12 BIG INCOME NEEDS
Early in my career, I learned that the first difference between those who earn a high income when working and those who support an expensive lifestyle when retired is that income taxes take a larger cut of the top-line income during working years.
The second difference is that big earners—if they are commensurately big spenders—need to generate a larger portion of their income investments in retirement because Social Security benefits top out at $3,100 a month. As a result, they need to invest more in the accumulation phase, and they face more market and other risks to income in retirement. These are upper-class problems, but they are challenges that must be considered, addressed, and conquered.
These were exactly the issues with which Mike and Madison arrived in my office as the New England leaves were turning summer into a spectacular fall. Mike worked for thirty years as a highly-paid outside salesperson for a technology firm. It was privately held and tightly controlled by the founding family. He followed the standard financial planning advice and maxed out his pretax plan. His employer topped it off each year to the maximum allowed by the IRS. It stood at $5 million when we met and was aggressively invested. Madison enjoyed her role as a homemaker and worked outside the home only sporadically, first as a classroom assistant in her son James’s second-grade class and later as an administrator at church when Jennifer, her youngest, hit high school.
After they finished funding their two children’s college experiences, they suddenly had extra income. They invested in a so-called nonqualified investment account that added another $2 million. Mike was tired of work and ready to retire. They were adamant that they needed $25,000 a month in after-tax income.
Working off a $25,000 monthly spending need, I got busy. Based on the current tax code, I figured they needed roughly $375,000 of pretax income if they made good on their promise to move to a state with no income tax.
LACK OF RELIABILITY
Mike could count on $36,000 a year from Social Security. Madison was eligible for half of this, or $18,000 a year. Because her own benefit was less than this, the system topped off her check to half of his. Their guaranteed income, backed by the US government, was slated to be $54,000 a year, or just under 15 percent of their need. (Compare this with 50 percent guaranteed for Bill and Sue and 90 percent for Tony and Toni.) Their assets would be tasked with generating the other 85 percent.
I roughed out their capacity, and despite a sizable pile of money, they were $1 million shy of the amount I’d ideally want them to have. They needed their investments to generate $321,000 in annual income. At 4 percent withdrawn per year, they needed $8 million. With only $7 million available, they would need to set the initial withdrawal rate at 4.5 percent.
Mike was adamant that he was out the door. “If I stay on to make the million and I get there in two years with substantial saving and a little help from favorable financial markets,” reasoned Mike, “the market could take a header, and I’d be two years older and right back where I am today. We’ve got what we’ve got. By any reasonable standard, it’s a lot, and it’s time to enjoy life.”
As I listened to Mike, I recalled a recent study that demonstrated that, on average, a retiree’s spending drops consistently throughout retirement. (Jonathan Guyton, CFP, “Why David Blanchett’s Retirement Spending Research Is a Big Deal,” Journal of Financial Planning, May 2016, https://www.financialplanningassociation.org/article/journal/MAY16-why-david-blanchetts-retirement-spending-research-big-deal.) Although I would have liked their money pile to be a bit larger, I knew we could make it work.
Madison recalled the stock market volatility chart I presented in an earlier meeting, which showed gains of at least 20 percent most frequently and downs in about one out of four years. “That chart makes me both hopeful and scared,” she said, a bit puzzled. “I am hopeful because a 20 percent year will drive a seven-figure return, providing almost four years of income, and scared because a drop like 2008 to early 2009 will erase that much or more in a few days.”
ADJUSTMENTS ARE POSSIBLE
At this point, we got philosophical and examined their budget. Yes, they wanted to spend $300,000 a year, but they didn’t really need that much to be happy. The $40,000 budgeted for annual travel could be reduced in tough times. And they learned from COVID-19 that there were plenty of enjoyments right at home. Prices tended to drop in recessions, which meant dollars stretched further, and they would likely spend less in their eighties than in their sixties. They didn’t want this factor built into their plan, but it provided a safety net—a buffer, a plan B—to which they could turn if needed.
We examined the three ways to generate income. Mike liked the simplicity of a 100 percent investment approach. He figured he’d been living his entire life without any significant financial guarantee by the government or anyone else for that matter. He didn’t see a need to pay for that now.
As he voiced this opinion, I noticed that Madison’s body language displayed discomfort, as she crossed her arms and locked her jaw. I asked for her thoughts. She was neither shy nor conflicted.
“I don’t need $300,000 a year,” she said, but she didn’t want to rely on only the $54,000 from Social Security.
BUILD A BIGGER BASE
No one can predict the future, and she wasn’t going to try. But just because financial markets have been favorable doesn’t mean they will remain that way. She figured she wanted a base of $10,000 a month. Then she’d be comfortable with pure investments producing the next $15,000.
Mike found wisdom in her approach and knew from decades of marriage that it was wise to get on board with her insights. I set to work designing a plan according to these specifications.
The next time we met, I presented their asset management and income generation plan. They had $54,000 arriving each year, in monthly increments, from Social Security.
To get this to $120,000, I researched annuity solutions. Since Mike and Madison did not have a corporate pension as Tony and Toni did, they had to create a private solution. Given low-interest rates, the pure annuity solution did not seem attractive. At their ages, they’d have to give an insurance company $1,365,000 to generate $66,000 a year for as long as each lived.
Alternatively, they could give a carrier $1,100,000 and generate the same income based on a rider guaranteeing a 6 percent initial withdrawal. It wasn’t perfect. The fees were significant, and the income might drop later if the contract ran out of money. But this approach allowed them to retain some control over the funds and generate a high rate of income from them safely. They funded this with a direct rollover from Mike’s employer plan.
This left $5.9 million to generate $255,000 of annual income. The $2 million nonqualified investment account would be responsible for $90,000. Of this, $270,000 was placed in US government-backed stable investments. The rest was invested in a tax-efficient growth and income portfolio.
The remaining $3.9 million in Mike’s retirement plan is needed to generate the other $165,000. Of this, $500,000 was allocated to the stable account—inside an IRA to preserve tax deferral—to serve as a three-year income reservoir. Mike and Madison invested the remaining $3.4 million in an IRA allocated to 70 percent equity to generate the growth of both asset value and real income that they required to fund their best lives.
As we wrapped up, I projected a spreadsheet on my office screen that demonstrated their asset and income plan. Of their $375,000 in income, $120,000, or just under a third, was guaranteed. Two-thirds would be generated from unprotected but well-managed, fully flexible investments.
In terms of their assets, they had $770,000, or 11 percent, allocated to stable, US government-based assets to serve as an income reservoir to get through bad times and $1.1 million, or roughly 15 percent, allocated to a protected annuity that would generate 18 percent of the initial income.
The remaining $5,130,000, or roughly 75 percent of their money, was invested for growth and income.
“Who pays the taxes?” asked a now relaxed Madison.
“You do,” I quipped, knowing that was not her real question. She frowned. “We will deduct them from your IRA withdrawals and send them directly to the IRS,” I explained. “Social Security will do the same. Some years, you may need to make direct tax payments, depending on what happens in your nonqualified or taxable account.”
They had one more important decision to make, I said, seeing they were ready to leave for a post-meeting meal. What day of the month did they want their money deposited? Madison said she wanted the annuity on the first of the month. Mike picked the fifteenth for his IRA and the twenty-first for the nonqualified funds. Having set up near-weekly paychecks for retirement, they left for dinner smiling.
The above article originally appeared as a chapter in It's All About The Income and is reprinted with permission from the author Michael Lynch. No parts of this article may be reproduced without correct attribution to the author of this book.