Last week, we reviewed several obstacles, like inflation, that can stand in the way of your client enjoying a retirement with dignity. Now, let’s see if we can illustrate a simple yet extremely powerful planning technique. This is a lifetime income planning option, because it involves mathematically allocating assets in a way that gives a person what may be the best chance for generating an income that he or she can’t outlive.
Here is a hypothetical situation where there is $250,000 of available savings, the client is age 70, and he has the following objectives:
- Needs $12,000 of annual income.
- Wants that income adjusted for a 2 percent rate of inflation.
- Wants to be certain, if possible, he will never run out of money (income will never stop).
With a multiple fund retirement planning approach, the client would divide the $250,000 into three amounts or funds.
The first fund will hold money and distribute income for a period of five years. During this period we will assume that the money in this fund earned a 4 percent rate of return. The money in this and the other funds can be invested in anything that the client prefers, but that investment must earn a 4 percent rate of return in order to make this example valid.
The second fund will hold money (grow without distributions) for a period of five years and then the money in this fund will be used to provide income for another five years (total of 10 years). Like the first fund, the money in fund #2 can be invested in anything, but that investment must earn a 5 percent ROR in order for this example to be valid.
The reason we are assuming that fund #2 will earn more interest than fund #1 is because it will be held for a longer period of time 10 years as opposed to five years.
The third fund will hold money (grow without distributions) for a period of 10 years and then the money in this fund will be used to provide income for another five years (total of 15 years). Like the first and second funds, the money in fund #3 can be invested in anything, but that investment must earn a 6 percent ROR in order for this example to be valid.
The reason we are assuming that fund #3 will earn more interest than fund #1 or #2 is because it will be held for a longer period of time 15 years as opposed to five years for fund #1 or 10 years for fund #2.
Based upon the objectives of the client in this hypothetical example and the rates of return that we have assumed for the three funds, the client would need to place $53,422 of his total money ($250,000) into fund #1; $46,214 of his total money would go into fund #2; and the remaining $150,364 of his total money would be allocated to fund #3.
Again, we have allocated the money to these three accounts or funds because each will be designed to do a specific job. He still has the same total amount of money $250,000.
The $53,422 in fund #1, earning a rate of return of 4 percent, should be able to provide an annual income of $12,000 (the client’s objective) if both interest and principal were used for the distributions. The concept behind this strategy is that by the end of five years there would be no money remaining in fund #1. His fund is completely liquidated because over this five-year period all of the earnings and principal were used to provide the $12,000 of annual income.
Because a large portion of the $12,000 of income received by the client was a return of his principal, only a small percentage (the amount from earnings) is considered taxable income. Depending on this client’s specific circumstances, this might have the effect of reducing his current income taxes.
Not only might it reduce this client’s taxable income, it might also have the effect of reducing the portion of Social Security income that could be subject to income taxes. Instead of more of their Social Security benefits going to Uncle Sam, in some circumstances, more of their Social Security income might be able to stay in their pocket.
Let’s go back to the plan.