A Look at Income Replacement in Retirement

Having multiple cash flows in retirement helps ensure reliable income.

The things that should end with a career are stress and traffic—income must maintain a steady flow for a comfortable and secure retirement. Debate abounds as to what constitutes a responsibly planned degree of income replacement, and anyone preparing for retirement may be torn on which advice to take.

The “80% Rule” is a popular notion. It stipulates that every retiree should aim to have that percentage of their working income accessible. But every rule of thumb must be dissected to see how well it applies to individuals. Successfully estimating a personal income replacement ratio starts with at least three key considerations: anticipated expenditures, the cost of accessing assets, and medical expenses.

You’re the best predictor of necessary income replacement

One flaw that critics of the 80% Rule cite is that it’s dependent on the cost of living declining after employment—which is why 20% of income can be comfortably lost. This may be the case for those who intend to enjoy a reasonably frugal retirement.

Some plan the opposite path, however, with goals of travel, philanthropy, and new hobbies in their post-work lifestyle. This latter group may need far more than 80% to fund their objectives comfortably.

The first step in estimating future expenditures is to make it personal. “Which lifestyle do I want in the future?” and “What responsibilities will I have?” are two key questions. These are, of course, fluid concepts. But we can roughly project the sort of retirement we’d like and consider the general costs.

The inevitable considerations around income replacement

The cost of accessing assets is how much will be paid in taxes on retirement income and the forms that income takes. For example, traditional IRA accounts and 401(k)s are taxable, but 401(k) withdrawals can be deferred until April 1 of the year (or sometimes, the following year) participants turn age 70 and a half. Tax is then unavoidable since it’s mandatory to withdraw a certain annual amount under the Required Minimum Distribution Rule (RMD).

The cost of access varies based on your post-employment tax bracket. Many find themselves in a lower tax bracket, but this isn’t always the case (or necessarily desirable). Future health is also something everyone must consider. An average 30-year retirement would cost $129,000 in medical expenses by today’s estimates, and these expenses are perpetually rising. Some forecasts for the next decade predict a 5.5% annual increase.

Spending retirement income on new investments or pursuits is a reward at the conclusion of a career, but keeping a sensible figure aside for taxes and healthcare is a necessity. Factoring these considerations into a personal income replacement ratio, therefore, heavily relies on sensible decumulation of assets. We recommend reading our previous article on retirement drawdowns for deeper insight.

Some methods of generating income during retirement

We’ll skip the apparent income of your retirement savings becoming readily available and move on to investments. Diversifying a portfolio is a good strategy, and ideally, many of the investments will generate income. But if any should falter, diverse interests in other areas should help maintain it.

Dividend-paying stocks are a generally reliable buffer against inflation, the incremental creep of which can drain retirement wealth. Stocks generally perform better from a tax perspective if they’re held in taxable accounts, but keeping some in a tax-deferred account is often advisable to protect against inflation.

As a stock complement, bonds tend to be more stable. Should you invest in municipal bonds, the interest generated will be tax-free. Treasury inflation-protected securities have their principal adjusted for inflation and provide guaranteed fixed-rate interest payouts twice a year. Bonds tend to generate income most effectively when held in a tax-deferred account.

Insurance and pensions

A lump-sum payment can secure an immediate fixed annuity from an insurance company, providing monthly income that may also support a spouse after your death. Deferred-income annuities activate at a later date after purchase and give bigger payouts the longer drawdowns are delayed.

If you have the option of drawing on a pension, income replacement can be sudden or gradual. Receiving it as a lump sum has the virtue of immediacy, but the risk of being depleted more quickly. A lifetime payout is structured as regular income and can protect against hasty decisions or market dips, assuming a retiree invested lump-sum payments.

Generating steady income with part-time work is another choice. Downgrading workhours in retirement doesn’t necessarily mean a massive dip in income since expertise often commands a premium. This cushion can significantly supplement savings and make reaching 70 a more comfortable experience, deferring drawdowns on other plans and their associated taxes for as long as possible.

Leverage Lindberg & Ripple’s expertise

Income replacement is best discussed with an experienced wealth advisor who can suggest more—and more complex—options than are listed here. Our team will help you weigh every available option to craft a strategy that safeguards and grows wealth.

Lindberg & Ripple offer customized wealth management, investment, and insurance solutions to wealthy families and successful businesses. We help our clients craft a comprehensive wealth planning model to achieve their financial goals with minimum fuss and maximum savings. Connect with us to learn more.


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