One of my favorite analogies for explaining retirement income is comparing it to taking water from a well. I realize that we’re fortunate and don’t need to do that much in this country, but let’s pretend that every day you go to a well to get your drinking water. Of course, you need to rely on it for providing you with water for a very, very long time. In order for the ability to quench your thirst for decades, you want to be sure you have enough of a supply of water at all times. But, you cannot control how much this particular well gets replenished with rain, so you would be careful to only take out the necessary amount to meet your needs, while not taking too much out and running a high risk of drying out the well. The level of the water, in the meantime, will rise and fall depending on the season you’re in – those rainy, plentiful seasons, and those dry and arid times when there isn’t any replenishment. Your job is to take what you need from the well, while having confidence in the ability to drink water even during those dry times. Through rainy seasons and dry ones, you need to be able to rely on a steady source of drinking water.
Retirement income is similar to this, isn’t it? After adding up your Social Security income and a possible pension income, if you’re like most people you then need to take out a certain amount from your investment portfolios. The sum of these income sources allows you to “replace your paycheck”, and enjoy yourself in retirement. “Work” at this point, is optional. But you’ll want to be careful with how much you withdraw from investments so you don’t increase your risk of running out of money during your lifetime. The portfolio amount needs to be around for the rest of your life: providing income so you can maintain your lifestyle. There is also a “risk” that you take too little and leave too much in the proverbial well – giving up the potential to do more with the resource you have at your disposal.
In the example of the drinking well, the level of the water will rise and fall. The same is true for investments, as our portfolio “well” (account value) rises and falls in the short-term. But we need to be able to trust that by taking an appropriate and time-tested amount, we’ll have a very good chance of never running out.
I think there is another very important piece to add to this comparison. What happens when a severe drought arrives? Say, ten years without rain, and only ONE well?! Ideally, I’d like to have a lot of wells, each with its own distinct geographical location. Some would be placed in an area that has more rainy seasons, and some that don’t (with the reliable possibility of an occasional deluge of rain). With investing, this type of strategy comes in the form of allocating our money into different asset classes: Large companies, small companies, US and International, Bonds, and cash, to name a few. This has historically helped out when one of the “wells” hasn’t accumulated much rain for a long time – allowing retirees to worry less about their portfolios and enjoy their lives.
I hope this helps you to understand your retirement income from a different perspective. Let us know if you wanted to discuss how your specific portfolio(s) works to bring you “water”. And if you’re not a client and wanted a second opinion on your retirement income strategy, we’d be happy to talk with you.
Pete Dixon, CFP®
Partner and Advisor