For many people, retirement is a leap into the unknown. In addition to the changes in lifestyle, plus the social and psychological impacts, there’s the financial side. Without the predictability of a steady paycheck, people often worry how they can generate income to replace their salary while continuing to meet their expenses throughout their retirement.
Fortunately, there are several options for producing income in retirement. In the U.S., the three main ways you can obtain income in retirement are (Dabit, 2020):
- Income From Assets
- Continued Employment
In this article we will take a look at these options and describe the upsides and downsides of each.
Principles Of Retirement
Before we start, it is important to understand the underlying principles of retirement so you can be guided in your decisions. They are:
The Principle Of Income suggests that you only draw retirement income from accounts that have not received significant losses.
The Principle Of Diversification suggests that you diversify your assets by objectives, like taking income, minimizing taxes, leaving a legacy, buying a boat, or whatever else you may want in retirement.
The Principle Of Planning suggests that predetermined guidelines increase your probability of future success. Winging your retirement is a great way to run out of money early.
We believe these principles can significantly increase the probability success in retirement. If you want to learn more, click here. Otherwise, let’s dive in!
Pensions used to be the prevailing retirement benefit for most workers in the U.S., but in recent decades it has largely been replaced by 401(k)s. Still, 31% of individuals age 65 or over were receiving pensions in 2019 (Pension Rights Center, n.d.).
Pensions are most common among government employees, and are also accessible to 12% of private sector retirees. The median annual pension benefit in 2019 was $27,687 for federal government retirees, $22,662 for state and local government retirees, and $10,788 for private company retirees.
An advantage of pensions is their predictability: like a paycheck, you can depend on receiving this amount each year, regardless of how the stock market or the economy is doing. While these amounts are often not sufficient to fund an entire retirement lifestyle, pensions do provide a valuable supplement to other retirement income.
If you’re one of the fortunate few that has or will have a pension, you may be wondering how to maximize the amount. We’ll cover that in just a moment.
A disadvantage of pensions relative to 401(k)s and IRAs is lack of control: the amount depends partly on factors outside of your control, and you can’t try to increase the amount by changing your investments.
Also, your pension is only as good as the credibility and stability of the company that manages it. Take a look at PanAm back in the day. Lastly, pension income is taxable. If taxes go up in the future, your pension income goes down.
Maximizing Your Pension
Most pension amounts are based on the number of years of employment and your salary while working. You can check with the HR department at your employer to find out the exact formula used, and consider working on the things you can control.
For example, could you try to increase your salary through raises and promotions? Can you work a bit longer to raise your length of employment? Keep in mind, however, that by working longer you’re trading years of your life for an incremental increase in your pension.
You could also consider negotiating with your employer for a larger pension amount. Many employers are having difficulty attracting and retaining workers, and are spending more on retirement plans to deal with a tight labor market (Tergesen, 2018). Yours might be amenable to offering a larger pension.
Some companies offer the option of paying your pension as a single lump sum instead of recurring payments over time (a pension buyout). This route can be advantageous for the company, as it avoids the expense and trouble of funding and administering a pension plan for two decades or more.
But is it advantageous for you? That depends on how confident you are that you can use the lump sum to generate a sustained income stream higher than the pension amount would have been. Your investment knowledge and style, risk tolerance, health and marital status, and other retirement assets you have all are factors to consider. It’s best to consult a qualified financial advisor when faced with such critical decisions. If you take the buyout (or lump-sum), make sure to roll it over into a traditional IRA so you don’t pay taxes.
Income From Assets
This is where your previous decades of prudent saving and investing finally pay off. Some popular income-generating assets are annuities, stocks, mutual funds, ETFs, bonds, and real estate.
An annuity is a contract typically between you and an insurance company and is specifically intended to generate income. You purchase an annuity with either a lump-sum payment or a series of payments. In return, the annuity issuer agrees to pay you a regular income, starting either immediately (an immediate annuity) or at an agreed-upon time in the future (deferred annuity).
You can receive the payments monthly, quarterly, or yearly. You can also choose to receive payments for a fixed interval of time, such as 20 years, or for the rest of your life. Like a pension, one of the main benefits of an annuity is guaranteed income in retirement.
Different Types Of Annuities
You can choose a fixed annuity, variable annuity, or indexed annuity. A fixed annuity gives a specified amount each time. But the return tends to be relatively low, typically slightly higher than that of a CD.
With a variable annuity, you invest your savings in a set of mutual funds within the annuity. The payout is based on the performance of those mutual funds. Be ware of the fees in variable annuities as they can be hidden and lead to significant underperformance.
An indexed annuity has a guaranteed minimum payout, and an additional payout that is based on the performance of a stock market index like the S&P 500. The upside is if the markets do well, you also can do well. But if the markets don’t preform, you don’t lose any money, but you also don’t make any money.
The payments you receive from an annuity include both a return of principal (your investment in the annuity) and a return on investments the annuity provider makes on your behalf. Like a 401(k) or traditional IRA, your annuity balance grows tax-deferred.
Please note, there are many different annuities available and they all have unique offers. Make sure to take your time and review what is being offered before you buy.
Normally your annuity payments are taxable as ordinary income. This depends on whether pre-tax or after-tax funds were used to purchase the annuity (Probasco, 2021). For example, if you purchase the annuity in a traditional IRA, this is pre-tax money and all payments are taxable. If you purchase the annuity in a Roth IRA or Roth 401(k), all payments are tax-free because the Roth IRA is tax-free. But the Roth IRA rules still apply: you cannot withdraw the payments from the IRA before age 59 ½ without penalty. If you purchase the annuity with after-tax funds, the gains will be taxed when taken out, but the principle will remain tax-free.
Annuities are right for some people but not others. Some advantages of annuities are:
- Tax-deferred growth
- Steady, predictable income (fixed annuity)
- Opportunity to benefit from stock market returns without risk to principal (indexed annuity)
- Flexible terms (you can choose when and how to purchase and receive payment)
Some downsides of annuities compared to other income sources are:
- Some have high management fees
- Illiquidity – usually you can only take out around 10% each year without a surrender charge
- Terms may be complex and hard to understand (variable and indexed annuities)
- Guarantee is only as strong as the insurance provider
Stocks and Bonds
Dividend-paying stocks, bonds, and income mutual funds are another way to generate income in retirement. While stocks are typically thought of as long-term investments, stock dividends are actually a popular source of retirement income.
Proper dividend investing can help protect your principal, ensure your income grows to keep up with inflation, and produce a growing income regardless of overall stock market performance. A portfolio of stocks that pay dividends which grow in value over time can give you higher returns than CDs.
With dividend stocks, much of the return comes from the dividends rather than growth in the stock price. If the dividend is consistently growing, your income stream will remain unaffected regardless of the stock price.
Many mutual funds also provide income. Investing in a single mutual fund can give you exposure to hundreds of stocks of different types and industries. This diversifies your savings so you’re not so dependent on the performance of a single stock. However, you don’t have control over which stocks the mutual fund invests in. Some stocks may not match your income goals or risk tolerance. Recently, Vanguard High Dividend Yield ETF, a well-known income mutual fund, lost 25% of its dividend income because the underlying stocks’ dividends were not safe. It took four years to recover.
Buying individual stocks gives you greater control because you can choose stocks that match your financial goals. You also avoid the management fees levied by mutual funds.
Dividend investing requires you to carefully select stocks for dividends while continually watching those companies over time to help ensure the dividends aren’t in danger of being cut. This requires some time and investment knowledge.
Some advantages of investing in dividend stocks are:
- Higher potential returns than CDs
- Relatively safe and predictable income as long as you focus on dividend safety
- High degree of control over your investments
Some disadvantages are:
- Requires investment knowledge and time to ensure the dividend remains safe
- Your savings balance can fluctuate with the stock prices
Bonds and bond mutual funds are another way to receive passive income. Corporate bonds and government bonds are the two main types.
There are two main types of corporate bonds:
- Investment grade corporate bonds. These are issued by companies with relatively good credit ratings.
- High-yield bonds (also called junk bonds). These are issued by companies with lower credit ratings.
High-yield bonds are riskier because of the companies’ lower credit ratings. While the historical default rate of investment grade corporate bonds is 3%, the default rate of high-yield bonds can be 7% or higher. So even if you hold a high-yield bond to maturity, there’s no guarantee you’ll continue to receive interest payments or the bond’s value at maturity.
Besides corporate bonds, other major types of bonds are:
- Federal government bonds. These are issued by the federal government and are considered the safest types of bonds. They are backed by the full faith and credit of the U.S. government.
- Municipal bonds. These are issued by state and local governments. They are somewhat riskier than federal government bonds, but are exempt from state taxes. This means the after-tax yield on a municipal bond may be higher than other types of bonds if you live in a state with high taxes.
Series EE savings bonds are issued by the federal government. These bonds pay interest until 30 years after purchase or until you cash out, whichever comes first. EE bonds pay a fixed interest rate, which is added to the bond monthly and is paid when you cash out. Additionally, at this time the Treasury guarantees that a bond purchased now will be worth twice its value in 20 years, if held that long.
The riskier a bond is, the higher interest rate it offers, to compensate investors for taking on more risk. So high-yield bonds have higher interest rates than investment grade corporate bonds, and corporate bonds have higher interest rates than government bonds.
The default rate on corporate bonds has historically averaged around 3%, but last year jumped to 6.2% because the pandemic shutdown impacted companies’ revenues and cash flow.
Bond mutual funds are a convenient way to invest in a basket of bonds with a single investment. A major disadvantage of bond mutual funds is that their value changes inversely with interest rates. By owning an individual bond, you probably will receive your investment back at maturity, regardless of how the bond price has changed in the meantime. With a bond mutual fund, the fund value may be higher or lower than when you bought it. Since interest rates are projected to rise in the next few years, it’s likely that bond funds’ values will decrease.
How much income does a stock and bond portfolio generate? A well-known rule of thumb is the “4% rule.” Following this rule, you withdraw 4% of the total value of all of your savings in the first year of your retirement. Each subsequent year, you increase the withdrawal amount by the amount of inflation. So, if your savings total $1 million, then in the first year you withdraw $40,000. If inflation is 3%, then in year 2 you increase the withdrawal by 3% to $41,200, and continue that for the next 30 years.
This rule is intended to give a high probability of not running out of money during a 30-year retirement (Williams & Kawashima, 2020). While the rule is simple to understand and follow, it’s currently considered more of a starting point than a hard-and-fast rule. Check out our Principles Of Retirement to learn more on how to apply this rule to your retirement.
The rule assumes your savings are invested half in stocks and half in bonds, and assumes historical returns on stocks and bonds will continue throughout your retirement. As mentioned earlier, some retirees will invest more in stocks and others less. Additionally, a 30-year time horizon may not be appropriate for you, depending on when you retired. Since market performance and retirees’ life situations change, we recommend you evaluate your plan yearly or as needed, possibly in consultation with a qualified financial advisor.
Rental Real Estate
Rental real estate can make a good retirement investment. Like dividend investing, it requires knowledge and time to determine which properties will make good rental properties. Commercial offices, apartment complexes, and private residences are all good candidates for generating income in retirement. But you need first-hand familiarity with the local area to know which locations to choose, and to be good with numbers to ensure your cash flow and expenses will be what you expect. Some locations will be in high demand even in a slow economy, while others may have difficulty getting suitable renters even in good times.
Rental real estate can be a good supplement to other income sources. If you own desirable properties in good locations, you can be virtually assured of a steady stream of income from renters. Additionally, by taking a more active management role in your investments, you can increase your income and have meaningful things to occupy your time. Rental real estate also is a way to diversify your savings. Even if your stock investments aren’t doing well for a period of time, the income from your rental properties will help make up for declining values in other asset classes.
Rental real estate does come with significant risk, though. Property taxes, maintenance, and insurance expenses could rise from one year to the next, even if your property value doesn’t rise as much. If you can’t find suitable renters for some reason, you could lose money on your investments. During the Great Recession of 2008, many real estate investors lost their properties because they couldn’t keep up with their mortgages while not having any renters. You will need to make sure you have enough other savings or income to cover periods in which your properties are vacant.
One way to participate in real estate investing with less risk is through real estate investment trusts (REITs) and micro-real estate investing platforms. These are like mutual funds for real estate investments. Although they can change in value, you incur much less risk because they require much less initial investment, no ongoing expenses, and are liquid so you can easily buy and sell.
We don’t mean becoming the proverbial Walmart greeter here, though these types of roles are a popular way for retirees to supplement their income. Phased retirement is an arrangement that enables an employee in or nearing retirement to work at reduced hours and workload.
Employees nearing retirement can gradually transition to retirement by systematically reducing their working hours and days of work. Those who have retired can come back on a part-time basis. Seasonal work and job-sharing are other forms of phased retirement.
Phased retirement benefits the employer because it enables the retiree to transfer their knowledge to younger employees before they enter full-time retirement. It also benefits you, the retiree, because it enables you to enter retirement gradually instead of taking a leap, helps you preview retirement to decide whether it’s really right for you at this time, and gives you meaningful and productive things to do during the week. Many retirees miss the social interaction and identity that come with being part of the workforce. Phased retirement also helps you keep a paycheck to add to your retirement income.
Many retirees also choose to pursue second careers, either related to their previous jobs or in completely unrelated fields. You could share your business knowledge as a consultant to new startup companies. A teacher could continue teaching or tutoring on a freelance basis. A hobby or interest you’ve cultivated during your working years could become a new job.
There are many ways for retirees to generate income to make up for a lost paycheck. Most retirees rely on multiple streams of income together, such as dividends, rental properties, and Social Security. The amount of income you’ll need depends largely on your intended lifestyle in retirement. Using the 4% rule as a guide, many retirees will need savings of around 25 times their annual expenses in retirement. Your situation may be very different, however, and you might consider working with a financial advisor to determine your particular needs.
Written by Maxwell Chi
Dabit, A. (November 17, 2020). What Is the Average Retirement Income and How Do You Compare? https://www.personalcapital.com/blog/retirement-planning/average-retirement-income/
Dividend Aristocrats (June 24, 2017). Johnson & Johnson (JNJ): One of the Best Dividend Aristocrats for Retirement Portfolios. https://1.simplysafedividends.com/johnson-johnson-jnj-dividend-aristocrat-stock/
Williams, R. & Kawashima, C. (July 17, 2020). Beyond the 4% Rule: How Much Can You Spend in Retirement? https://www.schwab.com/resource-center/insights/content/beyond-4-rule-how-much-can-you-safely-spend-retirement
Pension Rights Center (n.d.). Sources of Income for Older Adults. http://www.pensionrights.org/publications/statistic/sources-income-older-adults
Probasco, J. (April 27, 2021). IRA Vs. Annuities: What’s the Difference? https://www.investopedia.com/ask/answers/071614/whats-difference-between-individual-retirement-account-ira-and-annuity.asp
Tergesen, A. (January 18, 2018). With Tax Savings, Some Employers Will Boost 401(k) Contributions. https://www.wsj.com/articles/with-tax-savings-some-employers-will-boost-401-k-contributions-1516302593