Congratulations, investor. You’ve made it to retirement!

Or maybe you haven’t, but as a planner, you’re already thinking about how your money management will change after you retire. The fact is, your job as an investor is not done just because you’ve saved enough to afford a comfortable retirement or have left work completely.

Today’s post from Dr. Jim Dahle focuses on creating income streams and how to approach various forms of cash value life insurance if you already own them. It shouldn’t surprise you that adding this wrinkle complicates your financial planning as a retiree.

This post was originally published on The White Coat Investor.

Investing in Retirement Part II

In Part 1 of my Investing in Retirement series, I discuss the important principles that affect investing in retirement, including:

• the sequence of returns issue
• inflation
• safe withdrawal rates

Today we’ll talk about getting income from a few broad asset classes in retirement.

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Converting to Income

First, a caution. Investors, both before and after retirement, are often inappropriately focused on “income” such that they ignore their total returns, which in the long run are far more important. While it is true that income is generally more stable than total returns, it is not true that you can “only spend income” or that you “don’t want to eat into principal.” There are two main issues that focusing on income can cause you.

1. Income for many solid investments that probably should be in your portfolio is far lower than the usual 4% SWR, especially given current stock and bond yields. The SWR studies all assume you’re willing to spend principal. If your portfolio only provides 2% income, and that’s all you spend, it’s true that you won’t ever run out of money. However, it is also true that you are almost surely unnecessarily limiting your retirement spending.
2. The second issue is what investors often do about this fact. Rather than stick with a solid portfolio, they start holding all kinds of bizarre portfolios in an effort to increase income. Higher-income asset classes such as REITs, high-yield stocks, investment real estate, and junk bonds start showing up in ridiculously large proportions, causing terrible overall portfolio returns due to a lack of appropriate diversification. A total return investor, on the other hand, has far more control over the interaction between her actual portfolio performance and her spending.

Declaring Your Own Dividend

Real estate also requires significant expertise, unlike purchasing a handful of index funds. Great returns are available in real estate, but don’t kid yourself that all real estate investors are getting them. If your skill level at buying, managing, and selling property is low, your personal real estate returns may be terrible.

Although economically, rent tends to be sticky, it does go down (usually in the form of a higher vacancy rate) and can stay flat for years at a time. The rate of inflation in rents may not relate at all to your personal rate of inflation.

A retiree also must deal with the issue of leveraging. Leverage cuts both ways, and it is probably best for a retiree to use much less leverage (if any at all) than she used twenty years earlier. Properties that still carry a mortgage in retirement don’t kick off nearly as much income since the income is being used to pay a mortgage.

Unlike stocks, where it is easy to declare your own dividend, selling off part of a rental property can be impossible and selling the whole thing can be very expensive, especially when considering the tax aspects. Refinancing to pull out home equity can be problematic when you are no longer working, not to mention it increases leverage-related risks and decreases future income from the property. It also becomes trickier to invest in real estate using typical retirement accounts such as 401(k)s and IRAs.

Despite these issues, real estate, especially paid-off real estate, can be a fantastic addition to a retiree’s portfolio, whether purchased long-before retirement, near retirement, or in retirement. Just be careful to maintain diversification in your portfolio and to be cognizant of the dramatically increased effects of leverage in retirement.

What To Do With Cash Value Life Insurance

Many people, for better or for worse, own significant amounts of cash value (whole life, variable universal, and indexed universal) life insurance upon retiring. While I’m generally not an advocate of purchasing these policies as retirement assets, if you happen to own some as a retiree I wouldn’t necessarily ignore it. Ignoring it is, of course, a reasonable option. You can simply use the insurance as an insurance policy — to give money to heirs or favorite charities upon your death. In fact, this is often a great use for it.

Likewise, if you’re looking at an estate tax problem (a problem few of us have nowadays) and have bought insurance inside an irrevocable trust to try to pass money to heirs free of estate tax, you’re not going to be able to spend the cash value in that policy. But if you own a more typical policy, and were counting on borrowing from it tax-free (but not interest-free) as part of your retirement plan, you need to decide when and how to access that money.

There are two principles to keep in mind:

1. Remember that you don’t get the cash value AND the death benefit. You get one or the other. Whatever you take out in cash value is subtracted from the death benefit before it goes to your heirs.
2. It is very important that you make sure your policy never collapses. While the details of each type of policy are different, many policies have ongoing costs of insurance that must be paid from somewhere, either from your pocket, policy dividends, or from the policy cash value. If those costs cannot be paid, the policy collapses and all gains from it become FULLY TAXABLE at your regular marginal tax rates. That is a catastrophic occurrence but does happen occasionally. If you are withdrawing from a cash value policy, you and any advisor you may have need to be continually monitoring for this issue.

Also depending on the policy, the more you take out, the more interest you owe on the loan (yes, you pay interest to access your own money). That interest too must be paid from somewhere. You can minimize these risks by only withdrawing a small amount, or by accessing cash value late in retirement, but that will also minimize the tax diversification provided by these tax-free loans, which is probably one of the main reasons you bought the thing in the first place!

Surrendering or exchanging the policy is also probably not a great idea. The bad returns of cash value life insurance are heavily front-loaded. Once you get to retirement they should all be behind you. The returns on cash value life insurance, while rarely spectacular, can be acceptable (3-5% is typical for whole life) when held to death. An exchange generally involves another commission and more years of poor returns, although exchanges to low-cost variable annuities or even long-term care insurance is possible.

Certainly, including life insurance cash value in your retirement spending plan will make for more complex planning than you would otherwise have to deal with.

In Part 3, I’ll discuss how to avoid Safe Withdrawal Rate issues as much as possible.

• • Part 1
  • Part 2
  • Part 3
  • Part 4
  • Part 5

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What do you think about income investing? How do you look at your various asset classes as you move toward or through retirement? Comment below!