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Income vs. Drawdown: What’s the Best Retirement Strategy?


You’ve probably seen retirement ads promising ‘guaranteed income for life’ through annuities or bonds. On the other hand, you might be shocked to learn how little your nest egg will generate in ‘guaranteed’ income. Or you might want to continue growing your nest egg to leave more money to your children or other heirs.


The choice between an income-focused and a drawdown approach influences everything from your monthly budget to your ability to handle unexpected expenses, from the legacy you leave to your peace of mind. Choose too conservatively, and you might unnecessarily restrict your lifestyle. Choose too aggressively, and you risk outliving your savings.


In this article, we’ll cut through the jargon and sales pitches to help you understand the tradeoffs and ultimately make the best decision for your retirement.

Start by Estimating Your Spend


The easiest way to determine how much you should save and decide on a withdrawal strategy is to estimate your retirement spending. Moreover, you should categorize spending categories as essential or nice-to-have (more on why later) and apply an inflation rate to those amounts that are subject to price changes.


So, your spending might look something like this if you’re planning over 20 years and assume a 2% annual inflation rate:

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Of course, you should plan for less predictable expenses like medical costs, too. And remember that Medicare typically kicks in at age 65, where insurance costs could be lower than private insurance options in your earlier 60s.


Next, add up the monthly amounts and annualize them for each category—essential and non-essential—to determine how much you’ll need per year. For example, you’ll need $12,000 per year for a mortgage in this example. And determine how much Social Security per year you anticipate receiving.


Finally, you can use the total amount to plan how much you should save. For example, you might find you need $95,000 per year in inflation-adjusted dollars to retire. The amount you need to save will depend on whether you want to save enough to earn $95,000 per year in income or withdraw the total balance to zero—or somewhere in between.

Cover Expenses With Income


Income-based retirement strategies—as the name implies—focus on generating reliance income streams. While annuities provide a virtually guaranteed source of income, bonds, preferred stock, and even dividend stocks offer some level of steady income.


The benefit of income-based strategies is they provide an unlimited source of income. Since you never draw down the balance, you don’t have to worry about outliving your savings. In fact, some income strategies, like investing in dividend stocks, can grow your principal balance while providing a regular income.


The drawback is that income-based retirement is much more expensive. If you’re earning five percent interest, you would need $1.9 million in savings to earn $95,000 per year in income—and that’s before taxes! As a result, it might not be practical to rely exclusively on income-based strategies to finance your retirement.


A better option is to focus on income-based strategies to finance your essential spending. For instance, if your mortgage and food cost $15,000 per year after offsetting Social Security, you might try to save enough to cover that amount with income. Saving $300,000 will help you meet those needs indefinitely and avoid the worst-case scenarios.

Discretionary Drawdowns


A drawdown approach makes more sense for discretionary spending. For example, travel expenses, a mortgage on a second home, or budgets for dining out may be essential to a happy retirement, but you could survive without them.


The benefit of a drawdown approach is that you don’t have to sacrifice as much today to save for these costs down the road. For instance, a drawdown approach to spend $30,000 per year for 20 years would cost just $375,000 compared to $1 million if you were to finance it with income investments! That’s $625,000 you could be enjoying today.


The negative side of drawdowns is that the strategy will eventually deplete your portfolio. And saving enough depends on how long you expect to live (and be able to spend the money). For example, you might live until you’re 85 years old, but travel may not be feasible after you turn 75 years old. Some advisors refer to this as go-go versus no-go years.

Implementing Each Strategy


Calculating how much you need to save for each strategy is relatively straightforward, but selecting the right investments depends on your unique situation.


Income-based retirement strategies involve simply dividing the amount you need per year in income by the interest rate or yield you can earn. For instance, if you need $30,000 and anticipate earning 5% per year, you would divide $30,000 by 0.05 to get $600,000 in required savings by the time you need the income.

Popular Income-Focused Funds


These funds are sorted by their YTD total return, which ranges from 5.8% to 20%. They have an AUM between $480M and $33B and expenses between 0.35% and 0.96%. They are currently yielding between 1.9% and 7.9%.


Drawdown strategies involve using the present value of annuities formula for the most accurate answers. However, many advisors use the so-called four percent rule, which suggests that you can safely withdraw 4% of your initial retirement savings each year (adjusted for inflation) and have money last for 30 years.


Target date retirement funds are a popular option for savings for drawdown strategies. These funds take a more aggressive approach earlier and transition to a capital preservation focus later, ensuring that you don’t take on too much risk.

The Bottom Line


The best retirement savings strategy depends on your future spending and goals. By safeguarding essential spending with reliable income, you can avoid the risk of outliving your savings. Meanwhile, taking a drawdown approach for discretionary spending can help you balance enjoying life now with savings enough to enjoy retirement.

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Nov 05, 2024