Most people spend their working years focused on one retirement question: how much do I need to save?
It is an important question. But retirement introduces another one. How much income do those savings need to produce every month, and how much of that income can I afford to leave dependent on the market?
That is where retirement income planning begins, and it is the thinking behind a retirement income floor.
During your working years, your paycheck generally pays the mortgage, utilities, groceries, healthcare and other monthly expenses. Your investment accounts have time to participate in market recoveries because you aren’t necessarily depending on them to pay this month’s bills.
Retirement changes that relationship.
Now the assets you’ve accumulated may have to help produce the paycheck. And when withdrawals are occurring at the same time markets are falling, poor returns early in retirement can have a much greater effect than the same returns experienced while accumulating.
So before deciding how a retirement portfolio should be invested, it makes sense to answer a more fundamental question. What income must the household be able to count on every month?
Start With the Retirement Paycheck
The first step isn’t choosing an annuity, investment or withdrawal strategy. It’s understanding the household.
Separate retirement spending into two broad categories.
Essential expenses are the expenses that still need to be paid regardless of what the market does: housing, utilities, food, insurance, healthcare, transportation and other basic living costs.
Discretionary expenses are different. Travel, entertainment, gifts and other lifestyle spending may be important, but there is usually more flexibility in when and how that money is spent.
That distinction matters because it allows us to ask a much better planning question. Which expenses should depend on portfolio performance, and which shouldn’t?
Calculate the Income Gap
Next, compare essential expenses with income that is already expected to continue for life.
Consider a hypothetical retired couple with the following monthly numbers.
| Monthly need or income source | Amount |
|---|---|
| Essential retirement expenses | $7,000 |
| Social Security, Spouse 1 | $2,600 |
| Social Security, Spouse 2 | $1,500 |
| Pension income | $900 |
| Existing dependable income | $5,000 |
| Income-floor gap | $2,000 |
The calculation is simple. $7,000 essential expenses minus $5,000 dependable income equals a $2,000 monthly income gap.
That’s $24,000 a year.
But identifying the gap is more important than immediately deciding how to fill it.
The couple now knows something they didn’t know before. $2,000 of the income required to maintain their essential lifestyle must come from somewhere else every month.
If it comes entirely from investments, that portion of their retirement paycheck remains dependent on the portfolio.
How Much of Your Essential Income Should Depend on the Market?
This is where the planning conversation becomes more meaningful.
Imagine the couple retires and the market falls 30% during their first year.
The electric bill still arrives. The grocery store doesn’t reduce its prices because stocks are down. The mortgage company doesn’t suspend payments until the market recovers. Medicare premiums, insurance premiums and property taxes don’t wait either.
So I would ask the couple a straightforward question. If the market fell 30% the year after you retired, which part of that $2,000 would you still want deposited every month without having to sell investments to produce it?
Perhaps the answer is all $2,000.
Perhaps, after examining their expenses more carefully, they discover that $500 isn’t truly essential. They could comfortably reduce that spending during difficult markets. Then their essential-income gap isn’t $2,000. It’s $1,500.
That’s a planning decision, not a product decision.
There isn’t a rule saying a retiree must guarantee a particular percentage of retirement income. The objective is to determine which expenses the household doesn’t want exposed to market performance, and then decide whether the resources are available to protect them.
Why Guaranteed Lifetime Income Isn’t Just a Bond Portfolio
Once a household decides it wants some of that essential income protected, a reasonable question follows. Why not simply build a bond ladder and draw from it?
It’s a fair question, and the answer is where two instruments that both produce monthly income turn out to be structurally different.
A bond portfolio has to fund longevity from principal and yield alone. Because no one knows how long retirement will last, withdrawals must be managed with the possibility of a very long retirement in mind. That often means underspending, because the money has to last for a lifetime that has no known end date. The risk of outliving those assets remains with the retiree.
Guaranteed lifetime income works differently. An insurance company pools longevity risk across many people. Some in the pool will live shorter lives and some will live much longer. That pooling, sometimes described as mortality credits, allows the insurer to provide income for life in a way an individual account cannot replicate on its own. The individual no longer has to plan withdrawals around the possibility of personally funding an unknown number of retirement years. The insurance company assumes that longevity risk.
That is the distinction. A bond ladder, however well built, can’t pool longevity risk. It isn’t a return story, it’s a risk-pooling story. Which is why comparing an annuity’s payout to a bond’s yield misses what the guaranteed income is actually doing.
None of this makes an annuity automatically appropriate. Liquidity matters. Legacy objectives matter. Inflation matters. The financial strength of the insurance company matters. The terms of the contract matter. Most importantly, the client’s objectives matter.
But longevity pooling is the reason guaranteed lifetime income shouldn’t necessarily be evaluated as though it were simply another investment competing for the highest return. Its job may be different.
What Changes When the Portfolio Doesn’t Carry Every Dollar
Suppose our hypothetical couple has a $1 million investment portfolio.
Without an additional income floor, their $24,000 annual essential-income gap must be supplied by that portfolio. That’s a 2.4% annual withdrawal attributable to essential expenses alone, and it doesn’t include vacations, gifts, major purchases or other discretionary spending. More importantly, the $24,000 is needed whether markets rise or fall.
If the essential gap is instead covered by dependable lifetime income, the portfolio no longer has to produce that $24,000 simply to keep the household running.
Those assets can now have different jobs. They can provide growth potential. They can help address inflation. They can provide liquidity for unexpected expenses. They can fund discretionary spending. They can support legacy objectives and potentially be coordinated with tax strategies.
This is the division of labor that retirement-income researcher Wade Pfau has examined. His work on an efficient frontier for retirement income has suggested that a portfolio limited to stocks and bonds may be a less efficient way to meet retirement spending goals than one that also makes room for guaranteed lifetime income. The useful comparison isn’t whether an annuity can beat a stock or bond portfolio. The planning question is whether allocating part of a retirement portfolio to guaranteed income can improve the sustainability of the overall strategy by allowing different assets to perform different jobs.
An income-floor strategy doesn’t replace investment management. In many cases the two complement each other. An investment portfolio may be particularly well suited for growth, liquidity, inflation protection, discretionary spending and legacy objectives. Insurance may be particularly well suited for transferring longevity risk and creating contractual lifetime income. Those are different jobs.
And there is no universal answer. Two couples with identical portfolios may reasonably make very different decisions, depending on how much of their essential spending is already covered, how much they value liquidity, and how much they want protected for life. The planning opportunity is to decide which assets should perform which jobs, rather than expecting every asset to accomplish everything.
Do You Know Your Number?
Most people know approximately how much they have saved for retirement. Far fewer know their income-floor gap.
Try the calculation yourself.
Add up the monthly expenses you wouldn’t want to cut regardless of what happens in the market. Then subtract Social Security, pensions and any other dependable lifetime income you already have.
What’s left is the portion of your essential retirement paycheck that your portfolio may have to produce month after month, regardless of what the market is doing or how long you live.
Now ask yourself one more question. How much of that income am I comfortable leaving dependent on the market?
Structure follows objectives. Products follow structure.
If you’ve never calculated your retirement income floor, that’s where I would start.
Let’s calculate your income floor.
Kurtz Lytle is the founder of IUL.Solutions, an independent insurance and retirement income practice based in Nashville, TN. All recommendations are made only after a full suitability review in accordance with each state’s insurance regulations. IUL.Solutions does not provide tax, legal, or investment advice. NPN #8993693.