Building a Retirement Income Portfolio That Can Last
James had done everything right. He maxed out his 401(k) for 30 years, lived modestly, and retired at 65 with $850,000 saved. He felt proud walking out of his office for the last time.
Then reality hit. How does $850,000 become monthly income? He could see the balance in his account, but he had no idea how to turn that lump sum into the steady paycheck he’d relied on for decades.
James discovered what many retirees learn the hard way: accumulation and distribution are completely different skills, and most people spend their entire working life focused on the first without preparing for the second.
The Core Challenge
During your working years, investing can be relatively straightforward. You’re typically making regular contributions, you don’t need immediate access to the funds, and short-term market fluctuations tend to matter less because you’re investing consistently across different market conditions over time.
In retirement, everything flips. You’re withdrawing regularly, you need the money now, and market volatility can be devastating. Selling stocks in a down market can lock in losses and permanently reduce your capital base.
This is a sequence-of-returns risk: the risk that poor market returns early in retirement force you to sell stocks when they’re down, reducing your portfolio’s ability to recover and sustain income needs over time.
“The transition from accumulation to distribution may require setting up a different strategy,” says Jack Lamont, Senior Vice President of David Lerner Associates.
“The portfolio that got you to retirement may be more aggressive than what you actually need in retirement. It’s important to reevaluate how to preserve your capital yet still use it for your needs.
The 4% Rule and Its Limitations
The famous 4% rule suggests withdrawing 4% of your portfolio in year one of retirement, then adjusting that dollar amount for inflation each year. With a $1 million portfolio, you’d withdraw $40,000 the first year.
This rule came from research showing that historically, this approach would have lasted at least 30 years in most scenarios. But it has limitations:
It’s inflexible. Markets fluctuate, but your withdrawal stays constant plus inflation. This can deplete your portfolio faster in down markets.
It assumes a fixed timeline. Retiring at age 55 versus age 70 requires different withdrawal tactics.
It ignores individual circumstances. Someone with a pension and Social Security may withdraw more than someone with no other income.
Better approaches involve dynamic withdrawal strategies that adjust based on portfolio performance and market conditions.
The Bucket Strategy
One popular framework is the bucket approach. It involves informally dividing a portfolio into segments based on time horizon and purpose:
Bucket 1 (Cash bucket):
Some investors choose to hold a portion of their portfolio in cash, money market funds, or short-term bonds to help cover near-term expenses. This is what you live on and may reduce the need to sell more volatile investments during market declines.
Bucket 2 (Income bucket):
Another portion may be allocated to investments that have the potential to generate income or moderate growth, such as bonds, dividend-paying stocks, or real estate-related investments. These assets are sometimes used to help replenish shorter-term reserves (bucket 1) over time.
Bucket 3 (Growth bucket):
The remainder may be invested in assets for long-term growth such as stocks, with a longer investment horizon. These investments are typically more volatile but may help address inflation over time.
Some investors choose to periodically rebalance or reallocate assets among these segments, especially during favorable market conditions. During periods of market volatility, maintaining a mix of assets may help support different spending needs without relying solely on any one investment type.
Dividend-Focused Investing
Dividend-paying stocks are sometimes used by investors seeking a combination of income and equity exposure. Many established companies have a history of increasing dividends over time, which may help offset the effects of inflation.
When evaluating dividends, investors may consider factors such as:
- A long history of dividend growth at a company
- The relationship between dividend yields and investment risk
- The level of diversification across sectors
Dividend investing isn’t without risk. Companies can reduce or eliminate dividends, and stocks prices can change in value over time. It’s important to evaluate your needs, situation, and time horizon when choosing your approach for retirement income.
Bond Ladders for Predictable Income
A bond ladder is a strategy in which an investor holds individual bonds with staggered maturity dates. An investor might buy bonds maturing in 1, 2, 3, 4, and 5 years. Each year, a bond matures the proceeds can then be used to be reinvested into new bonds with longer maturities, creating a “ladder” effect.
This strategy may provide:
- More predictable income from interest payments
- Return of principal at maturity
- Reduced interest rate risk than a single long-term bond
- Reduced need to sell bonds before maturity
Bond ladders often work best with investment-grade corporate bonds or Treasury bonds. It’s important to keep in mind the risks of lower-rated bonds, including a higher risk of default.
Annuities as Income Foundation
Annuities can play a role in retirement income planning by providing a predictable income stream. However, without proper knowledge, they can be complicated and may involve fees and restrictions.
There are many types of annuities that offer different structures. Here are some types to consider:
Single premium immediate annuities (SPIAs):
Trade a lump sum for immediate income that can be structured to last for life or a set period.
Deferred income annuities (DIAs):
Trade a lump sum now for income at a future date.
Fixed index annuities (FIA) with an income rider:
An FIA provides returns linked to a market index, typically with limits, and generally includes protection against market losses. Adding an income rider can allow for a lifetime income stream based on contracted terms.
Annuities may be most effective as part of a diversified strategy, not as your entire retirement plan. Consider annuitizing enough to cover fixed expenses, leaving the remainder invested for growth and flexibility.
Dynamic Withdrawal Strategies
Rather than relying solely on fixed 4% withdrawal approach, consider strategies that adapt:
Percentage-based approach:
Takes distributions as a percentage of a portfolio’s value, which can result in income levels that vary as the portfolio fluctuates over time.
Guardrails framework:
Introduces upper and lower thresholds that may influence how spending levels change in response to market performance.
Age-Based Withdrawal Framework:
Uses life expectancy and account balance factors, similar to an RMD, to determine distribution amounts that adjust over time.
Floor-and-ceiling framework:
Separates essential and discretionary expenses, where more predictable income sources (such as Social Security, pensions, or annuities) may be used for core needs, while portfolio assets may support more flexible spending.
Tax-Efficient Withdrawal Sequencing
The order you tap into different accounts can matter enormously for tax planning:
Generally, withdrawals are often taken in this order:
- First from taxable accounts
- Then from tax-deferred accounts (like traditional IRAs or 401(k)s)
- Finally, from tax-free accounts (like Roth accounts)
However, in some situations, people may choose to withdraw from tax-deferred accounts earlier than expected. This can be done to spread out taxes over multiple years, reduce future required minimum distributions (RMDs), or help avoid moving into a higher tax bracket later on.
It’s important to factor in Social Security taxation, Medicare IRMAA, capital gains rates, and state taxes when planning your withdrawal strategy with tax-smart tactics.
Putting It Together
When building a sustainable retirement income strategy, you should address how to:
Generate reliable income: This may include a mix of income sources to help cover both essential and discretionary expenses.
Balance stability and growth: Combining more stable investments with those that have growth potential can help support income needs over different time horizons.
Manage withdrawals over time: A thoughtful approach to how assets are drawn down and taxed can impact how long a portfolio lasts.
Building a thorough retirement plan first involves understanding how much you actually need to retire comfortably. You can use our retirement planner to get a better idea of the numbers.
Want to discuss more in depth about retirement strategies? Speak to an Investment Counselor at David Lerner Associates, to discuss personalized strategies and guidance for your financial future.
Material contained in this article is provided for information purposes only. It is not intended to be used in connection with the evaluation of any investments offered by David Lerner Associates, Inc. This material does not constitute an offer or recommendation to buy or sell securities and should not be considered in connection with the purchase or sale of securities. These materials are provided for general information and educational purposes, based on publicly available information from sources believed to be reliable. We cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.
The subject of this article is fictitious and created for illustrative purposes only. It is based on events of a similar nature and should not be interpreted as a direct depiction of any specific individual, organization, or incident. Any resemblance to actual persons, living or deceased, or actual events is purely coincidental.