How do we determine the number that is needed for you to retire? You see these ING commercials with the numbers above people’s heads and assume that you need this ridiculously high “number” to retire.
But how do they come up with these numbers? Are you supposed to replace 70% or 80% of your current income?
Many retirement tools utilize different methodologies to determine the exact number you need in retirement, but the one thing they all have in common is that they assume you will utilize principal in retirement. These tools also assume they know when you will die or that you know when you will die. It seems crazy, doesn’t it!?
Another way to calculate your retirement “number” is to utilize some of the basic principles of income investing. The idea behind income investing is that you utilize your investment nest egg to generate a specific cash flow without touching the principle.
You can calculate your retirement number utilizing an income investing method which calls for needing to know what streams of income you will have in at retirement (if known) and what you will need for expenses. To start, use your current expenses. This way you can start setting realistic goals of what you will need in retirement and what you need to save to get there.
Let’s use a simple example, say you need $4,000 per month for expenses and you will have $1,000 per month in pension or rental income coming in during retirement. Then you will need to build up your retirement nest egg to a point where you are able to generate $3,000 per month. If we are able to build a portfolio that can generate 4.5% in dividends and interest per year, then your retirement goal would be to have a nest egg of $800,000 by the time you retire.
Now the question gets to how does someone build a portfolio that generates income. It starts with knowing the toolbox we have to choose from for an income-oriented portfolio.
First, you have dividend stocks. As companies mature and find fewer opportunities to reinvest in their own companies, they start to pay monies out to investors. What this means is that instead of using the cash companies generate to reinvest into the next big innovation, they pay you and me as investors. An example we could use is being a family. As we earn money we decide to invest that into our future (retirement) or into our kids future (college savings). If we find that all of these are filled up enough, then we may start looking into giving more money to philanthropic initiatives. By giving money to things outside our own family growth, we could look at it as being like a dividend and our family being at a more mature state.
There are also bond investments which are debt obligations. These companies, governments or municipalities borrow money and are forced to pay back the debt at a particular interest rate. They pay this interest rate to you and me. When we own a bond it is like being on the other side of our mortgage payment. Instead of having to pay the bank on our mortgage, we are, basically, the bank when we hold bonds; these institutions pay us.
Other income investments are preferred stock, REITs, and MLPs.
- Preferred stock is a blend of both a bond and a stock. They tend to pay a higher income stream than most stocks (which makes them similar to bonds), but they have some opportunity for price appreciation (which makes them similar to stocks). These investments tend to be a little less liquid (not as easy to buy or sell) than stocks. But you are able to access these within ETFs, which make them a little easier to buy.
- REITs stand Real Estate Investment Trusts. Simply put these are investments into different types of real estate (commercial, healthcare, apartments, etc.) where you are able to get income from the lease payments and also have some exposure to the upside of real estate values.
- MLPs stand for Master Limited Partnerships. These are investments in the pipelines that transfer natural gas and oil across the country. They tend to provide slightly higher than normal dividend yields because they are multi-year contracts which companies enter into. The MLPs pay out the income they generate to shareholders like you and me. Again, these can be less liquid investments, but investors have the ability to invest in ETF-like investments that hold multiple MLPs.
The goal with income investing is to get an asset allocation that is built utilizing all these different types of income investments.
It is great to build a portfolio that can pay you income, but it isn’t the end-all be-all for investors. There are many other ways to utilize your retirement savings, but income investing is an option that we’ve seen work for many retirees.
So, focus on growing your asset base over the years and constantly monitor what your “need” will be for living expenses in retirement. Have that be the “number” you are striving for, rather than just picking a large number out of thin air.