Cracking the Nest Egg: How to Generate Lifetime Income

The main goal of saving and investing during our careers is to turn the accumulated wealth into income and cash flow that will last our retirement years.

You want to establish a retirement paycheck that will continue no matter how long retirement lasts. You also might want to leave a legacy for loved ones or charity.

Most non-retirees worry about how they’ll generate income and cash flow in retirement. But few adopt cash flow strategies, and those who do often have poor strategies.

A survey by the investment firm Schroders found that 49% of Americans don’t have a retirement cash flow or spending strategy.

A survey by J.P. Morgan Asset Management found that most retirees let the IRS determine their retirement spending strategy. They use the formula for required minimum distributions (RMDs) to determine their distribution-and-spending strategy.

Among the problems with this strategy is that the distributions fluctuate with the portfolio value. If a bear market causes the value to decline 20% in one year, spending will decline by about 20% from the previous year.

The RMD formula also could cause the nest egg to be reduced more rapidly than you’d want.

The 4% Rule is another widely followed strategy in which your maximum spending from the nest egg in the first year of retirement is a percentage of the nest egg, usually between 4% and 5%. Each year after that, the dollar amount spent the previous year is increased by the previous year’s inflation rate.

The 4% rule has shortcomings, which I list in my books, such as “Retirement Watch: The Essential Guide to Retiring in the 2020s” (Regnery Capital: 2023).

A key problem is spending is unhinged from fluctuations in the portfolio’s value. In a long bear market, the portfolio could run out of money because spending increases even as the portfolio’s value steadily declines. In a long bull market, the retiree could spend far more than the 4% rule allows.

A big shortcoming of these and other spending strategies is that once established, they are on automatic pilot. They aren’t adjusted to match changes in the markets or the retiree’s life.

Another major problem with these and other spending strategies is they don’t reflect how people really spend money in retirement.

Regular surveys by the U.S. Department of Labor (DOL) show that in the first years of retirement, people tend to spend at rates comparable to what they spent in the last years of their careers.

Spending doesn’t increase automatically each year, though that’s what happens under both the RMD Rule and the 4% Rule.

Instead, after the first phase of retirement, spending tends to gradually decline. The DOL studies indicate that spending declines after adjusting for inflation. In other words, there’s a real decline in spending that begins as people reach their early to mid-70s.

We can use all this information to develop a retirement income and spending strategy that prevents you from being deprived of a standard of living you can afford and still reduces or eliminates the risk of running out of money.

The first step is to estimate the annual cost of your desired standard of living. You should do this even if you’re retired. Revisit the estimate every few years. After the inflation of the last few years, many people need to recalibrate how much retirement costs.

Then, decide how much of your spending should be supported by guaranteed lifetime income.

Most of you will have Social Security benefits. Some of you will have pensions from past employers.

Any additional guaranteed lifetime income can come from repositioning part of your nest egg in either single premium immediate annuities (SPIAs) or deferred income annuities (DIAs), also known as longevity annuities. You should consider a charitable gift annuity if you’d like some money to go to charity.

Most people should consider having their basic or regular expenses covered by guaranteed lifetime income. They’ll know money to pay those expenses will be deposited in their financial accounts each month for the rest of their lives.

Market fluctuations won’t matter, because the money to pay your regular expenses will be deposited regardless of what’s happening in the markets.

Keep in mind surveys show that the more guaranteed lifetime income a retiree has, the higher his or her spending is likely to be. Retirees who derive most of their cash from investment portfolios tend to worry about sharp market declines and are hesitant to spend principal. Those factors keep them from spending as much as they could.

The annuities pay fixed income that doesn’t increase with inflation, so you might need other cash flow sources that allow your spending to increase with inflation. But also keep in mind the Department of Labor studies that show spending for most retirees declines over time, even after adjusting for inflation.

Some of you will put a portion of your nest eggs into annuities while others don’t want to own any annuities, other than Social Security. Either strategy is fine.

The rest of your retirement savings will support the spending not covered by guaranteed lifetime income. You need a spending strategy to ensure the savings won’t run out during retirement, and some of you want to leave a legacy for loved ones or charity.

Some retirees want to spend only the income and gains earned by their portfolios, at least until later in life. That’s fine, but keep in mind that you’ll spend less money during your lifetime than the wealth you accumulated would allow.

Your spending also would be limited by interest rates and investment returns, which could be a problem if interest rates retreat to near 0% or stocks and bonds enter bear markets.

Most people will spend both income and principal from their portfolios during the retirement years, because the income alone from their investments won’t be sufficient to meet their spending goals.

In that case, you invest for total return over the long term and develop a spending strategy that determines the maximum amount you can take from the portfolio each year. You want to set a maximum spending amount so that the portfolio won’t run out of money during retirement.

You can, of course, use either the 4% Rule or the RMD Rule. It’s better to have a strategy that makes gradual adjustments in the maximum distribution as the portfolio’s value changes.

I recommend a modification of the strategy the Yale University Endowment Fund uses to determine its distributions to the university each year.

You determine the percentage of the portfolio to distribute the first year, and that’s the most you’ll spend the first year of retirement.

In subsequent years, 70% of the distribution is a percentage of the portfolio’s market value at the end of the previous year and 30% of the distribution is based on the previous year’s dollar distribution plus inflation.

To reflect the way people actually spend money in retirement, consider an adjustment to this strategy.

Because spending declines as we age, it makes sense to increase the percentage of the portfolio that’s spent in the early years. Then, the percentage can decline after a period of years.

I did an analysis in which the distribution rate is 7% for the first six years of retirement. In year seven, the distribution percentage declines to 5%. The distribution rate falls to 4% in year 15.

The most important action is to establish a strategy for turning retirement savings into a retirement paycheck or stream of cash flow. Too many retirees “wing it,” creating a lot of uncertainty and increasing the probability of running out of money or not spending as much as you could have.

Decide how much of your retirement savings should generate guaranteed lifetime income. For the rest of your retirement savings, establish a strategy that determines the maximum amount you can spend each year. The strategy should adjust distributions with inflation, market fluctuations and changes in your life.

There are more detailed discussions and examples of the different options in the September 2023 episode of my Spotlight Series webinar and in my book, “Retirement Watch: The Essential Guide to Retiring in the 2020s” (Regnery Capital, 2023).