Building Your Retirement Paycheck: Income Sequencing Strategies for the First Years of Retirement

It shouldn’t surprise anyone that retirees and those nearing retirement consistently list three things at the top of their “worry lists”: healthcare costs, the rising cost of living, and outliving their money. If you really boil it down, all three of these top concerns amount to pretty much the same thing: having an adequate retirement income.

It makes sense. After decades of hard work and a regular paycheck, retirees are entering a new reality without that paycheck. They must depend on what they’ve saved and invested, along with any income from pensions and Social Security, to pay for what they hope will be a comfortable lifestyle that they can enjoy for the twenty or more years they expect to spend in retirement.

Fortunately, there are some steps pre-retirees and retirees alike can take to build a strategy for greater peace of mind about their retirement income. There are ways to “design” your retirement paycheck by managing taxes, diversifying your income sources, and building in the flexibility to deal with inevitable changes in the markets, economy, and your own life.

How do I replace my paycheck when I stop working?

Most retirees rely on several sources of income, including Social Security benefits, pensions (defined benefit plans), taxable savings and investment accounts, and tax-advantaged retirement accounts (401(k)s, 403(b)s, SEPs, and others). As we’ve written previously, a well-designed retirement spending plan takes all these sources into account when building a flexible withdrawal strategy for retirement.

What is retirement income sequencing and why does it matter?

One of the most important ingredients of this strategy is the sequencing of retirement income withdrawals. This is because different risks can become more or less important as you move through retirement. Let’s look at a few of these risks and why they matter when designing a retirement income strategy.

1. Sequence-of-returns risk. This risk is most important in the early years of retirement, because it directly affects the amount of money that remains invested for future growth. Sequence-of-returns risk describes the risk that poor market returns early in retirement, combined with ongoing withdrawals, can leave fewer assets invested to benefit when the market eventually recovers. One way to help manage this risk is to keep enough available in cash or through predictable income sources, such as Social Security and pensions, so you’re less likely to sell long-term investments during a market downturn.
2. Longevity risk. As the name implies, this is the risk of outliving your money. In a previous article, we explored longevity risk and strategies for managing it. Some important ways to manage longevity risk include a solid retirement budget, planning for sequence-of-returns risk, and keeping a portion of your portfolio invested for long-term growth. It may sound strange to have “long-term growth” and “retirement income” in the same sentence, but because more of us are living well into our 80s, 90s, and even beyond, many retirees still need some assets positioned for long-term growth to help keep pace with inflation and preserve future purchasing power.
3. Inflation risk. This risk is typically top-of-mind for most retirees. Inflation is the “silent thief” that gradually erodes the purchasing power of our money over time. During our working years, we can generally depend on periodic raises to help our income keep up with the worst effects of inflation, but when we retire, we have to depend on the growth in our savings and investments to offset the ever-increasing cost of living. A sound retirement income strategy may limit withdrawals from assets intended for long-term growth, especially in the early years, giving those assets more time to grow and compound.

How does Social Security timing affect my retirement income plan?

For most retirees, Social Security and any pension income are important parts of the retirement income plan. Social Security benefits are backed by the federal government and aren’t dependent on how much you have saved elsewhere for retirement. They’re also adjusted for inflation, and even though these cost-of-living adjustments (COLAs) may not entirely keep up with inflation, they can help cover at least some of the annual increases in the cost of living.

Deciding when to start receiving Social Security benefits is one of the most important choices in the retirement income strategy. You can start taking benefits as early as age 62, but claiming benefits before full retirement age (FRA: 66–67, depending on the year of your birth) will reduce your monthly benefit permanently. Waiting beyond FRA can increase your benefit by about 8% per year until age 70.

If your plan is to retire before FRA, your retirement income strategy will need to account for the gap between your earned income ending and Social Security or other retirement income beginning. For those who can delay, the larger monthly benefit may eventually cover a greater share of basic expenses. Some people choose to continue working or use other sources of income until age 70 to receive the maximum monthly benefit from Social Security.

Ideally, once you begin receiving Social Security and any pension income, these predictable income sources can cover most or all your basic needs, leaving your investments and savings available for other goals.

At Aspen Wealth Management, we understand that each retiree’s situation is unique, so any approach to “designing the retirement paycheck” has to start with a clear understanding of your needs, goals, and resources. If you’d like more peace of mind about your retirement income strategy, we’d love to talk with you about it.

How can I make my retirement income strategy more tax-efficient?