Retirement Income Planning: Focus on Income—Not Assets—for Retirement Security
Leading up to retirement, many people focus on building up enough wealth to last throughout their golden years. But the focus should be on something a Nobel Prize winner in economics says is even more important: creating income throughout retirement.
Without this attitude, your retirement could be a disaster.
“The seeds of an investment crisis have been sown,” writes Robert C. Merton, recipient of the 1997 Alfred Nobel Memorial Prize in Economic Sciences and the School of Management Distinguished Professor of Finance at the MIT Sloan School of Management, in an article for the Harvard Business Review. “The only way to avoid a catastrophe is for plan participants, professionals, and regulators to shift the mindset and metrics from asset value to income.”
The value of their funds and the return on investment they deliver is driving many investors’ decisions—a trend sparked by the introduction of defined-contribution retirement plans rather than the formerly popular defined-benefit pensions, he says.
But the primary concern of those saving for retirement remains what it has always been: whether they’ll have enough income in retirement to live comfortably.
The danger of focusing on assets only
While U.S. Treasury bills have generally been considered the “definitive risk-free asset,” Merton writes, “… if we look at the unit of measure that matters to our consumer—how much the saver would receive if the investment were converted into an income stream—then T-bills are shown to be very risky, nearly as volatile as the stock market.”
Merton gives an example of someone who plans to live off the income from $1 million he invested in Treasury bills.
- In one scenario, the consumer retires in a given year and converts his investment into an inflation-protected annuity with a return of 4% to 5%. The annuity will provide an annual income between $40,000 and $50,000.
- In another scenario, the consumer retires a few years later, at a time when the return on the annuity has dropped to 0.5%. Now, his annual income will only be $5,000.
Even though the $1 million principal amount from the Treasury bills was fully insured and protected, converting the investment into an income stream did not yield nearly enough annual income.
What is investment income? Retirement income investing
Two methods Merton recommends for guaranteeing income after retirement include:
- Long-maturity U.S. Treasury bonds
While Treasury bills preserve the initial principal at all times, says Merton, the income received on them can vary “enormously” depending on annuity returns at the time of purchase.
Had the above-mentioned retiree bought a long-maturity U.S. Treasury bond (rather than bill) with his $1 million, his spendable income would have been secure for the life of the bond, even though the price of the bond would fluctuate substantially from day to day.
That’s true for annuities, too, Merton continues. Market value for annuities can vary daily, but the income they generate is secure throughout a retiree’s life, illustrated with the example of 45-year-old Betty, who wants to guarantee a certain level of retirement income once she turns 65.
Assuming Betty will live to age 85, the safe, risk-free asset for that person that guarantees her objective is an inflation-protected deferred annuity that will begin making payouts in 20 years—and then pays the same amount (adjusted for inflation) each year for the next 20 years.
If Betty has enough money in her retirement account to buy that annuity, along with the desire to lock in that future income, the “obvious decision,” says Merton, is to buy the annuity.
Under conventional investment standards, the annuity looks too risky as market value of annuities and other long-maturity fixed-income securities fluctuate due to changing interest rates, he says. But what doesn’t change is the income that annuity will provide in retirement, Merton continues.
Ultimately, the Nobel prize winner recommends that investment managers continue to manage the risk-free portion of an individual’s portfolio in a way that allows that person to purchase an annuity upon retirement that would generate income to support a targeted standard of living—regardless of where interest rates and inflation go in the meantime.
Work With a Professional to Achieve the Best Retirement Income Plan
Retirement income planning is complex. You may want to consider working with a retirement advisor to help you estimate your retirement income needs and then help with your retirement income planning.