Retirement Income Strategy - New Thinking

Having had regular salary income for all my working life, the likelihood of depending entirely on irregular income streams in retirement is causing me rethink how we will manage our finances.

Current Situation While Working

Since graduating for college, I have always had a job with steady and increasing base compensation. I always knew what my monthly paycheck would be and on about an annual basis, the amount would increase. Planning for living expenses, future large purchases, and emergency funds has been relatively straightforward. For us, planning has been taking a percentage of the monthly paycheck and putting it towards to right category.

Future Situation In Retirement

My sources of income in retirement will be: 1) Company profit sharing retirement account; 2) Personal savings and investments; 3) Deferred compensation (stock options); and 4) Social Security. With the exception of Social Security, the amount available from these sources will be entirely dependent on investment gains. If I retire in my forties, I won't have the benefit of Social Security payments until 62 or older.

Income Strategy

As I learned in my Wealth Builder Ratio Updates for 2007 Q1, even though the stock market has a good long term return, investment income may not be predictable in the short term. I have started to work with my financial advisor, to better understand the options. I'm sure that self-employed business owners are used to this situation, but having variable yearly income is a new concept to me.

Although the strategy is still not fully developed, here is how I am thinking about about it based on insights from my financial advisor:

Regularly guarantee one to two years of income. Each year, I will transfer retirement funds and create one to two years of income in short term money instruments (3 month to 1 year CDs or Treasury Bills) prior to needing the money. This will guarantee a certain yearly income is available no matter what the stock market situation is and give me peace of mind. Of course, I will give up some market gains by doing this.

Use a risk allocation to diversify my retirement portfolio. My retirement investments need to be better diversified by risk to offer short term income protection and potential gains exceeding market returns. As described above, a part of the diversification is to have the income needed for the next one to two years in low risk and certain (perhaps lower) returns investments. Thus, any declines in the market will not affect my short term income. However, I will still benefit from the higher longer term returns of being invested in a stock market portfolio and other higher risk investments, such as as real estate or a small business.

Risk allocation is different than asset allocation. Asset allocation reduces market risk by investing in different relatively non-correlated investments, e.g. stocks, bonds, real estate and gold, and thus minimizes the negative (and positive) impact of one sector should it deviate from the norm. Risk allocation puts investment funds into different categories of - very low risk, market risk and high risk. Very low risk would include one's house and income needs. Market risk is a diversified stock market portfolio. High risk might be a single stock, real estate or a small business.

Transition to a risk diversified portfolio before retiring. In the early 2000's, I personally knew several people whose retirement plans were negatively impacted because their company's stock fell 50% just before their retirement. While their financial advisor had recommended reallocating part to lower risk cash in the year before retirement, the future retirees didn't want to lose out on any gain by the stock's 30-40% gains the previous few years. Instead the stock fell precipitously in the bear market, causing great disruption to their plans.

Continue to build wealth in retirement. Since significant wealth building is achieved through concentration, I would continue to maintain a smaller percentage of my portfolio in higher risk and potentially higher return investments. These would include single stocks, stock options, partnerships, and real estate other than my house. I am encouraged by this element since my previous retirement investment strategy was not adequately allowing for continued wealth building.

Overall, I think this is a much better strategy than one of wealth preservation, which I had been using. I will be refining my income and investment strategies for retirement over the next couple months and will post updates as I develop them.

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This is not financial advice. Please consult a professional advisor.

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