Everybody needs a certain level of income to meet their basic needs. Let me give you an example of what I mean. Do you remember back when you were in elementary school? You needed a certain amount of money to buy lunch. To be clear, you wanted only lunch, no snack, no extras, just lunch. Let’s say that you needed $2.50 a day. So that is $12.50 a week or $50 a month. If you wanted a cookie, that was $0.50 extra. And if you wanted extra chocolate milk, that was another $0.50. So that added $5 more a week or $25 more a month. If you wanted to go all out and have an ice cream bar, that was $1.50!
Lunch is a basic need
Lunch was an example of your basic needs. You needed that every day or you went hungry. Going hungry is not a comfortable feeling. The cookie, chocolate milk, and ice cream bar were discretionary spendings. You did not need to spend that money. So the first $50 a month was really important. But the $25 was not as important; it was discretionary. And the $30 per month for ice cream was discretionary too.
How did lunch make you feel?
If you think about it, the essential money made you feel content and safe. You had food, and you could make it the rest of the day. The cookie and chocolate milk probably made you feel happy because chocolate makes most people happy, but that is about all it did. How did the ice cream make you feel? Did it do much more for you than the cookie and chocolate milk? Probably not.
The usefulness of money is its utility
The usefulness of money is called utility. The essential money you need has a high utility. In other words, paying the essentials in life are just that; they are essential. The more you spend beyond your essential needs, the less important it is. Discretionary money has a lower utility. Discretionary money is nice, but it does not give you the safety and security that essential money gives to you.
Essential income in retirement
The same idea comes into play when we are talking about your essential income in retirement. You have a certain level of income that is absolutely essential. You need to pay for your food, your housing, your medical care. After that, what you spend is discretionary. So, let’s say that you need $2,000 per month as an essential income. That first, $2,000 is really important. This money has a high utility. If you don’t have it, you could go hungry, not be able to pay for a place to live, or not have medical care.
Income flooring is essential to retirees
Building an income floor is the most crucial concept for a retiree to understand. The number one risk that you face in retirement is longevity. Income flooring will enable you to be assured that no matter how long you live, you will not run out of money in retirement. You probably will feel more comfortable about your essential income, if you know it is not at risk. Plus, you’ll probably feel more comfortable knowing that you will be able to pay for the essentials in your life thirty years from now, as well as you can pay for those essentials today. That is why most people do not want to take a risk with their essential money. They want to build an income floor that is a firm foundation for their income.
Income flooring should NOT be risky
How you manage your income will determine the risk that you do or, more importantly, DO NOT take with your money. The average income in the United States is about $4,900 per month. The average monthly Social Security retirement income is about $1,500. The average monthly expenses are about $3,000. So that means to just get by with the essentials, you should have another $1,500 per month of income. That can be from continuing to work, from savings, or a personal retirement plan.
Since the additional $1,500 is part of your essential income, you probably do not want to take any risk with that money. Good ways to safely fund that $1,500 is with fixed accounts, bonds, or annuities. How you fund your essential income all depends upon how much money you have and your understanding of how these types of accounts work.
How to handle emergencies and inflation
The next step in income flooring is to plan for emergencies and inflation. At this stage, you can begin to take more risks with your money if you feel comfortable with it. Some people might not, and that is OK.
Don’t take a risk with essential money
Some advisors might insist that you take more risks. I disagree. If you feel comfortable with additional risk AND you understand it very well, then, by all means, invest more aggressively. The worst thing you can do is invest with more risk because you feel you must have more money in the future. But if you do not understand the risk or it keeps you up at night, don’t do it.
Methods to fund an income floor
Social Security should be a primary component of an income floor. However, remember that Social Security is only going to cover about 30% of that average person’s retirement expenses.
How to increase your Social Security retirement income
If Social Security is one of the few assets that you have for income, the best way to increase your Social Security is to delay taking it. If you retire at 62, you are going only to get about 75% of what your full retirement income will be. And if you are married and your spouse takes the spouse’s benefit, they are only going to get about 30% of your income.
Here is the bottom line in general terms. If you delay taking your Social Security retirement income until age 70, you will come close to doubling your income compared to taking it at age 62. The income will not only increase by what the government allows. But if your income continues to grow until you are 70, it will increase because you continue to work. And more income for most, not all, but most Social Security accounts will translate into an increased income at age 70.
Using bonds to fund an income floor
There are several ways to fund an income floor. You can use bonds because there are two fundamental guarantees to a bond. Remember that a bond is a loan, and with that loan comes a guaranteed interest rate and a guarantee that the money will be paid back at the end of the loan period.
The best bonds to use for income flooring are government bonds because there is no risk of default. One problem that we see with government bonds is that the interest rates are so low. As a result, living only off of the interest takes a large amount of money for most people. To pay $3,000 a month only from interest, you would need $5,000,000 at current interest rates! Interest-only would not be the best way to go.
On the other hand, let’s say you know you are going to need $36,000 in 10 years, but you are worried about inflation. If you deposit $36,000 into TIPS or Treasury Inflation-Protected Securities that are back by the federal government, they are guaranteed to keep up with inflation. You know you will have what you need.
Don’t forget the taxes on TIPS
If you like the idea of guaranteed income and you have enough money, you can stagger when bonds are available to pay you a regular guaranteed annual income. You do have to consider income taxes along the way too. Even though you will not get the pay off of a bond for many years, you must pay the taxes on the assumed growth of that money each year.
A big problem still exists
The only problem that still comes up is you do not know your longevity. You do not know how long you are going to live. So, you do not know how long you are going to need an income.
The only solution to the longevity problem is an annuity. An annuity will guarantee a monthly income for the rest of your life, no matter how long that is. And that is the ultimate solution to creating an income floor.
Once you have your essential income needs to be met by creating an income floor, you can then use other strategies to increase your wealth. And next week, we’ll talk about some different strategies for paying you an income beyond your essential income.
Join me on the Retirement Learning Lab on YouTube Live next week at 11:00 am. Heres a link: https://www.youtube.com/channel/UCuJa7bmdZ_lxyGP6sRpiFwg/live
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