Retirement Income Sources

Almost all Americans will receive income from multiple sources in retirement. All income sources are not created equal. Each source has its own advantages and disadvantages. There are two dimensions to consider when gauging the value of a retirement income source – vertical and horizontal.

The vertical dimension concerns how much periodic income the source can provide. This depends on the source’s accumulation potential, based on its pre-retirement rate of return, its exposure to taxation in retirement, its retirement rate of return and the risk to principal. The horizontal dimension concerns how long the income will last. This depends on the capital sum or accumulation relative to the withdrawal rate and the contractual or political commitments underlying the income.

Many analysts believe that people throughout the world tend to overweight the vertical dimension and underweight the horizontal dimension in planning for retirement. This is especially significant with the increases in life expectancy at age 65 that have occurred in the late 20th century.

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The List of Retirement Income Sources

A list of income sources, along with their advantages and disadvantages, should include the following:

Retirement plans – This includes 401(k)s, IRAs, SEPs, 403(b)s, 457s, Keogh plans and more. They need to be considered as a group because of their structural similarities, but their underlying asset makeups can differ. Surveys show this category to be the most popular source of expected retirement income, even though past history places it far behind Social Security as an actual retirement income source. Retirement plans rank very high on the vertical scale because their tax-deferral investment and growth status and high proportion of equity investment give them the largest accumulation potential. They rank much lower on the horizontal scale. IRS rules make withdrawals mandatory no later than age 70 ½ and investment risk poses danger to principal value.

Social Security – Ranking second-highest in surveys of expected retirement income, Social Security has provided far and away the largest part of actual retirement income – nearly 40% over the last few decades. Its Ponzi-like structure depends on favorable demographics for its viability, and increases in life expectancy and declines in birth rates have thrown a monkey wrench into this plan throughout the world. Consequently, Social Security ranks lowest of all on the vertical scale. It ranks very high on the horizontal scale because its political promise of benefits is geared to life expectancy. Moreover, Social Security benefits are indexed to inflation as measured by the Consumer Price Index, which may be counted as both a vertical and horizontal plus.

Pensions – Surveys rank this as the third-leading source of expected income, although its relative ranking is lower than in past decades because defined benefit plans have taken a back seat to defined contribution plans. Pensions rank lower on the vertical scale than retirement plans. Earnings are taxed as ordinary income. Public pensions rank higher than private ones unless they produce large reductions in Social Security benefits. Pensions rank high on the horizontal scale because of their life-annuity structure. Their chief drawback is the risk to principal. Private pensions are endangered by the failure or deterioration of the company. Public pensions are more secure, but recent events suggest that even they are not invulnerable.

Personal savings – Interestingly, this is one of only two categories where surveyed expectations dovetail with the past history of retirement income. Historically, this is one of the four major categories of retirement income. It comprises assets such as CDs and savings accounts, which are politically insured by agencies such as the FDIC. This category ranks fairly low on the vertical scale because of the low rate of return and taxable status, but slightly higher on the horizontal scale because it is not subject to mandatory withdrawals. Its chief horizontal drawback is its vulnerability to inflation.

Part-time work – This is the other category where surveyed expectations line up with past history, which links about one-fifth of retirement income with earnings from work. This category ranks only moderately high on the vertical scale because people will be less able to hold a job and less productive on the job after retirement. During the more productive years, income may reduce earnings from Social Security. It ranks even lower on the horizontal scale because work life increases much less than proportionately with biological life.

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Home equity – Surveys rank this as a significant source of expected retirement income. Respondents generally intend to borrow against the value of the home to finance consumption in retirement. Ironically, economists consider home ownership a very important source of real income in retirement for a different reason – the value of the services provided by the home itself. Home equity is hard to evaluate on the vertical scale. On the one hand, a home is indivisible, thus somewhat lacking in liquidity. On the other hand, this problem can be surmounted with home equity and reverse mortgage loans. These measures raise further potential problems, particularly for estate planning. Home equity ranks high on the horizontal scale because the long-run trend of real estate prices is inexorably upward. The only drawbacks are the expenses of maintenance and the risk posed by short-term fluctuations in prices – as the current crisis attests.

Annuities – Many analysts consider this the most underrated potential retirement-income source. On the horizontal scale, it is superior to pensions because insurance company investments are much more diversified, hence safer, than the assets of a single company. Annuities are superior to Social Security because they are backed by two promises, one contractual and the other political (the state Insurance Guaranty Fund). On the vertical scale, annuities rank fairly low, in the same ballpark as private pensions. Many analysts believe that the predominance of Social Security accounts for this low ranking by forcing private annuities to accommodate a mostly-long-lived clientele, thus driving up their costs and driving down their payout.

Rents, royalties, etc. – This is a small but not insignificant share of both expected and past retirement income. Its vertical status varies according to circumstances from moderately high to very high, despite its taxability. Its horizontal ranking is high because of the durability of rental assets and copyrights.

Equities

Stocks and bonds are two asset categories not treated separately above. Stocks rank just below personal savings in surveys of expected retirement income; their status has declined during the current financial crisis. Their vertical ranking is very high because of their accumulation potential, growth potential, high withdrawal rate and the tax advantage of paying long-term capital gains tax compared to ordinary income tax. Their only drawback is a serious one – principal is at considerable risk during market downturns such as the one in 2008-2009. They rank high on the horizontal scale because their growth potential makes it possible to lengthen the income-receiving horizon. This tradeoff between vertical risk and horizontal growth makes it reasonable to hold a limited stock portfolio even in retirement, given today’s longer life expectancies. It should probably be held in the diversified, managed form of a mutual fund or exchange-traded fund, rather than in individual stocks.

Bonds are often not considered separately in surveys despite their obvious importance to retirement. Their vertical ranking is fairly high because of their predictable withdrawal characteristics and comparative safety; this is why stocks are so often converted to bonds in retirement. Their horizontal ranking is also fairly high because long-term bonds can be purchased and easily rolled over to last for the length of retirement. Once again, they are vulnerable to inflation, although the recent introduction of indexed government bonds reduces this risk.

Summary

The list of potential retirement investment assets is lengthy. Gauging their relative value is a complex process that should apply both a vertical scale and a horizontal one. The vertical scale considers how much income the asset can potentially provide. The horizontal scale considers for how long the income can be provided.

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