How to replace your paycheck in retirement

As you approach retirement, one of the biggest hurdles – and the question I get asked most often – is “how do I replace my paycheck in retirement?” If you’ve been earning a paycheck for 30-40 years, it’s natural to wonder. And since you have only one shot at retirement, it’s important to get a clear answer before you quit your job.

In this article I’ll describe two common strategies that are inflexible or guaranteed to leave money on the table. I’ll also describe the one strategy I prefer.

This article is for educational purposes only. Please do not make any decisions based on this article without first speaking to a professional.

Don’t: Buy an annuity

One way to replace your paycheck is to… buy a paycheck. Many insurance companies sell products called annuities which provide the buyer a monthly paycheck for the rest of his or her life. These products will reduce the risk that you outlive your money, and a steady paycheck is an appealing option to consider, but there are at least two downsides.

The biggest downside to annuities is a lack of flexibility.

First, consider the extreme worst-case scenario in which you die in a tragic accident shortly after purchasing your annuity. Your retirement savings do not pass on to your heirs; the insurance company uses your money to pay benefits to other annuitants who are still living. Many annuity products do have beneficiary provisions which will pay something to your surviving spouse or children, but you will pay for these provisions through a reduction in your living benefits.

Second, and more importantly, when you purchase an annuity, you are giving up a great deal of flexibility. Most annuities contain provisions called “surrender charges”, which is a penalty you must pay if you want to withdraw more than the guaranteed amount. Surrender charges are typically in effect for at least 7 years after purchasing the annuity. In other words, if you buy an annuity, you’d better be darn sure that’s what you want.

These are not the only downsides to annuities, but you’ll have to buy me a drink to hear more.

Don’t: Live off (only) the interest

An alternative plan is to retire and live on the income – the dividends and interest – created by your investments. This strategy is appealing because you don’t need to sell any shares to create income, providing the effect of security and longevity.

This method can work well, but there are two problems. First, you need a huge pile of savings; if you wanted your portfolio to create $2,500 of income each month, you would need to have around $1.5 million in savings.

The other problem is when you only spend the dividend income, your savings account balance will grow throughout your entire retirement, and when you die you’ll have a large pile of money for your heirs to deal with. And while a large pile of money sounds like the best problem to have, it represents missed opportunities; you could have spent that money on a family vacation, or you could have given it during your life to a person or a charity you care about.

Do: Spend your principal

If you want an income plan that is flexible and that maximizes your spending potential in retirement, you will need to sell and spend down some of your principal balance. This is usually done alongside portfolio rebalancing: if stocks are up, you’ll sell stocks; if stocks are down, you’ll sell bonds.

And while depleting your savings may make you uneasy, if done properly it is quite safe, though there’s a lot resting on that big “if”. To do it right, you must select an appropriate asset allocation, rebalance with discipline, and spend prudently.

How much can I sell?

There have been numerous academic studies that inform a prudent retirement spending plan. The most famous of these created what’s known as the 4% rule, which allows you to spend 4% of your portfolio balance, adjusted for inflation, each year for 30 years.

The rule was created using historical data (i.e. it’s not guaranteed to work in the present), and it has its own downsides, but it’s usually a good place to start when creating your spending plan. Since the 4% rule is a fixed (after inflation) spending amount, it’s known as a “static spending” rule.

There are also software programs which use probability-based projections to give you an estimate of how much you can safely spend in any given year, a concept known as “dynamic spending”. These programs are the “heavy machinery” of retirement planning and should not be used without having the knowledge needed to interpret the simulation results.

About the Author

Joseph Fowler, CFP® is a financial planner and co-owner of 402 Financial in Lincoln, NE.

402 Financial helps people who are in or nearing retirement spend their money. Joe always acts as a fiduciary and never takes commissions on product sales.

If you are considering retirement, click this link to see if you have enough.