Updated: October 9, 2019
By definition, retirement is the time when you can live off investments. The traditional retirement model is to withdraw 4% a year from your retirement savings to live but an increasingly popular alternative is to get income from investments instead.
Is it safest to withdraw or get investment income to live in retirement? Creating investment income from quality assets allows retirees to withdraw less from retirement savings so it is safer than withdrawal methods.
In this post I’ll expand on why getting investment income is safer than planning to withdraw savings in retirement. It’s been almost 15 years since my husband, Larry, retired early. We have been generating alternative income streams to “pay the bills” ever since.
While I’m an AFC® (Accredited Financial Counselor), I mostly share what we learned from this experience, and almost 40 years of investing in stocks, bonds and alternative assets.
How Retirement Withdrawal Works
Your retirement account is made up of 4 elements.
- Savings deposits
- Dividend income
- Capital gains (increases in value from your assets)
- Compounding from all the above
When you withdraw retirement savings to live, you’re pulling from one of these 4 elements.
While these withdrawals are commonly referred to as retirement income, but income is only one source in your retirement account. Often, at least some of the withdrawals you make are usually not really “income” from stock dividends and bond interest.
For most people, this is true unless, you’re very wealthy since you’d be generating a lot of interest and dividend income if you have a million or more earning that interest and dividends.
It’s important to note this exception for high net worth investors or with investors focused on high income strategies. Read my related post How Much Money Do You Need to Retire.
With the popular 4% Withdrawal Rule, you withdraw 4% from your retirement savings in year one. Then in subsequent years, most retirees adjust their withdrawal amount up or down for inflation.
By adjusting the amount you withdraw annually by the amount of inflation, you’re able to maintain the purchasing power of your withdrawals.
Read my related post Does the 4% Rule Include Dividends?
Problems with Retirement Withdrawal Vs Investment Income
There are several problems when you withdraw money to live in retirement as in the case above. In this section, I’ll address the various problems with the 4% Rule for retirement and then how they affect retirees living off investment income.
Note that there have been other studies suggesting a 2% to 3% retirement withdrawal rate is safer than a 4% withdrawal rate. You can read more about that in my post Do Retirement Withdrawal Strategies Still Work?
Uncertainty with Retirement Planning for Withdrawals
Uncertainty is a real problem when you plan to withdraw money to live in retirement. The calculators that estimate whether retirement withdrawal will work are based on assumptions.
They have to be. That’s all we have.
While financial calculators are great tools to use for estimating your financial future, they provide just that: estimates.
This is because you have to enter best guesstimates for:
- Future investment returns
- How long you’ll live
Past market data provides excellent information for estimating future returns and inflation. But like me, you may have noticed that the unexpected sometimes happens in life, especially in the financial markets!
And you just can’t predict how long you’ll live.
(I’m getting anxious just typing this!)
Uncertainty for Retirees Living Off Investment Income
While it varies based on the type of income asset you own, income from investments is fairly predictable.
Income from Stocks and Bonds
For example, while stock dividends are sometimes cut, this isn’t extremely common. (Diversification can also reduce the effect of this problem for income investors.)
Bond interest is very predictable when individual bonds are bought, but this is rare these days since most people invest in bond funds which have changing interest rates.
Income from Slightly Alternative Investments
On the other hand, income from quality real estate rental investments is highly predictable.
Income from small business is less predictable yet it is more under your control than stock dividends if you own the business yourself (vs increasingly popular crowd funding).
Covered call income varies from month to month, but it is still fairly predictable in sideways or rising stock markets.(Covered calls don’t work well in down markets.) Read my related post How Do Covered Calls Work?
While the investment income method admittedly has some elements of uncertainty, the uncertainty is shorter term and can be addressed from year to year.
Here’s my point: The investment income method is not a result of guessing what will happen over the next few decades in an attempt to live off savings withdrawals.
Read my related post The Best Income Stream to Start before Retirement.
Watch my video where I explain living off investments vs planning to withdraw from savings in retirement.
Financial Factors Beyond Your Control
The things that determine whether retirement withdrawals will work or not is based on factors completely beyond your control.
This includes the stock market, the bond market, interest rates, inflation, politicians, and the economy, which are all intertwined.
Control with Investment Income
On the other hand, you have much more control over income generating assets. Even stock dividends, for example, have more predictability than capital gains from stocks.
(Recall capital gains are the third source of money in your retirement savings noted at the first of this post.)
And you can diversify into income generating assets you own (and control more) as opposed to assets that are completely out of your control, like stocks and bonds.
Read my related post How Many Income Streams Should You Have?
Assumptions with Retirement Withdrawals
There is a huge assumption with the retirement withdrawal method: What if you run out of money when you’re 90 and you live for another 5 years?
Given all the assumptions and estimates that must be made in retirement planning for the 4% Withdrawal Rule, many retirees simply can’t know if they have enough money to retire if they rely only on withdrawals and low bond and stock income.
Read my related post How to Not Outlive Your Money.
Living Off Investment Income Assumptions
When living off investment income, you can begin creating income streams before you retire. You can tweak your model in your 60’s and 70’s as needed.
Many retirees who rely on investment income to live diversify among assets such as real estate and small businesses. Such assets are less correlated than only traditional income investment assets, such as common stocks and preferred stocks, for example.
There aren’t a lot of future assumptions with the investment income method. An asset either generates income or it doesn’t. No major assumptions required, only evaluations and decisions.
And I like this.
Read my related post How to Buy Assets That Generate Income.
Emotions from Retirement Withdrawals
After decades of worrying about having enough money to retire, withdrawing retirement savings is a fear and guilt invoking activity for all but the wealthiest investors.
And even very high net worth investors have grown their lifestyle spending to meet their level of wealth creating internal pressure to maintain that lifestyle.
Emotions with Investment Income Model
Ideally, with the investment income model, enough income is generated to pay for living expenses in retirement. This avoids the retirement withdrawal guilt and fear syndrome altogether.
The opposite feelings of empowerment and security result from having enough investment income to live comfortably in retirement. There is a confidence and peace that comes from having diversified assets and more control than you can get from owning simply stocks and bonds.
How Inflation Affects Retirement Withdrawals
As you saw, the 4% Retirement Withdrawal method is adjusted annually for inflation by most retirees to maintain their purchasing power.
Inflation has reportedly averaged 2% in recent years. No big deal, right?
But there are several ways inflation can derail retirement withdrawals.
- Inflation could return to the long term average of 3%.
- While it seems highly unlikely, we could have insane inflation rates like we saw in the early 1980’s.In 1980, inflation was over 13%!
- Many reliable experts support that inflation measures aren’t accurate, and that inflation is actually much higher than the government reported number. This is because some categories are excluded from the inflation calculation the government provides. (My dry cleaners have raised prices from $1 per peice to $3.29 per piece on the past 15 years or so!)
The unfortunate reality is that a higher percent of your retirement savings must be withdrawn if inflation rises.
We can reasonably plan for at least 2% inflation in the future. Over only 10 years in retirement, 2% a year becomes a 20% nominal adjustment.
A 20% adjustment to 4% becomes 4.8%. In my world, that may as well be 5%.
Think about the effects of inflation over 2 or 3 decades! While inflation sounds like boring economic jargon, it is a real threat to our financial future!
I feel obliged to note that while some years have negative inflation, which is deflation, deflation is worse than mild inflation from an economic standpoint, signaling other problems.
Read my related post What Are the Risks of Bonds?
Investment Income and Inflation
Here’s the good news. Some assets provide income that keeps up with inflation.
And many retirees using the investment income method have one or more assets that are inflation hedges. Here are several examples:
Investment Income from Real Estate
Real estate rental properties are excellent inflation hedges that are simply to understand.
Rents tend to rise with inflation. Property values also rise with inflation.
Read my related post How to Get More Income from Investments.
Investment Income from Oil
Income oriented oil investments, such as MLP’s or other income generating oil investments are usually good inflation hedges.
The price of oil typically rises with inflation so this is very logical.
Investment Income from Gold
Gold is also traditionally an inflation hedge.
While gold is not normally considered an income generating asset, it certainly can be. An example of an income investment in gold is a gold mining stock with a high dividend.
A safer gold income investment may be investing in a gold ETF. Since ETF’s are funds, they are naturally diversified.
Covered Call Income
While the Gold (or other) ETF itself may not have a high dividend, a covered call strategy can be used to significantly increase income while slightly lowering risk over owning the gold ETF outright (without selling covered calls).
While some stocks can be inflation hedges, inflation hurts bond performance since the income is fixed. Also, the value of most bonds drops with rising inflation.
Retirement Withdrawals and Bear Markets
Bear markets can cause a problem for retirees planning on using the Retirement Withdrawal method.
And bear markets are a fact of life for stock investors. On average a bear market occurs about once every 3 and a half years. And on average, they last about 15 months and stocks drop about 32% in bear markets.
Now, making withdrawals from the income element alone allows you to leave your savings deposits, capital gains and compounding intact. This can be ideal if you have enough wealth.
Retirement Withdrawals and Living Off Investment Income Overlap
This is important: If an investor can live off investment income from stocks and bonds, we’re really looking at the investment income method to fund retirement withdrawals. This is an ideal scenario and where the distinction of these two methods blur.
But, unfortunately, it takes more wealth (investments) than most people have to generate enough income from typical stock and bond investments for most retirees to live comfortably. (Read my related post How Much Money Do You Need to Live Off Investments?)
Since most retirees don’t have enough savings to live off investments, withdrawing from deposits, investment income, capital gain and the related compounding often becomes the source for retirees to live.
And assuming there will always be capital gain is where bear markets can hurt retirees planning to withdraw savings to live in retirement.
Note that most long term stock investors choose to ride out bear markets. (Click here to read my important related post How Will a Stock Market Crash Affect You?)
Bear Markets After Retirement
Here’s the bummer: The older you are, the less time you have to recover from bear markets lowering the amount you have in your retirement savings accounts.
For example, after experiencing the two horrific bear markets in the 2000’s decade just as Larry “slipped into” early retirement, we learned that bear markets were real problems even for retirement savings accumulation of a decade.
It’s one thing to ride out a bear market when your employment income is growing, or at least steady. It’s another thing to ride out bear markets in retirement. It’s unnerving.
And even though stock markets do eventually recover, the drop in net worth is painful.
Given that the stock market as measured by the S&P 500 index didn’t get back to break even for over 10 years in the 2000 decade, you can see this isn’t a short term issue to be taken lightheartedly for anyone in retirement.
Will we have another decade with poor stock market performance? History tends to repeat itself with a slightly different version.
Here’s a clue as to when the next bear market will occur in retirement: The better the stock market has performed in the years preceding retirement the more likely it is to decline in subsequent years. It only feels like the opposite will happen.
For more on this, read my related post What Will Stocks Do Over the Next 10 Years?
Investment Income and Bear Markets
Whether bear markets affect retirees living off investment income depends on the income asset they own. But since the investment income method is based on living off investment income vs withdrawing funds from capital gains, bear markets are less of an issue for retirees not counting on withdrawals to live.
For income investors who rely on stock dividends, they will experience a drop in net worth during bear markets but the dividend income should, nevertheless, remain steady throughout the bear market.
Read my related post Reducing Risk in Stocks with 13 lessons from past bear markets.
Note that bear markets call for reducing investment risk in general, however, even for stock dividend investors. This can be problematic for income investors who have increased risk with stocks that pay higher dividends.
Examples are with leveraged payouts and companies that pay dividends that are higher than sensible based on their company earnings.
Read my related post Is Dividend Investing Worth It?
Annuities Vs Retirement Withdrawal vs Investment Income Methods
Since annuities are a common way to have retirement income, I’ll briefly address them here.
While annuities can provide guaranteed income, those promised returns come at a cost. In other words, annuity returns are generally lower than from investing outright in stocks and bonds.
Too, annuities often have a large portion of an investor’s net worth tied up in the annuity in order to generate enough retirement income. This limits capital for other opportunities, such as buying dividend stocks after a bear market when they are cheap, or buying real estate rentals.
Then there is also the extremely remote possibility that the insurance company funding the annuity payouts can go under.
Read my related post How to Live Off Investments During Low Interest Rates.
Withdrawal vs Investment Income Summary
Only you can determine if it is safest to withdraw or get investment income in retirement. It is my hope that the factors addressed here will help you make a sound decision.
And it doesn’t have to be all or none.
Combining a retirement withdrawal method with an alternative investment income method for at least some of your retirement years can be a smart solution that is in the middle.
Lean toward the side of caution since no one wants to run out of money while celebrating their 90th birthday and it’s too late to do much about it. We’re not all Buffett’s, who can continue to invest brilliantly in our late 80’s.
But then, who knows? Maybe we can.
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