Retirement Income Revamped
Is there a safe way your clients can increase their income?
May 16, 2011
When it comes to financial issues, in the wake of the recent economic crisis, while foundations of the American retirement system, such as 401(k)s, are under heavy scrutiny for sweeping reform, one area I believe is deserving of change but has been lost in the rubble is the method in which your clients create retirement income from their investments.
While an entire book can easily be written on this one subject, it’s impossible to adequately summarize these important concepts in a limited-word column, but I will most certainly give it my best attempt.
Myself included, the way most clients have historically generated income from a sum of money typically comes down to generating income from an entire asset base.
For example, suppose when I retire I end up with the nice round number of $1 million in my diversified asset base of stocks and bonds. Using the widely accepted “Withdrawal Rate” from my million dollars, I can expect to receive somewhere around $40,000 per year; an amount that, for most, is usually exposed to significant tax.
In addition to high-tax exposure, one of the biggest potential pitfalls of the traditional approach is the potential market risk. Evidenced by a lackluster decade of returns, drawing income from an asset base during market turmoil can very easily thrust a client’s assets into a tailspin headed for disaster. Thus, the recommended low withdrawal rate is designed to provide a cushion, not if, but when the market returns take a turn for the worse.
Even when understanding these issues, many clients understandably still want to know if there’s a way they can safely increase their income. Although not attractive, the answers basically come down to any combination of the following:
… none of which sounds all that attractive (except, of course, winning the lottery).
There is, however, an alternative approach some clients are not aware of and most certainly deserves a closer look.
In simple terms, Split Approach involves splitting a client’s assets into two very distinct “buckets” as follows:
when the time comes to generate income from an asset base, rather than drawing it from the entire base (as in the Traditional Approach).
In this approach, using my million-dollar example, the assets are initially divided as follows:
Assuming a three-percent return on assets in the Income Bucket and a seven-percent return on assets in the Growth Bucket, at the end of the Year One, here’s how things would presumably appear:
It’s now time to draw income.
In this structure, an income of $50,000 is drawn only from the Income Bucket, reducing the $515,000 down to $465,000 (see figure below). During the year in which I live off this initial $50,000, the $465,000 left behind in the Income Bucket just sits there, continuing to grow by my assumed three-percent return. While this is happening, assets in the Growth Bucket are left untouched, growing by an assumed or guaranteed seven-percent return.
Notice something important: In a Traditional Approach, most of my income is usually taxable, whereas in the above Split Approach, I drew $50,000 from the Income Bucket but only a small portion of this income is taxable (due to the fact that $35,000 of the $50,000 is from my initial principal, and thus only the remainder is from taxable earnings). The fact that only a small portion of my income is taxable significantly increases the amount of money I will actually have left to spend.
Furthermore, notice over on the far right, the Total Assets, has preserved my initial million dollars; a goal most people obviously want to accomplish. Although I am withdrawing $50,000 from the Income Bucket, the untouched earnings from the Growth Bucket is helping replenish this amount, thus preserving the asset base for this year and all others to follow.
As the years progress, the above cycle repeats itself until the end of 12 years, the period in which the Income Bucket is expected to exhaust itself:
After the twelfth year, I have several options to continue receiving my income, such as:
In any of the above, to compensate against inflation, the amount of income I’d expect to receive is projected to be greater than the original $50,000.
When compared to the Traditional Approach, the Split potentially accomplishes:
More Income, Less Tax
Since I reduced my taxes significantly, my spendable income has increased greatly:
Remember: Assets in the Income Bucket are invested generally in low-risk portfolios, such as highly conservative bonds.
As for assets in the Growth Bucket, while income is being withdrawn from the Income Bucket, Growth monies are left completely untouched. In my example above, leaving these assets untouched for 12 years gives these assets a greater chance of achieving success than in a typical traditional approach in which clients are very often withdrawing income from this base at the same time as they are also requiring growth.
These days, one of the understandable concerns some clients will have are low-interest rates and stock-market risk:
Planning investment income is a complex matter and whether your client follows the traditional approach or the split approach (or a combination of both), greater details on all the above would be necessary to determine which strategy and products, if any, provides the best fit for a specific client.
With that in mind, I do hope this brief introduction to the Split Approach provides just enough information to show you that other than saving more, spending less, working longer, hoping for high returns or winning the lottery, there are indeed ways to increase a client’s income beyond traditional means.
Alan Haft is an investment advisor representative with an insurance license, author of three books including the national bestseller, You Can Never Be Too Rich, and makes frequent appearances in national print, television and radio media such as The Wall Street Journal, Money Magazine, CNBC, BusinessWeek and many others. You are welcome to contact Haft for more information on split and traditional approaches here.
For full disclosure, Haft is a part of a firm that utilizes all industries which typically includes us receiving percentage based fees for brokerage services as well as commissions when implementing insurance based plans. Haft does not work for any particular financial company or industry nor should this column be construed as an endorsement or condemnation for any particular product. Readers should note that all views and vendor recommendations as expressed in this article are solely the author’s and do not necessarily reflect the views of the AICPA CPA Insider™ or the AICPA.
* This article is not intended to provide financial planning, tax or legal advice and should not be relied upon as such. Any specific tax or legal questions concerning the matters described in this article should be discussed with your tax or legal advisor.
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