Creating Income from Assets for the Final Years of Life

January 9, 2018 | by the National Care Planning Council

Sometimes older individuals want to convert their savings or investments into an income stream. Generally, the purpose for this is to provide a reliable income for their final years of life. This is often a better strategy than making periodic withdrawals from those assets. Older people have a tendency to hoard their cash and not spend it and often in their years they live in poverty when there is no need for it. Even with sufficient assets, they won't make withdrawals and spend the money. Turning it into an income stream can provide a better assurance that there is money to pay the bills and even to provide some recreation or travel.

Systematic Withdrawals

A systematic withdrawal is a regimented way to convert an asset to income over the lifespan of the recipient. It can also be used to produce income over a certain number of years. The withdrawal is based on a calculation of receiving a fixed monthly income over a certain period of time – which might be the life expectancy of the recipient – with the balance of the account earning a certain presumed rate of return. The idea is to maintain an account balance over that period of time based on the withdrawal and the earnings of the remainder in the account.

Systematic withdrawals can also be set up to incorporate monthly amounts that increase each year to keep pace with inflation. Systematic withdrawals are particularly useful in accounts that have some volatility such as stock accounts or mutual funds that contain stocks. The concept is that withdrawing a fixed amount each month will sometimes be done when the account is down, but that will be offset by times when the account has done well. The overall effect on the account results in an averaging effect that could produce more income than just simply taking the money out and transferring it to a fixed account for income purposes. The reason for this is that the timing of large withdrawals from an account that is going up and down with the market is difficult to determine. One never knows when the market is reached its high and taking the money out prematurely may have the effect of not letting the account reached its maximum potential from positive earnings.

Another useful strategy for systematic withdrawals is incorporated into some deferred annuities. The deferred annuity is specifically designed for producing a systematic withdrawal income that is not penalized as an early withdrawal. The income is not a result of the annuitization of the account but simply a monthly fixed amount withdrawn from the account. The advantage of this type of income is that the underlying deferred annuity – during certain periods of low fixed interest – can produce a slightly higher interest rate of return and this allows the underlying asset to last longer and produce more income before depletion.

Asset Allocation Strategies for Maximizing Income

Another useful strategy for producing income from assets is to have the money in two separate accounts – one earning a fixed interest rate of return and the other invested more aggressively in stocks and long-term bonds. The aggressive account could be a stock mutual fund. The actual percentage of the assets in each account is predetermined based on the period of time income will be produced. This income interval of time could be the life expectancy of the person producing the income for himself or herself. Typically, the longer the income interval of time that income will be produced, the smaller the percentage of assets in the fixed account versus the aggressive account.

Over long periods of time, stocks and long-term bonds have historically produced greater rates of return. By putting a larger portion of the assets in these types of investments, the potential is for the assets to grow larger than they would have if they were 100% in a fixed interest account. The problem is that if the aggressive account is used solely to produce income using a systematic withdrawal, there is great risk that in down markets the withdrawals could eat into principal – if the downturn lasts too long – and thus deplete the account prematurely.

The strategy is to have enough cash in the fixed interest account to bridge down markets. The fixed interest account is used to create a systematic income withdrawal and the aggressive account is used as a growth vehicle for transferring money into the fixed account. The fixed account would contain enough money to produce a predetermined number of months of income – say for example 60 months – through systematic withdrawals. At some point during that predetermined income period the account will be replenished to a predetermined level to perpetuate the predetermined number of months of income indefinitely. The replenishment would be timed to take money out of the aggressive account when markets were showing a positive return. The idea is not to outguess when the top of the market has been achieved, but simply to take money out at a predetermined market performance and not worry whether the timing was perfect.

Single Premium Income Annuity (SPIA)

An income annuity is an insurance product that guarantees a certain monthly income for a certain period of time. This income stream is purchased with a lump sum of money called a single premium. Once the contract goes into force, the purchase amount disappears and is replaced by a guaranteed monthly income stream. The annuity has an advantage over a systematic withdrawal, for two reasons. First, the annuity will guarantee an earnings rate on the purchase amount that is being used to generate the monthly income. When interest rates are high, income annuities make a lot of sense because they can preserve a high rate of return over a number of years. A second reason for using an income annuity instead of systematic withdrawals is the annuity can be set up to pay out for the life span of the person who purchases it – who is called the annuitant. This so-called life annuity will pay up to the death of the annuitant. Thus an income is guaranteed and will never go away until death. Some people don't like life annuities because if they die too soon, they may never receive back the amount of money they put into purchasing the annuity. There are certain other arrangements that can be used to produce a life annuity payout to get around the issue of dying too soon.