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Investing Specialists

A Checklist for Retirement Cash Flows

Maximizing nonportfolio sources of income can reduce demands on your portfolio.

Note: This article is part of Morningstar.com's 2020 special report, "Are You Able to Retire?" 

If you’ve been following the discussion about safe withdrawal rates, you’ve probably been a bit discouraged by the latest news on the topic. Thanks largely to very low bond yields, which portend weak returns from bonds over the next decade, retirement experts like Wade Pfau argue that new retirees need to be very careful when deciding how much to take out of their portfolios.

Rather than starting with the oft-discussed 4%, which back-tests have shown to be sustainable over rolling 25- to 30-year periods in modern U.S. market history, Pfau thinks the years ahead could be more challenging. For that reason, he believes that a 3% initial withdrawal rate is more like it for new retirees. (Other retirement experts, such as Jonathan Guyton, believe that the key to sustainability is to adjust withdrawals to reflect portfolio performance.)

Seeing a $1 million portfolio translate into a $30,000 cash flow in year 1 of retirement can be discouraging. But the good news is that few retirees are reliant on portfolio income alone. Most retirees will have Social Security as a key income source in retirement, and lifetime benefits can be enlarged by delaying and/or harmonizing benefits for married couples. And while pensions are ebbing away in the private sector, about a third of today’s retirees have some type of pension income. Annuities, while controversial, diverse, and sometimes costly, can be another tool for boosting income and in turn shrinking portfolio-withdrawal needs. Finally, retirees may bring other sources of cash flow into retirement, including rental income from properties, royalties, or income from part-time work.

In short, a key task when developing your retirement plan is figuring out how to enlarge that baseline of nonportfolio income and ideally finding a way to stretch it over your basic household expenses: food, utilities, rent or property taxes/HOA fees, insurance, and so on. Armed with that information, you can then determine the impact on your portfolio withdrawals and in turn your portfolio’s positioning.

As you take stock of these income sources, here are the key steps to take.

Develop your Social Security strategy.
Social Security is incredibly valuable for a few key reasons. One is that it’s a lifetime source of income; Social Security will pay you for as long as you live. Another big plus is that the income you receive from Social Security isn’t subject to market volatility but it is inflation-adjusted. It’s backed by the financial wherewithal of the U.S. government. All of these qualities make Social Security akin to the most perfect annuity you could dream up.

That's why maximizing your benefit from Social Security is so important. While the increased benefit from delayed Social Security filing isn’t always as great as is touted and some people are indeed wise to claim earlier, delayed filing still makes sense in many situations. Run the numbers based on your own situation and earnings history; married couples with different anticipated retirement dates and earnings records may find that claiming benefits at different times makes sense. 

The starting point is creating a My Social Security account, where you can see the earnings history that’s being used to determine your primary insurance amount, or PIA. That PIA, in turn, underpins how much of a benefit you’ll eventually receive. I’ve been experimenting with Mike Piper’s free Open Social Security calculator and have found it incredibly helpful; you can even factor in potential benefits cuts to Social Security in order to determine the ideal filing date.

Take stock of any pension income.
Of course, most of us will have a big old zero on this line, as pensions have been ebbing away for several decades. But for those retirees lucky enough to have a pension, the lack of market risk and lifetime income inherent in pension income is attractive. If you have reason to believe that you have a pension from an old job but have lost track of it, the Pension Benefit Guaranty Corporation has resources for finding it.

A key fork in the road for people with pensions is whether to take the benefit as a lump sum or an annuity. As Morningstar contributor Mark Miller notes, the lifetime income and lack of market risk makes taking the stream of payments through the annuity option attractive in many situations. At the same time, the economic effects of the coronavirus pandemic will put additional stresses on pension finances. Low yields aren't helping pensions, either.

If you opt for the annuity, you’ll typically have the option to choose the benefit for your life only or for your life plus that of a survivor. You may also be able to opt for a benefit over a certain period of time rather than your lifetime. If you were to die prematurely, your survivors would still be able to receive benefits. Because decisions related to pensions can have such a big impact and lump-sum buyout offers can be complex, getting some professional advice can be money well spent.

Evaluate the appropriateness of an annuity.
If the combination of Social Security plus any pension income doesn’t quite cover your basic in-retirement living expenses, than additional lifetime income through an annuity may be appropriate. (There are other reasons to consider adding an annuity, but enlarging a baseline of lifetime income is the main one.) 

Of course, annuities are a big basket that encompasses minimalist lifetime income products alongside more complicated, costly ones. In general, the academic literature indicates that adding a very simple, low-cost income annuity, either immediate or deferred, can help improve the longevity of a retirement plan. If you're venturing beyond these product types, it's crucial to understand what you're buying and what it will cost, as well as any trade-offs associated with the product.

Assess how other income fits in.
While Social Security, pensions, and annuity income all provide lifetime income streams, retirees may also be able to lean on other nonportfolio sources of income. In this idiosyncratic category of cash flow sources I’d include income from working, to the extent that you care to do so in retirement, as well as income from passive nonportfolio sources such as property rentals or royalties. Of course, whether you count on any of these cash flow sources depends completely on your situation and your personal preferences.

Additional nonportfolio cash flow sources may include cash values on life insurance as well as reverse mortgages. Retirement researcher Wade Pfau calls these "buffer assets," meaning that they’re most advantageous in periods when pulling from a portfolio is a bad idea because the holdings are depressed.

Add them up to determine portfolio impact.
The last step in the process is to total up your expected annual cash flows from these nonportfolio income sources. For some of us, this will be a single line item: how much we expect from Social Security. Armed with that information, you can then subtract out that annual dollar amount from your anticipated yearly in-retirement expenses. (Of course, it may not be quite as simple as that, in that you may not have all of these sources to rely upon in each year of retirement.) 

The amount you’re left over with is the amount that you’ll need your portfolio to replace annually. Divide that amount by your expected portfolio balance in the first year of retirement, and that’s your withdrawal rate. If you've determined that amount is sustainable, you can then calibrate your portfolio’s asset allocation based on those expected withdrawals.