Safe Retirement Income

A reader asked, in the comments on a previous post, why I don’t use the “conventional wisdom” of a safe withdrawal rate of 4%. I have given a lot of thought to producing income from investments, which I’ll lay out below. I’m going to ignore rental income from real estate investments, because I view that as a part-time job. People who do it, already understand it.

The safest, most secure option is an annuity. This is practically the same as buying a portfolio (or ladder) of bonds. The principal is guaranteed, the payments are guaranteed, and it’s set for life. An additional benefit, if the money is non-registered (outside of an RRSP), the taxation is smoothed over the life of the contract, producing a greater after-tax income than a portfolio of bonds. The income includes a return of capital, so that the income is guaranteed to last the rest of your life, then it’s all gone at death. This is perfect for someone who wants to spend their last penny the day they die. The last time I looked, the income represented about a 5% payout.

Another option is to buy a portfolio of growth stocks, then sell a portion each year to produce income in retirement. The first problem is how much can we sell without drawing down capital? Because the order of returns matters, only a low withdrawal rate is sustainable. Backtesting has shown that 5% will work about 75% of the time, and a 4% withdrawal rate is safe over 90% of the time. The second problem is demographic. If a large cohort (baby-boomers) all retire around the same time, who’s going to buy the shares they are selling? Possibly their children and possibly foreigners, but there is a chance for a supply/demand imbalance. The benefit of this strategy is that the capital is still available, either for lump-sum needs or to bequeath at death.

A hybrid approach is the Guaranteed Minimum Withdrawal Benefit (GMWB) offered by life insurance companies. Like an annuity, there is a minimum guaranteed payment for life. Like stocks, there is a chance of higher payments if the portfolio grows and a chance some capital could be left at death. In practice, the income offered is 5% and the fees are often over 3%, meaning that if the stock market doesn’t return over 8% consistently (again, the order of returns matters), there won’t be any increase or remaining capital. The retiree needs to choose whether or not the guarantees are worth the cost.

Another modification to the “all capital gains” method is to use “buckets.” In this scenario, a retiree would keep three to five years worth of income in cash or, better, government bonds. If the stock market turns down, the bonds are sold to fund retirement income. Later, when the stock market grows, profits can be used to fund the bond “bucket”. This adds some safety at the cost of lower returns on bonds than on stocks, but market can take longer than five years from crash to full recovery. It’s an improvement over all capital gains, but it’s not as safe as all guarantees.

The final option is to use dividends from stocks. The yield that can be achieved is probably 4% – 5% currently, but it depends on the market level. The risk is that dividends are not guaranteed and could be skipped or cut. The benefit is that there is also a possibility of capital gains to fall back on. Sometimes the market favours large, dividend-paying companies (and the current environment seems to be one of those times), and sometimes those companies fall from favour (such as the Nifty Fifty). Nothing is foolproof.

Many people will only use investment income to supplement a government pension (eg. CPP) and benefits (eg OAS) and possibly a company pension. In this case, guarantees are in place and are less necessary for income from investments. The approach that’s right for any given individual depends on the level of income required, the various sources of income in place and the degree of guarantees they need to feel comfortable. But in each of the above examples, 4% – 5% seems to be about the most income a retiree (who is never planning to return to work) can expect.

On a personal note, I’m happy to plan using the total amount of income I am currently receiving from investments. That’s partly because I bought during the market crash, when yields were high because share prices had fallen precipitously, and partly because I always plan to earn income through some form of work.

Are there other options for income from investments? Which ones do you feel most comfortable with?

11 thoughts on “Safe Retirement Income”

  1. I think most people would prefer to have consistent income, rather than spending only the profit from the prior year. If someone is retired and invested in stocks, they can’t just stop taking income for a year (or longer!) while waiting for the market to recover.

    I will admit that I didn’t look closely at the website you suggested. However, this is about exploring ideas, and not tools. I want to understand people’s reasoning for what they do, and “I used the calculator on a website” makes for a very short discussion.

  2. One of the best “ideas” is to spend what this “tool” projects as being available to you, each year, in a lifetime plan. You spend from your stocks, bonds, GICs and annuities to the extent you “prudently” are able based on this tool’s projections. You re-evaluate once a year to ensure that you are not overspending. This is much more confidence inspiring than picking an arvitrary draw-down rate.

  3. The tradeoff with annuities is that in exchange for a guaranteed income, you no longer have access to the capital. So if you needed to dip deeply into reserves, they’re not available.

    Thus I’ve decided that when I’m approaching 80 years old, that a ladder of CDs is probably the best compromise between an annuity and the challenge of maintaining a stock/bond portfolio.

  4. George, you’re right, of course, about the tradeoff with annuities. I see a pension as being equivalent to a pension. I mentioned pensions at the end, as a source of guaranteed income. There is very little decision-making around a pension, but it may affect the other decisions you make. For example, if 50% of your income is guaranteed from pensions, and it covers all your basic needs, you may choose to be more aggressive in generating investment income, such as selling profit from stock investments.

  5. I’m a member of an excellent defined benefit plan… problem is if I only work for 5-7 more years, its not going to reach its potential.

    I have to admit that I’m intrigued with preferred shares, especially those of the Canadian banks… can you say 6% yield anyone? Garth Turner is a big proponent of them, for what its worth…

  6. Jon Snow, Preferred shares have their place. They’re much like debt, without all the guarantees of bonds. If you’re looking to buy some, I’d suggest reading up to learn exactly how they perform during different economic environments. The way they are priced currently, it seems likely that they will experience capital losses at maturity, hence a lower than 6% yield to maturity.

  7. The biggest problem with preferred shares is that often they’re callable and thus you can be randomly closed out of your positions. Like bonds and bond funds, if you don’t have huge sums of money, the best investing method for preferred shares appears to be investing in a preferred shares fund.

  8. George, Thank you for sharing that. It’s definitely worth keeping in mind. If your shares are called, you get your money back, but you can’t necessarily reinvest it at the same rate of income (re-investment risk).

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