Retirement

The Three Tiers of Retirement Income

Matt Sommer, CFP, CPWA, CFA
In a low interest rate environment, generating income can be challenging for many retirees. As a result, the search for a competitive yield has led some investors to assume additional, but not always fully understood, risk. The impact of these decisions is commonly felt during times of market volatility and prolonged economic stress and can quickly devastate a portfolio’s ability to generate sustainable, long-term cash flow.
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Think Differently

Investors looking for income may benefit by implementing an entirely different approach to their investment decisions. The starting point is the recognition that income and yield are two entirely different concepts. Income represents total cash flow inclusive of Social Security, pensions, royalties, rental income and is what helps retirees meet their essential household expenses. Yield, meanwhile, is related to the income a particular investment pays. While yield can be helpful to evaluate specific investment opportunities, investors are likely to be much better served formulating a strategy based on income.

The Three Tiers of Retirement Income is a simple, yet powerful, tool to help investors allocate money to generate the cash flow they need.

How to meet essential
retirement needs

Tier one is dedicated to anchor income or income that is needed to meet essential needs in retirement, to determine how much should be allocated to anchor income investments, a retiree may look at the monthly expenses needed to meet their essential needs. These expenses include recurring monthly costs for rent, utilities, insurance, food, health care and more. Estimating the total amount of monthly expenses provides a specific amount of income that will be needed and may be used to determine how much to allocate.

Anchor Income Examples:

  • Social Security
  • Pensions
  • Royalties
  • Annuities

How to meet your essential retirement needs

Tier 1 is dedicated to anchor income or income that is needed to meet essential needs in retirement. To determine how much should be allocated to anchor income investments, a retiree may look at the monthly expenses needed to meet their essential needs. These expenses include recurring monthly costs for rent, utilities, insurance, food, health care and more. Estimating the total amount of monthly expenses provides a specific amount of income that will be needed and may be used to determine how much to allocate.

Getting the cash flow needed to meet essential retirement needs

Once the total amount to meet essential retirement needs is known, a retiree can look at anchor income to pay a specific, periodic amount that can generally be relied upon regardless of market or economic conditions. Specific examples include employer pensions and Social Security payments. Another example is an annuity that pays fixed monthly amounts. Many retirees may find peace of mind if their anchor income sources equal their essential household expenses. If there is a shortfall, it may be wise to use a portion of their existing portfolio to purchase an annuity that will provide the necessary additional monthly income.

Anchor Income Examples:

  • Social Security
  • Pensions
  • Royalties
  • Annuities

Covering unexpected expenses and income gaps during retirement

The second tier of the Three Tiers of Retirement Income is dedicated to cushion income. These investments can be used to pay unexpected expenses or cover a gap needed to pay essential expenses and discretionary expenses. A good rule of thumb is to allocate at least two years of expected living expenses, in excess of those already covered by anchor income sources outlined in Tier 1: Anchor Income. For example, a couple might decide that they would like $1,000 a month for discretionary expenses. Setting aside enough cash to cover two years of retirement, $24,000 might be allocated to this tier.

Investing to get the cash flow needed

This category of investments consists of defensive income investments such as savings accounts and money markets. Investors looking for greater return potential who have a higher risk tolerance might also consider short-term bond or low-duration bond mutual funds or ETFs. Although bank deposits may be guaranteed as to principal and interest, investment products are not and investors should use caution to make sure the portfolio consists of high-quality investments since they can lose value. Having cushion income may help avoid selling stock investments after they have recently gone down in value. If effective, a pool of cash is readily available for withdrawals and can be augmented or replenished from the yield portion of the portfolio.

Cushion Investment Example:

Covering unexpected expenses and income gaps during retirement

The second tier of the Three Tiers of Retirement Income is dedicated to cushion income. These investments are used to pay unexpected expenses or cover a gap needed to pay essential expenses and discretionary expenses. A good rule of thumb is to allocate at least 2 years of expected living expenses, in excess of those already covered by anchor income sources outlined in Tier 1: Anchor Income. For example, a couple might decide that they would like $1000 a month for discretionary expenses. Setting aside enough cash to cover two years of retirement, $24,000 might be allocated to this tier.

Investing to get the cash flow needed

This category of investments consists of defensive income investments such as saving accounts and money markets. Investors looking for greater return potential who have a higher risk tolerance might also consider short-term bond or low-duration bond mutual funds or ETFs. However, bank deposits may be guaranteed as to principal and interest, investment products are not and investors should use caution to make sure the portfolio consists of high-quality investments since they can lose value. Having cushion income may help avoid selling stock investments after they have recently gone down in value. If effective, a pool of cash is readily available for withdrawals and can be augmented or replenished from the yield portion of the portfolio.

Cushion Investment Example:

Getting more income from your
portfolio

Tier three of the third tier of Retirement Income is dedicated to yield. These higher risk investments should generate more income than the other retirement income tiers while offering diversification from the stock or growth portion of the portfolio. After the first two tiers of income are addressed, any remaining cash is allocated to investments with the potential to generate higher yield. As these investments often pay interest and/or dividends, those payments may be reinvested or can be used to augment or refill anchor income, the income needed to meet essential expenses, and cushion income or income needed to meet discretionary expenses.

Investing for more income

Yield is one, but not the only, calculation that can be used to help select these investments. Specific examples include government and corporate bonds of various maturities and credit quality and high-dividend-paying stocks often found in the utilities, financials and the real estate sectors. More complicated investments may also fit this category including preferred stocks, convertible bonds and master limited partnerships (MLPs). Further, investors may wish to look beyond U.S. companies as international bonds and stocks may offer higher yields and diversification benefits. If individual security selection seems intimidating, an equity income, strategic income and/ or global income mutual fund or ETF can provide a convenient alternative. Prior to a decision, be sure to understand the benefits and limitations of your available options and consider factors such as differences in investment-related expenses, tax treatment and other concerns specific to your individual circumstances.

For some investors, their income needs may be such that interest and dividends are required to help meet immediate expenses. Even in these cases, however, investments should be made as part of a coordinated and thoughtful retirement income plan, rather than relying on yield measurements alone.

Yield Investment Examples:

Getting more income from your portfolio

Tier three or the third tier of Retirement Income is dedicated to yield. These higher risk investments should generate more income than the other retirement income tiers while offering diversification from the stock or growth portion of the portfolio. After the first two tiers of income are addressed, any remaining cash is allocated to investments with the potential to generate higher yield. As these investments often pay interest and/or dividends, those payments may be reinvested or can be used to augment or refill anchor income, the income needed to meet essential expenses, and cushion income or income needed to meet discretionary expenses.

Investing for more income

Yield is one, but not the only, calculation that can be used to help select these investments. Specific examples include government and corporate bonds of various maturities and credit quality and high dividend - paying stocks often found in the utilities, financials, and the real estate sectors. More complicated investments may also fit this category including preferred stocks , convertible bonds, and master limited partnerships (MLPs). Further, investors may wish to look beyond U.S. companies as international bonds and stocks may offer higher yields and diversification benefits. If individual security selection seems intimidating, an equity income, strategic income and/ or global income mutual fund or ETF can provide a convenient alternative. Prior to a decision, be sure to understand the benefits and limitations of your available options and consider factors such as differences in investment-related expenses, tax treatment, and other concerns specific to your individual circumstances.

For some investors, their income needs may be such that interest and dividends are required to help meet immediate expenses. Even in these cases, however, investments should be made as part of a coordinated and thoughtful retirement income plan, rather than relying on yield measurements alone.

Yield Investment Examples:

Case Study

The Three Tiers of Retirement Income is a simple, yet powerful, tool to help investors allocate money among different investment alternatives to generate the cash flow needed in retirement. Using a hypothetical scenario of a couple looking for retirement income, the case study below demonstrates how The Three Tiers of Retirement Income can be utilized.

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A retired couple

Tom and Mary, both age 66, retired recently and were looking for help structuring their investments to provide the cash flow they will need in retirement. Their starting combined portfolio was $800,000, and together they receive $1,200 a month from Social Security. The couple estimated that their essential expenses will be $2,000 a month but would feel more comfortable with $3,000 a month to cover their leisure activities and hobbies. Tom and Mary feel that they have a moderate risk tolerance and would be comfortable allocating half of their portfolio to growth-oriented investments such as stocks. Using the Janus Henderson Three Tiers of Retirement Income approach, this is how Tom and Mary could structure their investments to receive their targeted cash flow of $3,000 a month:

Determine how the portfolio will be allocated between growth and income investments. In this case, half of the portfolio, or $400,000, will be allocated to generate the monthly income they need.

Determine how much should be allocated to Anchor Income investments. Tom and Mary’s essential expenses are $2,000 a month. Social Security will cover $1,200, leaving an $800 gap. Based on a hypothetical calculation, $143,000 would purchase an additional $800 of guaranteed monthly income for life. This strategy would provide the couple the $2,000 a month of guaranteed income they need, but of course, would immediately reduce their total portfolio by $143,000, the cost of the annuity.

Determine how much should be allocated to Cushion Income. The couple would like $1,000 a month for discretionary expenses. Setting aside enough cash to cover two years of retirement, $24,000 should be allocated to this tier. Tom and Mary will withdraw $1,000 from these investments each month, or as needed.

Determine how much should be allocated to Yield. At this point, the couple has $233,000 left over. As these investments typically pay interest and/or dividends, those payments may be reinvested or can be used to refill the Cushion Income tier.

Tom and Mary’s Retirement Income Tiers

Anchor Income

$143,000 allocated
to an immediate
fixed annuity

Cushion Income

$24,000 annuity

Yield

$233,000

Anchor Income

$143,000 allocated
to an immediate
fixed annuity

Cushion Income

$24,000 annuity

Yield

$233,000

Anchor Income

$143,000 allocated
to an immediate
fixed annuity

Cushion Income

$24,000 annuity

Yield

$233,000

Each year, Tom and Mary should reevaluate their portfolio to ensure the allocation remains in line with their risk tolerance. Rebalancing also provides an opportunity to refill their cushion investments, thus providing ample cash to meet the couple’s cash flow needs in the months to come.

Notice that in this case study, Tom and Mary are not living off of interest coupons or dividends payments per se. Instead, these investments represent part of a broader strategy. For some couples, their income needs may be such that interest and dividends are required to help meet immediate expenses. Even in these cases, however, investments should be made as part of a coordinated and thoughtful retirement income plan, rather than relying on yield measurements alone.

Next Steps

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