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It's All About the Income, Chapter 9: The System is the Solution

In this chapter, author Michael Lynch addresses the keys to developing the correct financial plan for yourself and maintaining financial independence.

By Michael Lynch, CFP

9: THE SYSTEM IS THE SOLUTION

Maria’s is a simple case to solve. She required roughly $3,000 a month of pretax income. Of this, $2,000 would arrive from Social Security. She needed only $1,000, or 2.4 percent, from her assets.

Michael Lynch, CFP®, is a financial planner with the Barnum Financial Group in Shelton, CT, where he focuses on his clients’ finances so they can focus on their lives. He teaches consumer-oriented financial planning courses for leading organizations, including Madison Square Garden and Yale New Haven Health Systems. He is a member of Ed Slott’s Elite IRA Advisor Group and the author of “Keep It Simple, Make It Big: Money Management for a Meaningful Life,” October 2020. You can find more articles and videos at michaelwlynch.com. He can be reached at mlynch@barnumfg.com or 203-513-6032.

Michael Lynch

Stop and apply this point to your finances. One of the largest misconceptions I hear regarding financial independence derives from a failure to separate income needed from assets and total income. The result is a belief that retirement isn’t possible or that it will come with a reduced standard of living.

It’s easy to see why. Applying a 4 percent withdrawal rate, Maria would need $900,000 to support her lifestyle of $3,000 a month. The number would drop to $300,000 if she appropriately restricted her need to equal income generated from assets.

GO YOUR OWN WAY

Don’t be held hostage to someone else’s income and asset needs. I hear it all the time: “So-and-so at work said I need $1 million to retire.” The person is usually short of this, approaching retirement, and a bit despondent. I run their numbers, and often I am a bearer of good news: they are already financially independent or rapidly approaching such bliss. A leading cause of delayed retirement is the ill-informed workplace know-it-all at the watercooler, who may want coworkers to stay around and share the misery. Discuss sports or music but neither money nor politics while hydrating.

With her $500,000, Maria was financially independent, provided she implemented a prudent asset management and income generation plan.

Given that Maria had more than half of her income coming from the “reliable income” bucket, she had the luxury of focusing on the “safety of principal” bucket—her favorite and the source of her economic misery—and the “growth of asset and income” bucket.

Her annual income need was roughly $12,000 from assets. She should leave $100,000 in “safety of principal” assets and invest $400,000 in a diversified portfolio of equity-based and fixed-income assets. Since she was very conservative, a moderate portfolio of 60 percent equity and 40 percent bonds would likely be appropriate. However, I’d try to move her up to 70 percent equity because I feel that’s better balanced considering her overall allocation.

SAFE ENOUGH

Here’s why. One in five of her dollars—or 20 percent—were already in the stable value assets. If we add that to the 30 percent in bond or fixed-income assets, only one in two dollars would be exposed to stock market risk. Over the long run, this has been only the “risk” of increasing both asset value and income generated at a rate greater than inflation. You saw this in Chapter Two. But in the short term, financial markets can collapse suddenly without warning, and you must plan for this.

If you step back further, you will see that although half of Maria’s assets would be subject to stock market risk, less than 33 percent of her income would be subject to this risk. More than half of her income was guaranteed and provided by the US government. I know it’s not perfect, but at present, there is no better guarantor in the world. Focus narrowly, and she seems to be accepting risk. Pull back on your aperture, and her system’s prudence and conservatism come into focus.

Counting Maria’s income dollars, you’ll see how this system works. She had $400,000 of investments generating $12,000 a year, allowing a roughly 3 percent withdrawal rate. Historically, she’d beat this with performance three out of four years (according to the Vanguard balanced index). She’d have more at the end of the year, after taking income, than she started with. In the one in four years of substantial portfolio declines, she could stop withdrawals on the portfolio and start drawing down her reservoir or safe account.

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AN EVEN MORE CONSERVATIVE SOLUTION

Maria may balk at this solution. It’s a large move from all cash to a preponderance of money that will fluctuate by the minute, day, week, month, and year without any predictable guarantees.

This is where annuities fit into a plan.

These are tools that provide both certainty in the present and guarantees for the future, subject to the claims-paying ability of the insurance company providing them.

We all have different tolerances for investment fluctuation and desires for portions of our income that we want guaranteed. During our entire lives, we accept risk with very few guarantees of our incomes, except the 1.5 percent of American workers who draw their checks from Uncle Sam. I’m appalled at the notion that new retirees suddenly need to be ensconced in some low-return, low-volatility plan for generating retirement income. It’s as if we revert to toddlers who must be kept away from the world’s many harms as well as its charms.

A BRIDGE TOO FAR

That said, Maria balked at my solution for a reason, and likely the $400,000 was a bridge too far for her to cross. In these cases, the insurance industry is more than happy to step in with many customizable solutions. In Maria’s case, I’ll examine just one.

Watching the pain on her face at the prospect of putting $400,000 of her hard-earned money directly into financial markets, I suggested she set aside $200,000 in a deferred variable annuity with an income rider. The deferred nature would allow her to retain control of the funds. This would provide some comfort. The income rider would allow her to withdraw a guaranteed percentage of these funds each year regardless of market performance. If the invested assets ever dropped to zero, the insurance company would provide monthly income for the rest of her life. This all came with restrictions and fees. Maria would need to understand it was a contract between her and a large insurance company. She would want to understand the nuances, definitions, and restrictions. She would need to read the prospectus. These tools are complex and not for everyone, but so are bulldozers, airplanes, and electric cars. Life in the modern world is often enhanced with the aid of complex tools.

In this case, she selected a contract that provided a 6 percent income stream while the money lasted and a guarantee of 4 percent thereafter if the funds ran out. This $200,000 now generated the $1,000 Maria needed each month. It increased her initial guaranteed income to 100 percent. It was not free, however, and the price Maria paid was not only the annuity fees but also the increased risk that inflation would erode the value of her income stream.

She now had $300,000 in complete reserve. In this system, she could keep $50,000 liquid for unexpected large expenses and invest $250,000 into at least a 70/30 mix of equity to fixed income. This would need to grow over time because it would be responsible for offsetting the effects of inflation on her annuity income. This plan secured all of Maria’s initial income with guarantees.

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The future will always remain uncertain. No objective way exists to predict which of the multiple plans available to Maria would prove to be her best. There are scenarios in which her all-cash status quo would win—for instance, if interest rates spiked, inflation stayed low, and financial markets collapsed and this unlikely cocktail of misery persisted for many years. If financial markets perform as they historically have and Maria enjoys a long life, then the investment-heavy approach is optimal. Many scenarios exist in which the annuity approach wins as well.

There is no such thing as a perfect plan. However, there is the right plan for you and your family.

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.


Read more of It's All About the Income

Introduction

Chapter 1: The Paradox of Retirement Income Planning

Chapter 2: Safety First!

Chapter 3: Getting Risk Right

Chapter 4: Two Out of Three Ain't Bad

Chapter 5: Win by Winning

Chapter 6: How Long for the Rebound?

Chapter 7: Building Blocks of Success

Chapter 8: Assess Your Needs and Fix Your Target