How to Turn Assets into Income
Addressing the most underdiscussed issue in personal finance
Dividends and other “income” oriented investments (I’m looking at your real estate) provide a simple answer to one of the most challenging problems in wealth management; turning a pile of money into a predictable income stream.
In that post, I also pointed out the flaws in dividend investing and other overly simplified strategies like the 4% rule.
In today’s post, I’ll discuss tried-and-true methods of how to turn assets into income.
There are two types of retirement income
Fixed income: This is predictable—Both in the amount of income you’ll receive and when you’ll receive it.
Examples of fixed income include Defined Benefit Pensions and government pensions like Social Security (U.S) and CPP (Canada), annuities, and interest generated from bonds.
Pros of fixed income:
It’s predictable, which makes budgeting simple
Fixed income is less risky and won’t fluctuate based on short-term market volatility
Cons of fixed income:
The limited upside to continue building wealth.
If a source of fixed income is not indexed for inflation, your purchasing power will reduce over time.
Annuities can come with heavy fees.
No liquidity to cover big unexpected costs
Variable income: Essentially, this is your portfolio both in your retirement and taxable accounts.
Examples of variable income include dividends from stocks and selling stocks, bonds, and other investments to help fund your retirement.
Pros of variable income:
Can provide liquidity to cover unexpected expenses
Ability to continue growing wealth
Potential to leave an inheritance
Cons of variable income:
Budgeting with variable income is complicated
If your portfolio is too aggressive, you are at the mercy of the markets—which is unpredictable.
If you’re sitting on too much cash, inflation can eat away at your retirement income.
Before we continue: This post is not intended to be an “off-the-shelf retirement plan.’ Every person’s situation will be different, and I will not cover every single aspect of retirement income in this post. The intention of this post is to take you a level above the “4% Rule.”
How long will your money last?
This is the most important question when planning for your variable income in retirement.
At some point, you’re going to start selling assets and turning them into income. That’s when you need to ask one of the scariest questions of your financial life; when will I run out of money?
To answer that question, you have two options.
Use the formula developed by Leonardo Fibonacci in the 13th century.
Use a simple function in Microsoft Excel that requires zero math skills.
The hard way
Let us quickly review the nerdy finance equation that dates back to the Time of Leonardo Fibonacci in 13th-century Italy.
Not because I expect any readers to actually use this equation (It’s much easier to let Excel do the math for us), but I believe it’s important to at least have some basic understanding of how the math works.
So here is the equation that can tell us how long our money will last.
t= 1/r ln (c/c-Wr)
t= The number of years until our nest egg drops to $0.
r= The return on investment or interest earned from our nest egg.
c= How much of our principal we use each year.
W= The initial size of our nest egg.
The easy way
It’s easy to create a DIY equation using Excel, even if you have limited math skills.
When you open up a spreadsheet in Excel, go to “Formulas,” click on “Financial,” scroll down and click on the “NPER” function.
It will bring up a box that looks like this.
Rate= The return on investment or interest earned from our nest egg (r.)
Pmt= How much of our principal we use to fund our lifestyle (c.)
Pv= The initial size of our nest egg (W.)
FV and Type we will leave blank.
Let’s say you had a $1 million retirement nest egg, which earned 4% per year, and of which you needed to withdraw $60,000 per year to fund your lifestyle.
Here is how you would use the “NPER” function in Excel to figure out when you would run out of money.
Rate: Enter 4%/12. NPER is a monthly function, so we will need to divide our assumed annual rate of return (4% in this case) by 12.
Pmt: Enter 5,000. Again, we are converting our $60,000 annual withdrawal from the principal into a monthly number.
Pv= -1,000,000. You must put the negative sign in front of your initial principal; otherwise, you will get the wrong answer.
FV= Zero or leave blank. Remember, this function is telling us when our $1 million nest egg will go to $0.
Type= leave blank.
If you input that into Excel, it will give us an answer of 330 months, which is equal to 27.5 years.
So, if you had $1 million, which earned 4% per year and needed to withdraw $60,000 per year to fund your lifestyle, when would you run out of money?
In 27.5 years.
Sadly, life is not a spreadsheet
In the example I just gave you, you'll notice that it assumes every year is an “Average year.”
Your investments might return 4% per year on average over 30 years, but there will be few (if any) years they returned exactly 4%. Some years your portfolio will be up 15% or down 40%.
This highlights the biggest threat to funding our retirement with variable income: Sequence of returns risk.
Let’s discuss why sequence of returns risk has the potential to wreck your retirement and how to plan around it.