
For more advice on creating a retirement investment system, you can find Keep It Simple, Make It Big on Amazon.
About the Author
Michael Lynch is a Certified Financial Planner with nearly twenty years of experience working with American families to craft plans that fund their dreams, educate their children, and finance their retirement. Michael has contributed to the Wall Street Journal and Investor’s Business Daily, and hosted Smart Money Radio for a decade. He’s served as an adjunct faculty member at Fairfield University and currently teaches financial planning to employees of corporations like Madison Square Garden and Yale New Haven Health Systems. Michael is a five-time Financial Planner of the Year for MetLife and a 2019 inductee to the Barnum Financial Group Hall of Fame. You can enjoy his latest articles and videos at www.michaelwlynch.com.