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Guaranteed income offers all kinds of benefits to a financial plan but also comes with tradeoffs, namely growth and cost. Finding the “sweet spot” for a guarantee in a financial plan is tricky and not always readily apparent. Furthermore, differences in opinion within a family unit can cause disagreement about the “perfect” design.

When referring to a guarantee in this article, I am referring to income annuities and pensions. These vehicles offer buoyancy to the financial plan in the form of guaranteed income, typically for life. The vehicles may or may not have a COLA (cost of living adjustment) and may or may not offer an option to rollover a lump sum to a Traditional IRA.

Guarantees offer peace of mind in the form of perpetual income. That’s why they exist. That’s a bedtime story many retirees enjoy waking up to.

What’s the 75% guideline?

Over the past 10 years, I’ve discovered what appears to be a reasonable generalized guideline for the preferred guarantee level. The guideline came about from completing lots and lots of financial plans, watching them play out, and having reviews with clients afterward to discuss the results. This preference seems to apply to clients in a specific financial position. The profile is usually a client with a guarantee (such as a pension) PLUS enough additional market-correlated assets to offset long-term inflation. I discovered that these clients often felt their plans were “just right” when the guarantees fell to about the 75% level of guarantee versus annual expenses. In my opinion, it’s easy to see why.

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The 75% guideline is called a guideline for a reason. If it were less subjective, I’d call it a “rule.” Here is how it works. When considering total expenses and starting retirement, guaranteed instruments cover 75% of total expenses. That can include a pension, social security, and in some cases, an income annuity.

Why not 100%?

In my experience, this is where guarantees get subjective. As mentioned before, the cost of any guarantee is the loss of hypothetical growth. That is the rate of return on what the annuitant could have done with the money. There is no question that it generally makes no sense to put all of one’s money into a guaranteed vehicle. That’s because the tradeoff with guaranteed money is that pesky erosion effect by inflation. Something must be set aside to capture market appreciation. So what is the logic as to why not 100%?

I generally separate expenses into two distinctive categories: essential expenses and discretionary (or non-essential) expenses. The non-scientific “client-friendly” explanation is that of total expenses, roughly 75% are probably necessary non-negotiable expenses. The remainder tends to be identifiable as discretionary. So basically, we’re just shoring up essential expenses but not going so far as to offset ALL expenses. The sweet spot tends to be of all the expenses, around 75% guaranteed and 25% non-guaranteed.

The logic is if there is a downturn, it’s less impactful to pull back 25% of expenses versus 50% (or more). That leaves just enough room for the guarantee’s stability but also practically maximizes other market accounts for growth and as an offset to long-term inflation.

If the preference is to cover all discretionary expenses, then that’s a personal choice. If inflation is successfully offset, I’ll say “do it.”

What’s the point of saving all that money if you’re not going to spend it?

The good kind of COLA

I’m not referring to carbonated high fructose corn syrup kind of COLA. A Cost of Living Adjustment (COLA) is an annual guaranteed increase attributable to pensions, annuities, and social security. If a COLA is attached to an income source, they are often the game-changing detail we’re hunting for when developing a sound income plan. What is amazing is the frequency of clients who are completely unaware of what a COLA is and if they have one. Even what appears to be a relatively minor adjustment of 1 -2% adds up over time and can double or even triple a retiree’s income throughout retirement.

One caveat is that COLAs, specifically with income annuities (SPIAs), can be cost prohibitive. Most traditional pensions and social security have COLAs by default and are often pre-built into the program. Those pensions are, I find to be, the “good ones.” When a COLA is optional or an add-on, that’s typically the signal to look a little closer at that “cost.”

Still, a COLA’s positive effect on the plan is massive. That’s because not only does the pension offer buoyancy, but because of the COLA, it also offers an offset to further shore up stability over time. It’s now doing much of the heavy lifting against future inflation needs. That’s huge! A COLA can free other deferred money (IRAs, 401(k)s) to take on more risk to potentially “go for it” and cause significant damage against long-term inflation beyond what the COLA is not already doing. That offers a peace of mind that is often hard for the new retiree to visualize. It’s what I call the “bulletproof” financial plan.

Real Estate as guaranteed-like income

As a financial advisor, I am unique because I believe in Real Estate as an income strategy for specific clients. It generally goes against the conventional interest of many in the financial services industry (aside from the real estate gurus). I will say, though, that there are excellent reasons for the masses not to utilize Real Estate as a reliable strategy for income. But in the right situation with the right personality, Real Estate can offer a fantastic solution for dependable income in retirement. Income associated with Real Estate will never be considered a “guarantee.” Still, with some properties, it sure looks a lot like a guarantee (sometimes better).

We discuss many of the pros and cons of Real Estate in our article Pros & Cons of Becoming a Real Estate Tycoon. The bottom line is that the right combination of personality, experience, and commitment across everyone in the family unit can present a wonderful opportunity offering both income and growth. The “ace” in this situation is perhaps when the property is personally usable. I suppose that is why the wealthy love Real Estate as an investment. Ironically, many of the oldest insurance companies utilize this strategy, owning hotels for 100 years or more in all the major metropolitan cities. They must also enjoy a stable income too.

How much is too much?

I have seen many cases where the pension is the only asset an individual has aside from a house and maybe a deferred investment account (IRA, 401(k), etc.). In these cases, there often isn’t significant amounts of other money to rely upon should a sudden need arise. 

For example, imagine the water heater suddenly died. And due to a lack of liquidity, the new one has to go on the credit card temporarily. It then gets paid off only once the pension income eventually shows up. Repeat that for any unforeseen events and major expenses throughout retirement. The fundamental issue is the lack of liquidity when income needs inevitably spike.

Your Nana is missing because she’s been passing those bum checks all over town, and she finally pissed off the wrong people!

-Kramer, “Seinfeld” The Pledge Drive (TV Episode 1994)

This situation requires saving up or credit “backstopping” to account for these one-off events that are inevitable from time to time. It’s not a financial crisis, but it’s certainly not the ideal level of flexibility everyone seems to want when developing the “perfect financial plan.” When I see plans, I’m looking for a sound foundation for income (guarantees), offering a reasonable degree of buoyancy and plenty of tactical liquidity (cash, post-tax brokerage accounts).

I know what you’re thinking, yes the deferred accounts (IRAs, 401(k)s, Roth) can still act as a supplemental resource. Still, due to their taxable nature, this can create a natural resistance to wanting to spend from these accounts and utilizing them as a reliable resource for supplemental income beyond a guarantee. Deferred accounts tend to prefer to focus on growth and offset long-term inflation. And, of course, Roths offer tax-free growth, so they generally also benefit from a “let ’em ride” approach to account management. Cash and post-tax brokerage accounts can provide the lovely backstop to guaranteed income and, ideally, cover (possibly along with any RMDs) that extra 25% not covered by the guarantees. To boot, wouldn’t it be nice also to have that post-tax “engine” be primarily municipal bonds and other “safer” income vehicles to reduce risk? Then just let the deferred account go to town on inflation. Or maybe that’s just me.

To learn more about the benefits of post-tax brokerage accounts and withdrawal strategies, read our article Planning a Sustainable Withdrawal Strategy for Retirement.

Editor’s note: This blog offers informal investment and financial planning advice. We know nothing about your unique financial situation. The buying and selling of any financial product or security should only be considered in context. If appropriate, seek the counsel of experienced, ideally objective, financial, tax, or estate planning professionals. Past performance is not indicative of future performance.

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