One of the most common questions we receive from clients or prospective clients prior to retirement is “How do I generate an income stream from my portfolio?” There are different strategies you can use, and each has different considerations and implications to weigh before implementing. Below are brief descriptions of three of them.
1. Have the dividends from your investments paid out to you. In this strategy, the investment company pays out all interest and dividends that are received on a schedule you determine (i.e., weekly or monthly). One advantage of this strategy is that you do not have to generate cash for withdrawals.
Individuals who use this strategy often like that they are not selling any investments to cover their monthly income. However, portfolios that use this strategy are often overweight in dividend-producing investments and not as diversified as they should be. Income can also vary each month, which can make budgeting difficult.
2. Take a flat withdrawal amount from the portfolio. This strategy focuses on a flat monthly withdrawal (or annual lump sum withdrawal) to keep cash flow consistent. Two advantages of this strategy are that you have consistent cash flow and you are using more than one type of income—both dividends and investment appreciation.
This withdrawal strategy typically allows for a more diversified investment approach because it does not have to focus solely on dividend payouts—it can also look to capital appreciation. However, it is important to know the overall withdrawal rate on the portfolio and ensure that it is not too high. This strategy works only if the amount withdrawn is reasonable for the allocation of the portfolio and expected long-term returns of that allocation.
3. Purchase an income annuity. In an income annuity strategy, you give up a portion of your assets for a guaranteed stream of income for a specific period (i.e., income for life or for a specific number of years).
This strategy is often considered for more conservative investors because you are taking market risk out of the equation for guaranteed income. However, there is still a risk because you are giving up assets and their future appreciation for that income. In this strategy, you may receive a lower income over the long term in exchange for not experiencing the market risk.
What You Financial Plan Should Consider
For the majority of our clients, the second strategy is the best fit because it allows for diversified investing and also the most flexibility in income payouts. However, for those using this strategy, quite a bit of work must be done before determining the appropriate income payout amount.
A comprehensive financial plan is the best strategy for answering this question. The plan should look at all of your current expenses coupled with your goals for the future. It is crucial to plan for changing goals in retirement and how they might increase your income needs.
Your plan should also consider your other income sources (e.g., Social Security, company pension plans, and business income) and your overall assets (e.g., your nest egg, savings accounts, retirement accounts, and real estate).
One other important component of the financial plan is that it needs to take allocation and market volatility into account. A financial plan based on just an average rate of return will not adequately reflect the impact of changes in the market on your long-term goals.
What to Look for in a Financial Advisor
It is also important to make sure that your financial advisor operates as a full-time fiduciary, meaning they are legally required to put your best interests first, at all times. Also look for fee-only advisors in your area. Fee-only advisors do not receive commissions or any compensation other than what you pay them directly. Serving as a fee-only fiduciary reduces the risk of a conflict of interest when it comes to the advice you receive.
Remember that no two financial plans look the same and that the right retirement income strategy for you might be a combination of multiple strategies—or different strategies at different periods of retirement. The important thing is that you find a fiduciary advisor you can trust and that the plan is customized to your needs and goals.