Planning to retire soon? Here’s advice on how to plan for investment income.

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As the long-awaited day of retirement approaches, most people will need an investment strategy to generate income to cover living expenses. Peace of mind comes from knowing you’ve put a plan in place that will provide financial security throughout your retirement years.

Two primary investment risks to consider

Planning for retirement income requires careful consideration of the risks soon-to-be-retirees face. While Social Security provides a foundational pillar of retirement income, for most it falls well short of covering the entirety of expected expenses. This means most retirees will need to come up with additional savings to invest for retirement income.

When investing for retirement income, there are two primary risks that come into play: longevity risk, and inflation risk. Longevity risk is the risk of outliving your retirement savings, and inflation risk is the risk of a dramatic increase in the cost of living overcoming your ability to maintain your standard of living. Not surprisingly, there are a number of investment alternatives well suited to overcome these challenges. Today we’ll consider two of the most popular.

Immediate fixed annuities: Take advantage of higher interest rates

An immediate fixed annuity is a contract between you and an insurance company in which you agree to hand over a lump sum of money in exchange for guaranteed income. The income is fixed, paid monthly until your death, and is not affected by stock market volatility or fluctuations in interest rates. These features make this option ideal for those concerned about longevity risk.

The sharp rise in interest rates over the past 18 months has meaningfully increased the yield of immediate fixed annuities. According to Kelli Hueler, CEO of Hueler Companies, if a 65-year-old male had invested $100,000 in an immediate fixed annuity in 2020, he would’ve received $495 per month until death. Today, that same $100,000 invested in an immediate fixed annuity will pay a 65-year-old male $671 per month until death. That’s a 35% increase in retirement income.

The guaranteed income provided by immediate fixed annuities comes with its own risks because they lock in the current interest rates for your lifetime. A surge in inflation could lead to a cash flow crunch if too much of your retirement income is fixed. One strategy is to build a ladder of fixed annuities, meaning you invest $100,000 in an annuity today and another $100,000 a year or two later if rates continue to rise.

Balanced funds: Pursuing both income and inflation protection

While higher interest rates give immediate fixed annuities increased appeal, an alternate approach is to invest in a well-managed, low-cost balanced fund. Balanced funds invest in a combination of stocks and bonds and can allow retirees to meet their income needs while preserving a high probability of protection against inflation.

If you’re willing to accept the unpredictability of year-to-year market fluctuations, you’ll be facing what industry experts call “sequence of returns” risk. This is the risk of experiencing a significant loss early in your retirement journey which impacts your portfolio’s long-term income production. Despite this risk, this approach offers meaningful long-term advantages.

To put the appeal of balanced funds, and the risk-return tradeoff they represent in perspective, it’s reasonable to consider a scenario where a balanced fund generates an average long-term (i.e. multi-decade) annual return of around 8%, which is a conservative estimate for some of the best funds in this genre. In this scenario, a 65-year-old investor who puts $100,000 into a balanced fund, earns 8% per year, and withdraws 4% per year for income, could expect monthly payments averaging $638 over a hypothetical 30-year retirement period. Importantly, for the same investor who lives to the age of 95, there’s the potential for over $300,000 to remain to offset any future inflation or pass on to heirs.

Choosing the path that fits your future

The use of immediate fixed annuities or balanced funds hinges on your individual goals, risk tolerance, and long-term financial aspirations. While immediate fixed annuities offer guaranteed income and protection against market volatility, the balanced fund approach aligns with those who seek to balance income needs with the desire to build wealth to protect against inflation or leave a legacy to their heirs. Some choose to combine the two strategies to cover longevity, inflation, and sequence of return risks. The ultimate decision should reflect your financial objectives as well as the legacy you wish to leave behind, embodying the balance of a secure present and a prosperous future for you and your loved ones.

This column was also featured in the Milwaukee Journal Sentinel and Star Tribune. The material provided is for informational purposes only. Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Francis LLC does not offer personal legal advice.

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