Will You Conquer the Cash Crunch in Retirement?

How to Meet the #1 Financial Challenge Facing Baby Boomer Physicians and Avoid Common Pitfalls

By David Mandell, JD, MBA and Dinah Bird, Ph.D., CFP, CIMA

Those of you born between 1946 and 1964 are part of the 77-million strong Baby Boomer generation – one that is now contemplating retirement. If you were born before 1946, you may already be retired or seriously considering it. If you fit into either of these groups, the following issue will be paramount for all of your financial decisions moving forward: “How do I take the wealth I have saved and efficiently turn it into cash income to sustain me during retirement?” No wonder, as the quote above makes clear, so many soon-to-be retirees are so worried about running out of money in their retirement.

In this article, we will discuss problems with the solutions retirees typically rely on to generate cash income in their retirement and suggest alternatives that may be safer and more efficient.

Conventional Wisdom on Generating Cash in Retirement

“Conventional wisdom” suggests that financial planning for retirement should include various investment strategies for generating cash to live on. Let’s examine the leading strategies for generating cash and the significant risks inherent in each of them:

1. Periodically liquidate a portion of investments

This technique is used in almost all retirees’ planning. It simply means periodically selling assets to generate cash to live on – whether those assets are in IRAs, personally-held securities and investments, real estate, the family home, business, etc. The problems with periodic liquidation are:

• Risk #1: Market timing Timing the sale of an asset can be tricky, as many retirees can attest to in the aftermath of the stock market crash of 2008. The investment you are selling may be discounted 30 to 50 percent at the time you need to sell. Being stuck in a “liquidation only” strategy in market downturns can be dangerous.
• Risk #2: Taxes When selling almost any asset, you will pay capital gains taxes at both the federal and state level. These taxes can eat up 25% of the gains. For distributions out of a qualified retirement plan or IRA, the tax bite can be as high as 45%! Relying solely or significantly on liquidation strategy means being subject to these taxes and to the risk that such rates will increase. Given that federal capital gains tax rates are at the lowest in their history, being subject to future tax increase is not a risk to overlook.

2. Allocate heavily to a ladder bond portfolio/ dividend producing stocks

A laddered bond portfolio is a strategy commonly used by retirees whereby an investor purchases a group of bonds with different maturities, attempting to match cash flows with the demand for cash. One bond might mature in one year, another in three years, and the remaining bonds might mature in five-plus years. Each bond represents a different rung on the ladder.

• Risk #1: Inflation As inflation goes up, the bonds in the laddered portfolio do not keep up with buying power. The bonds and their interest may pay the same, but the investor can purchase fewer goods with the same amount of money.

• Risk # 2: Interest Rate As rates rise, the prices of a fixed rate bond will fall, and vice versa. Although bond laddering is a tried and true approach, consider the problems of allocating a substantial amount of money to a laddered portfolio in light of today’s interest rate environment and a seven year treasury paying 2.875%!

• Risk #3: Market Timing/Downturns In terms of dividend-paying stocks, dividend pay outs are based on a percentage of the stock’s price. As the stock market fluctuates, so does the yield from the stock. The stock dividend will go down dollar-wise if the market takes a down turn — just when the dividend is most needed.

3. Purchase an annuity

The life annuity (not to be confused with the variable annuity) is designed by actuaries to pay interest and principal back to you over your lifetime. Essentially, you write an insurance company a check today and they pay you monthly, quarterly, or annually for the rest of your life (or the longer of your life and your spouse’s).  The benefits of this strategy include:

1. The amount the insurance company pays you is “fixed” and will not decrease if the stock market crashes or if interest rates fall.
2. Even if you outlive your life expectancy, the insurance company continues to pay you or your spouse for as long as you are alive.

However,  as interest rates have been at historic lows for a number of years, annuity payment rates are also extremely low.  This makes their internal rate of return (IRR) very poor.  As with any insurance product, the strength of the insurance company is also a risk. Since you may want payments for decades in the future, only the strongest carriers should be considered.

Finally, the inflation risk to this technique also weakens its attractiveness. If inflation repeats itself like the early 1980s with the prime rate at 21% or even a reasonable 8%, then a 3% annual check from the annuity (not uncommon in today’s market) is not as attractive.  For these reasons, a life annuity can be part of a balanced cash income strategy, but it typically should not be heavily relied upon.

Case Study: Abby the Allergist

Abby is on the brink of retirement at 62. Abby has social security, a $1.2 million home near her four grandchildren, a 4% life annuity on a $500,000 policy, and an impressive 50/50 investment portfolio of stocks and bonds valued at $3 million that is a combination of her IRAs, 401(k)s and savings. Abby enjoys semi-annual vacations with her grandchildren but otherwise expects to easily live on $200,000 income per year during her retirement. She is in good health and, due to her family history, expects to live until the age of 90. Abby divorced many years ago and has no alimony liabilities. She has a long term care insurance policy that will pay her $10,000 annually. All is looking good for Abby’s retirement.

Abby’s practice was bought out two years ago, and has decided to retire five years earlier than planned.  She considers this a safe decision, as she has a paid-off home, an annuity, long term care insurance and a $3 million 50/50 stock/bond portfolio. Despite retiring earlier than anticipated, she has planned well and is better positioned than 99% of Americans at retirement.

Abby decides to keep her house to avoid selling at a loss. She forgoes a reversible mortgage because the “fees are outrageous.” Current inflation is benign at 1.7%, which is a nice advantage. She has the cushion of long term care if needed. Abby is living within her $200,000 per year budget.

Abby’s meets her $200,000 annual cash needs by these income streams:

1. Social Security                                    =  $30,000.00
2. Annuity payments (4% of $500,000)                  =  $20,000.00
3. Dividend payments from her 50% in stocks (2.00%)      =  $30.000.00
4. Interest payments from her 50% bond ladder of 1-10 years,

Which has a blended yield of (3.00%)            =  $45,000.00

Total in flows            = $125,000.00

Abby’s two largest drains on her annual income are:

1. Income tax     ($50,000.00)
2. Property tax on her home     ($30,000.00)

Total out flows = (80,000.00)

Netting out the outflows from the income, leaves a shortfall of $155,000 of cash.

Abby will need to liquidate stocks and bonds in her investment portfolio to make up the shortfall of $155,000 for taxes and cash. Chances are very high she will have to liquidate some of her stock when the market is down due to normal stock market fluctuations. Consequently, Abby will have to sell even more stock to generate the appropriate amount of cash needed. Plus, there is a high probability that inflation will cause the price of her bonds to decrease as she liquidates them for cash.

Abby’s investments will most likely not sustain her for the 28 year time horizon and her portfolio will be depleted before her death. Abby may very well experience the number one fear of retirees — running out of money in retirement!

Can Abby modify her investment liquidation strategy so she will not outlive her income?

The Alternative Income solution can help Abby overcome this challenge. Instead of liquidating her portfolio of stocks and bonds for cash each year, Abby can add alternative cash income to her bond portfolio. By doing so, she will boost her income, provide an inflation hedge and liquidate less of her stocks/bonds, allowing her portfolio to grow. An alternative income strategy will help extend the life of her investment portfolio so she will have investments for as long as she lives.

What is an ALTERNATIVE INCOME Strategy?

“Traditional” investments are considered stocks, bonds, currency, or hard assets, such as real estate. An “alternative cash income strategy” is one that involves combinations of such assets to create a unique portfolio designed to generate cash income.

REIT – Based Alternative Income Strategy

One Alternative Income Strategy provides a diversified cash flow stream from hard assets that are in the form of an investment security called a Real Estate Investment Trust or REIT. The advantages of using REITs for forming a foundation of a cash-focused retirement strategy are:

1. According to the law, at least 90 % of the cash flow streams generated from properties in the REITs must be passed to the owner/investor of the REIT.
2. REITs can be an inflation hedge; as inflation increases, the property rents usually increase as does the value of the property.
3. REITs typically offer a low correlation to the U.S. stock market, which means that REITs help decrease volatility.

A REIT-based Alternative Income strategy basically works like this:

An investor buys into an REIT portfolio, which will generate about 6.5% income to supplement the money needed for expenses. Consequently, fewer securities are needed to be sold out of the retiree’s portfolio, which should generate more growth in their investments.  Adding REITs as an alternative income to a portfolio has the potential to augment conventional strategies by enhancing cash flows and extending the life of the retiree’s investment portfolio.

Conclusion

Generating income throughout retirement is a significant challenge. Common techniques, including asset liquidating, bonds, dividend-paying stocks and life annuities, all have significant risks associated with them.  Therefore, the use of alternative income techniques is often recommended to augment traditional techniques.

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The information contained herein should not be construed as personalized investment advice. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. You can contact the authors at (877) 656-4362 or through their website www.ojmgroup.com.