Turning your retirement savings into a flow of predictable income payments is, of course, essential to a successful retirement. It's also often one of the hardest and most overlooked tasks leading up to actually retiring.
There are three components to the job. Some experts may give them different names but they amount to Your Preparation, Your Buckets, and Your Investments.
Review 10 or even 20 retirement books and the same preparation steps appear over and over again. Here are the primary ones common to most approaches:
1. Add up the value of your savings and investment accounts.
2. Calculate how much additional money you can afford to set aside each year.
3. Play with some different possible rates of future investment gains and see what your nest egg looks like down the road when you'd like to retire.
4. How long do you think you'll live? Most experts recommend erring on the side of longevity but your family health history may argue otherwise. For starters, figure you'll be able to pull 4 percent out of your portfolio every year and not risk outliving that income. However, this 4 percent "rule" is increasingly being challenged as too inflexible in today's volatile market environment. Use it as a guide.
5. Factor in Social Security and any pensions you are set to receive.
6. Total your annual retirement income (don't forget to consider taxes).
7. Build a realistic retirement expense budget; consider setting aside a cushion for emergencies.
8. Compare your income and expenses. Perhaps you'll need to tack on some more working years before they balance out. Most likely, you'll need to cut expenses as well.
Retirement income needs to be broken down into components that achieve different objectives. Some people call these pieces of retirement income buckets; others may call them tiers or layers.
Most experts say you should have a cash spending account that begins with enough money to pay all your expenses for at least several months, and even longer if you can afford it. This will reduce the pressure to sell securities when market conditions are bad. It's also the account into which your retirement income payments will flow, often automatically due to electronic deposit arrangements.
Next, you should think about aligning your guaranteed income with your essential expenses—the things you have to pay. Guaranteed income includes Social Security and pensions. If this income does not cover your basic expenses, many advisers suggest using some of your nest egg to buy the missing piece of guaranteed income.
The most common way is by buying an annuity, but you also could consider buying U.S. securities and using their interest payments to cover the basic expense gap. At the same time, many other advisers say they prefer to close this basic spending gap with investment earnings from your nest egg. Odds are, you'll earn more money than with an annuity. And while your investment earnings are not guaranteed, you will not have to largely give up control of your funds, which is the case with an annuity.
Discretionary spending would then be provided from your investment funds. The thinking here is that you could curb such spending if market downturns reduced your investment income. You could even split your discretionary spending into smaller buckets, reserving your highest risk-highest return holdings for luxury and whimsical spending plans that wouldn't crush you if your investments fizzled out.
Lastly, you may have a legacy bucket and want to leave money to your heirs.
Once you've defined your income buckets, there is still a lot of heavy lifting to actually produce those regular income payments. Where are all your investments parked? Which ones are taxable and which ones aren't? How do you maximize tax benefits when withdrawing funds? What about those federal rules requiring minimum distributions from IRAs at a certain age? How do they work?
There is lots of good news here for self-directed investors who can't afford or don't want their own financial adviser. It's hardly a secret that millions of baby boomers are entering their retirement years. Trillions of dollars of employee retirement accounts will need to be converted in coming years into sources of long-term income payments. Investment firms, particularly the big mutual fund companies that manage 401(k)s for millions of employees, want access to this stream of conversions and lucrative long-term investment fees.
They have invested heavily to build online retirement planning, investing, and retirement spending tools. Many tools are sophisticated enough to reflect tax strategies, different investor risk preferences, and nuances of individual retirement needs. At the same time, investment companies are creating new breeds of retiree investment funds that offer systematic withdrawal plans and other "set it and forget it" funds that generate monthly payouts from investment accounts.
U.S. News reviewed the online retirement tools of the six self-directed investment firms that received the highest overall satisfaction ratings from J.D. Power and Associates. They have planning and spending tools to help shape retirement plans. Vanguard and Fidelity have the most extensive materials. In February, Fidelity launched its Income Strategy Evaluator, which is designed for retirees and helps create a specific investment program to produce retirement income.
Here are the online retirement sections of the six firms:
Sharebuilder Securities (part of ING)
In terms of general advice, "I don't think investors are going to make wholesale changes in their portfolio" when they retire, says Maria Bruno, a retirement income specialist with Vanguard. "They just want to know how they can draw money from it." This can be as simple as having dividends paid out in cash rather than reinvested.
Tax considerations play a big part in the mechanics of actually pulling income from a portfolio, Bruno notes. Investors with tax-deferred accounts or with equity holdings that have capital gains considerations are generally more likely to have several accounts from which to pull income. Investors without extensive tax concerns may choose to consolidate all of their retirement accounts into a single fund that is managed to produce regular income.
Such "all-in-one" funds have a single portfolio that can be set up to reflect a retiree's goals and desire for investment diversity and risk tolerance. "An all-in-one fund can offer great convenience to retirees," Bruno wrote in a recent piece for Vanguard customers. A newer kind of all-in-one fund called a managed payout fund takes the concept a step further. Vanguard offers three such funds and has a good explanation of how they work.
Bruno cautions, however, that any single fund approach will sacrifice flexibility and investment control in exchange for the convenience of a single source of retirement income payments. In particular, if tax optimization is a major concern, she says, an all-in-one fund may not be for you.
Chris McDermott, a Fidelity senior vice president for personal investing, spoke about the firm's recent move to provide actual retirement spending solutions in its Income Strategy Evaluator. Since 2004, he said, Fidelity has provided increasingly sophisticated retirement planning tools and has done such plans for three million customers. "What was missing was a consistent and systematic way for the investor to understand, 'How do I translate my nest egg into an income strategy?' In the past, a lot of that ... was left to the investment adviser," he says. Now, investors can do a lot of this work themselves.
The Evaluator is the most sophisticated tool among the six investment sites we reviewed. It's the only one that goes beyond helping to build a retirement savings plan and also creates a recommended portfolio of specific holdings that will produce the regular retirement income you need.
"At the end of the day, there tend to be three product categories in the retirement income space," McDermott says."The majority of portfolios will still be invested. The second piece will be some type of fixed income annuity ... Then the third piece will be a variable annuity."
Fidelity is high on annuities because they can provide guaranteed income for life and thus provide longevity protection. It recommends a layer of variable annuities to provide an opportunity to participate in future market gains, and also let investors have some control over how their annuity funds are invested. McDermott emphasizes that annuities might not make sense for everyone, and the Evaluator provides options to tailor the three product categories.
It also provides informed support on projected investment performance, tax rates, and other key variables. When it recommends an annuity package, the income guarantees and product expenses are actual features of specific annuity products offered through Fidelity. "We go out to the market [in real time] and get actual rates and fees for all of the annuities," he says, "and most of them are not Fidelity annuities."
Users of the Fidelity tool do not need to be current customers, but do have to register with their names and email addresses. McDermott says this permits Fidelity to save all the data entered by users and provide them a way to access it later. But because retirement income plans can be complicated, he also acknowledges that Fidelity believes this tool will generate lots of follow-up calls to Fidelity. "We're going to have a lot of one-on-one conversations at some point."