As the U.S. economy teeters on the brink of recession, you may be wondering how you can build a retirement income portfolio that will stand the test of time. Like many other pre-retirees or retirees, you’ve probably been spooked by the stock market in 2022.
If your retirement income strategy includes annual withdrawals from your investment portfolio to fund your lifestyle, a stock market decline like this could negatively impact you. This is because withdrawals in addition to market declines can permanently damage your nest egg. This may mean cutting back on your lifestyle so you don’t run out of money.
One way around this dilemma is to build a portfolio that creates a steady source of reliable cash flow while allowing for the potential for capital appreciation. This strategy, combined with a retirement plan based on a realistic estimate of retirement costs and optimized Social Security claims, sets the stage for success.
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This article will discuss how an income-driven approach to retirement planning works, as well as the benefits of using it in your retirement income portfolio.
Create a realistic retirement income plan
To create a realistic retirement income plan, there are specific steps that put cash flow at the center of your retirement planning process while avoiding chasing results. These three steps are:
- An assessment of your specific income needs based on your anticipated retirement lifestyle. This budget or spending plan should include non-discretionary and discretionary spending. You’ll also want to cover other contingencies that arise in retirement, such as inflation, taxes, and rising medical costs in later retirement.
- Optimizing Social Security and other sources of income includes determining what sources of income you will have and the best time and sequence to activate those sources of income.
- Then bridging the income gap is very easy. You subtract your expected income from your expected expenses to get this number. While there are many ways to generate this income, one involves an approach based on multiple dividend strategies and structured notes, which will be explained in the example below.
How Cash Flow Driven Retirement Planning Works
Let’s say you’re getting ready to retire. You need a pre-tax income of $100,000, adjusted for 4% inflation over the previous year to account for the inevitable inflation that will occur during your retirement. You and your spouse will claim Social Security benefits of $64,000 per year. This creates an income gap of $36,000 per year that should be generated by your $1 million tax-deferred IRAs.
There are many ways to generate that $36,000 to close the income gap. Many advisors use fixed index annuities. Unfortunately, they lack liquidity and often carry high fees.
Dividend stocks and structured bonds are viable alternatives to fixed index annuities. Dividends from growth companies with a proven history of increasing dividend payouts over time offer earnings and dividend growth to offset inflation. You can use structured notes to fill this gap. Structured notes (opens in new tab) are debt instruments with a derivative component. Available through financial institutions, structured notes come in a variety of maturities and styles.
The interest rates associated with structured notes vary based on market factors, interest rates and other variables. Equity-linked structured notes like these are tied to a specific market index, such as the S&P 500, the Dow Jones Industrial Average and the Nasdaq 100.
Structured notes come in several different styles. These European-style equity-linked structured bonds include a feature known as an interest rate barrier. An interest rate barrier is a point at which you believe the index you are investing in will not fall within the time frame of your investment. These structured notes have a 50% interest rate barrier.
The notes are intended for investors seeking a contingent interest payment with respect to any review date for which the closing level of a group of indexes—in this case, the S&P 500, the Nasdaq 100 and the Dow Jones Industrial Average—is greater than or equal to 50% of its original value.
In other words, the interest rate barrier means you’ll get your money back plus interest payments as long as none of these indexes fall by 50% or more. However, if any of the indices falls by 50% or more during the period of time you own the structured note, the value of your investment will fall by any market loss that occurs — whether it is 50% or more. You will still collect the monthly income payments.
It is important to understand that you can negotiate barriers, term lengths and coupon yields that are higher or lower depending on your risk tolerance. Like all investments, structured notes are subject to risk and potential loss. The examples are for illustrative purposes only.
There are different ways to build your portfolio depending on your risk tolerance and how much you want to invest. Here are two examples:
Benefits and risk reduction
There are many benefits to this approach. These include the ability to avoid selling stocks when the market falls in order to get income to fund your lifestyle. This benefit mitigates what is known as return sequence risk, which occurs when withdrawals during a market downturn further deplete your portfolio, leaving less principal to rebuild when the market rises again. This situation can leave you with even fewer principles to draw on in the future, meaning you’ll potentially have to cut back on your lifestyle.
Another point in favor of this type of portfolio is liquidity. In other words, you retain access to your savings if you need them for other purposes or decide to reposition your portfolio.
A cash flow-centric approach also helps you deal with market events such as bear markets and highly volatile markets. This is because you generate income from dividends and interest produced by your investments, not from selling those investments. This gives you time to recover from bear markets that could otherwise negatively impact your retirement.
If you are preparing for retirement but have not yet retired, you can reinvest the dividends and interest produced by your investments or keep them in cash. When done strategically, such an approach can provide you with either additional investment principal for growth or a year or two of cash retirement income. If you choose to keep that income in cash, you could use those funds for your expenses when you initially retire, allowing your investments to continue to appreciate.
Dividend investing also offers a reliable and predictable income stream near and after retirement, stable investment returns and preferential tax treatment. Structured notes offer the opportunity to earn relatively high interest rates with little risk.
On the downside, dividend investing, like other types of stock investing, is subject to the risk that a dividend stock or stocks will underperform and the market itself will fall. Dividend stocks may not perform as well as the rest of the market. Also, the companies that offer the dividends you invest in may change their dividend policies. Structured bonds are riskier than conventional bonds. If the market falls more than you bet it will, you could lose principal.
The bottom row
Dividend stocks tend to be less risky than non-dividend stocks in general, but to get the most out of all they have to offer, you should familiarize yourself with both the pros and cons of dividend investing before you attempt to. implement them as part of your investment portfolio strategy. Similarly, you should familiarize yourself with structured notes and their advantages and disadvantages before investing in them.
This type of retirement income portfolio provides ample cash flow, creates plenty of liquidity and income, while reducing consistency of returns and market risk.
Amy Buttle contributed to this article.
Investment advisory services offered by duly registered persons through CreativeOne Wealth, LLC, a registered investment adviser. CreativeOne Wealth, LCC and MOKAN Wealth Management are unrelated entities.
This information is provided by a representative of the investment adviser and does not necessarily represent the views of the presenting adviser. Statements and opinions expressed are those of the author and are subject to change at any time. The content provided is for review and informational purposes only and is not intended and should not be relied upon as individual tax, legal, fiduciary or investment advice. All information is believed to be from reliable sources; however, the presenting insurance professional does not guarantee its completeness or accuracy.
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