Once we enter the workforce and begin our careers, paychecks become a regular part of our lives. We get a deposit on a regular basis into our checking accounts, and we build our financial lives – saving some, paying bills, planning for vacations, etc. Handling household expenses from regular deposits becomes natural after a 40-year history of working.
What happens when the paychecks stop, and retirement begins? It is one of the most pressing questions we hear from people approaching retirement. The question doesn’t seem to be tied to the size of one’s nest egg. They want to know mechanically, how the household expenses will be paid each month when the paychecks stop.
Addressing this issue was a big part of the reason pensions were created in the 19th century. Most older workers could not afford to stop working. Replacing a paycheck with a monthly pension check provided a means for companies to retire older workers. Social Security checks began in 1940 and provided yet another replacement for a paycheck during retirement.
Savings started to grow for workers approaching retirement, and they bought bonds to generate interest that could be used for income. Banks started issuing certificates of deposit (CD) in the 1960s which were used in much the same way. Retirees merely needed to buy enough bonds and/or CDs to have enough interest to use as their retirement paychecks to pay their expenses.
Today, pensions are being eliminated by many companies and interest rates are at historic lows. Social Security is still around although its financial stability is in question. Social Security was not meant to replace a worker’s paycheck in retirement, but as a supplement to retirement income.
Advisers have created many systematic approaches to address the retirement paychecks challenge. It is not unusual to pick up a trade magazine to find yet another “approach” to an income generating strategy for retirement. Some strategies utilize a portfolio of bonds and dividend-paying stocks. The portfolio simply passes through income as it is received. Other strategies recommend using income annuities to create a private pension for life for part of the portfolio. The balance is invested for growth to provide an inflation hedge. There are many ways to approach investment strategy in retirement but in the end, we need to answer just one question – will this strategy effectively replace regular paychecks all the way through retirement?
Our Approach to Generating Retirement Income
At Rodgers & Associates, we approach this issue with the objective of generating a steady, reliable, retirement paycheck. The goal is to achieve this with the least amount of risk, taxation, and expenses. Ideally this can be done while providing as much flexibility as possible while maintaining a long-term investment strategy. The first thing we address with the client is the mechanical process of generating their retirement paycheck. A deposit can be made monthly to their bank account on the same day and in the same amount. They can pick the day of the month. Some prefer the same time Social Security benefits are paid. Others want it split into two deposits on the first and fifteenth. Whatever works best for the client.
The details of where the funds are coming from are left to us. Whether it comes from dividends and interest, capital gains liquidations, a required minimum distribution from an IRA, or a maturing bond is part of the strategy. We make these decisions based on minimizing taxes, transactions costs, and maintaining a balanced investment portfolio. The mechanical challenge of how to generate their retirement paychecks entails maintaining a predictable stream of cash. We never want a bad market to affect their monthly paycheck. Knowing when interest and dividends are being credited while having bonds mature on a regular schedule helps to achieve this goal.
Capital gains are not as stable and predictable as dividends or interest. However, capital gains are key to the long-term viability of the income stream and insulation against inflation. Our objective is to have several years of income planned out with dividends, interest and maturing bonds. This should allow the market time to go through a complete cycle, so we have the opportunity to harvest gains. Capital gains can generate substantial amounts of additional retirement income — we just can’t predict when that will be. Managing gains over time allows us to take a steady approach of generating regular deposits into a client’s checking account combined with other sources of income.
I’m often asked whether the simplest solution to generating steady retirement paychecks is to purchase a traditional single premium immediate annuity. The retiree would effectively be buying a private pension income. Indeed, for the most risk adverse client, this is a solution worth considering. Although, I would be hesitant to ever recommend annuitizing 100% of a retirement portfolio. The annuity provides no flexibility. Once the terms are set and the income starts, it most often can’t be changed. There is also nothing left for children or heirs. The income ends at death (or for some certain period). However, it does move the risk to the company issuing the annuity.
The bottom line is there are many approaches to producing retirement income. Our approach is one that has worked for our clients in good times and bad. We continue to review our policies and strategies to fine tune the process. Generating a regular paycheck for our retired clients is a matter we take seriously.
Learn more about our approach to retirement planning and what sets us apart from other financial advisers.
- The Social Security Act was signed in 1935 but the first monthly income check was not issued until January 1940.
- The first certificate of deposit was introduced in 1961 by First National City Bank of New York (now Citibank).
- Andrew Carnegie founded the Teachers Pension Fund, which in 1918 became the Teacher’s Insurance Annuity Association (now known as TIAA-CREF).