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Will You Conquer the Cash Crunch in Retirement?
By: David Mandell and Dinah Bird, PhD
Posted: January 30, 2012, from the February 2012 issue of Skin Inc. magazine.
Those born between 1946–1964 are part of the 77 million-strong baby boomer generation—a generation that is now contemplating retirement. If you were born before 1946, you may already be retired or are seriously considering it. If you fit into either of these groups, the following issue will be paramount for all of your financial decisions moving forward. A common question is: How do you take the wealth you have saved and efficiently turn it into cash income to sustain yourself during retirement? Conventional wisdom suggests that financial planning for retirement should include various investment strategies for generating cash with which to live.
This simply means periodically selling assets to generate cash, whether those assets are in IRAs, personally held securities and investments, real estate or the family home. Timing the sale of an asset can be tricky, and the investment you are selling may be discounted 30–50% at the time you need to sell. Being stuck in a liquidation-only strategy in market downturns can be dangerous. Also, when selling almost any asset, you will pay capital gains taxes at both the federal and state level, which can eat up 25% of the gains. For distributions out of a qualified retirement plan or IRA, the tax bite can be as high as 45%. Relying solely or significantly on a liquidation strategy means being subject to these taxes and to the risk that such rates will increase. Given that federal capital gains tax rates are at the lowest in their history, being subject to future tax increases is not a risk to overlook
Laddered bond portfolio
A laddered bond portfolio is a strategy commonly used by retirees whereby an investor purchases a group of bonds with different maturities, attempting to match cash flows with the demand for cash. One bond might mature in one year, another in three years, and the remaining bonds might mature in five-plus years. However, as inflation goes up, the bonds in the laddered portfolio do not keep up with buying power. The bonds and their interest may pay the same, but the investor can purchase fewer goods with the same amount of money. Also, as rates rise, the prices of a fixed rate bond will fall and vice versa. Although bond-laddering is a tried-and-true approach, consider the problems of allocating a substantial amount of money to a laddered portfolio in light of today’s interest rate environment and a seven-year treasury paying 2.875%. In terms of dividend-paying stocks, dividend payouts are based on a percentage of the stock’s price. As the stock market fluctuates, so does the yield from the stock.
The life annuity is designed by actuaries to pay interest and principal back throughout your lifetime. Essentially, you write an insurance company a check today, and they pay you monthly, quarterly or annually for the rest of your life. The benefits of this strategy include: The amount the insurance company pays you is fixed and will not decrease if the stock market crashes or if interest rates fall; and even if you outlive your life expectancy, the insurance company continues to pay you or your spouse for as long as you are alive. However, because interest rates have been at historic lows for a number of years, annuity payment rates are also extremely low. This makes their internal rate of return very poor. Because you may want payments for decades in the future, only the strongest carriers should be considered. Finally, the inflation risk to this technique also weakens its attractiveness. If inflation repeats itself like the early 1980s with the prime rate at 21% or even a reasonable 8%, then a 3% annual check from the annuity is not as attractive. For these reasons, a life annuity can be part of a balanced cash income strategy, but it typically should not be heavily relied upon.
Generating income throughout retirement is a significant challenge. Consider working with a trained financial advisor to determine the best route your retirement should take.