How to Replace Income in Retirement

Retirement, Beginner

I had the distinct pleasure of spending time with my wife’s family this week. Between catching up on life events and helping with a few household chores, my father-in-law (let’s call him John) took the opportunity to ask his financially-minded visitor a question directly pertinent to his own immediate goals.

“How can I use my investments to cover the bills in retirement?”

I knew that John is a CPA and a knowledgeable investor who has actively traded his family accounts for years. So as a well-educated student of retirement finance, I naturally jumped in to an explanation of safe withdrawal rates, retirement spending methods, and how portfolio theory can be used to tweak the numbers to safely spend a certain percentage of his portfolio every year without fear of running out of money over his expected lifetime. John listened intently and replied with a deceptively simple follow-up question:

How do you guarantee that level of investment income every year?

That’s a terrific question, and the simple answer is you don’t have to. But that’s the exact moment I recognized my own investing bubble. The internet these days contains more information than ever about every nuance of retirement finance, but the gap between the theory debated by eggheads and John’s completely rational income-driven paradigm is just as perfectly normal as it is surprisingly wide to bridge.

I was talking about systems theory, and he just wanted to directly replace income. Which makes perfect sense! And I imagine many of you may have the same question.

So rather than jumping into a painfully long series on every possible way to tweak the numbers, let’s start with the basics. If you’ve ever wanted to know how to safely move beyond depending on regular work income to pay the bills, this article is for you.

Be like water


One of the most common metaphors in personal finance is the idea of money behaving like water. Accountants talk about inflows and outflows. Bloggers write about income streams and liquid assets. You get the idea.

The water comparison is helpful not only because it is a good way to visualize the allocation of a resource but also because the flow accounts for direction and time. Like water, money is rarely stagnant. It’s always moving and changing. And that dynamic nature is useful for understanding lots of things like electricity, heat, and yes — even cash.

So let’s keep with that comparison and talk about the flow of money over time.

Income at the tap


Just like water, your personal cash flow starts at the tap.

Think of your job like a water faucet that supplies a steady stream of income. That water source has to supply all of the needs for you and your family, and much of your work energy thus revolves around maximizing the throughput. Some people strive to earn a raise that turns up the flow. And when there isn’t enough water to offer, others get a second job to double the number of incoming pipes.

So much of the financial world today is built around income. Children are given an allowance, and adults are offered a salary. When you apply for a loan they ask for your income. Even when it’s a school loan to students who have nothing, they ask for their parents’ income. Tax bills are based on income. Job descriptions are sorted by income. Many online retirement tools are built around the idea of generating a certain percentage of income replacement. In many ways, income appears to rule the world.

In fact, modern society is so income-focused that people sometimes think that way even when it doesn’t make sense. Perhaps one day you’ll have the pleasure of applying for an apartment as a retiree living off of your investments. Imagine the look on the face of the leasing agent whose job it is to tell you that your income doesn’t qualify when you try to politely explain that their application simply didn’t have a field to list savings and investments. When everyone thinks in terms of income, sometimes it can be hard to see past the blinders.

So when considering the prospect of turning off the faucet for good, I can totally understand the worry. The idea of the water not flowing is terrifying, and we’ve been conditioned our entire lives to fixate on income to the point where other approaches are rarely even considered. But the good news is that income isn’t the whole story! And there are great examples of alternative water management all around us.

Filling the jugs


One of the first examples of money management that young people are exposed to is the idea of an emergency fund. That’s the equivalent of filling up a few pitchers to have on hand if there’s an unexpected issue with the water supply or a surprise surge in consumption. Did the pipes freeze? Do you have a sudden need for more water than the sink can dispense in time? No problem! The emergency pitcher has you covered while you sort things out.

Buffers like that are a really important concept that can be used to smooth out the balance between income and spending. The world is messy and unpredictable, and it’s not always possible to perfectly match income to necessary expenses every month. So even a small amount of savings kept in reserve can make a big difference in how you handle adversity.

But while water jugs and emergency funds are extremely useful when the tap stops unexpectedly, they’re just a temporary stopgap. So to manage bigger problems we’re going to need a larger tank.

Managing the hot water


Properly managing water supply is fundamentally a systems design issue involving income rates, usage rates, and reserves. It can admittedly get a little complex to understand for those not accustomed to thinking about dynamic systems, but you’re probably more familiar with it than you think.

Have you ever taken a shower only to find that someone else already used up all of the hot water? Congratulations! That cold shock is a great example of your home water system falling short of your needs.

The primary cause for most cold water issues is usually a simple matter of the usage outpacing the reserves. The intake line is only so large and the heating takes time. So when the entire family takes a shower at the same time, the last person in line may be in for an unpleasant surprise as the outflow outpaces the inflow and the hot water reserve hits empty.

One option to solve the problem is to reduce water usage or work together to pace the consumption to a more sustainable rate. Another option is to upgrade the intake to a fancy tankless option that instantly heats a massive flow of water, but that’s not always realistic. So when the problem becomes too large for simple consumption fixes, smart planners who understand what’s going on will upgrade to a bigger tank with the capacity to meet the heavy draw times without running out.

Savings accounts work a lot like a hot water heater to accumulate needed cash resources and manage the outward flow. Even when the income pipe is relatively small, as long as the income is consistent and the expenses don’t all hit at the same time you’ll be just fine. If your account ever starts to shrink close to zero, the first step is always to cut back expenses or work to stagger them to a better schedule. But you know what also helps? Upgrading to a bigger tank. Make it a point to grow your savings account, and eventually you’ll never need to worry about the timing of bills.

That’s the system reserve at work.

Building your lake


Of course, paying the monthly bills without stress is a far cry from larger goals like retirement. Imagine the water tank required to supply showers for your entire family for life even with the intake pipe turned off. That’s a lot of water, so we’re going to have to think bigger. Much bigger.

Instead of simply holding your income in a closed tank like a bank, investing for retirement is like getting serious about water management and building a dam on your income streams to create a big, beautiful lake. And when moving from enclosed savings account tanks to exposed investment account lakes, there are a few new details to think about.

When times are good and it’s raining money, water levels will rise at a pace that dwarfs your meager income stream. Of course the opposite is also true, and when times are bad and drought sets in for years water levels can fall dangerously low. With lakes, you also have to account for natural seepage and evaporation that slowly drains water much like trading or advisor fees. And then there’s also the issue of your city growing around the lake over time and requiring more water every year to meet the same baseline needs just like inflation.

Lake management is complicated! But people do it all the time, and you can, too.

Draining it over time


While the lake metaphor is pretty solid, there’s also one huge factor working in your favor that no water management expert can claim. Unlike lakes, your own personal reserves don’t have to last forever! So it’s ok to drain them slowly over time.

This is the point that I’ve seen trip up plenty of intelligent and responsible savers who are well versed in personal finance. Once you’ve spent an entire lifetime thinking in terms of keeping your expenses below your income, the idea of turning off the income stream and allowing your expenses to far outpace new income sounds downright irresponsible. To address that cognitive dissonance, it’s very common for people to frame their income mindset and investing philosophy in one of several ways.

Dividends and interest

The most conservative method focuses on using dividends and interest as a direct income replacement. For a verbal indicator of this mindset, it often coincides with the explanation that “I don’t want to touch the principal.” In the water sense, it’s like making sure you never take more water out of your lake than is already replaced by small side streams.

Now don’t get me wrong — there’s nothing particularly wrong with that, and it’s an extremely safe approach. But if you imagine someone complaining about being thirsty while sitting on the dock of their own massive personal lake, you might start wondering if they’re missing the big picture. At some point it’s ok to tap the reserves.

Follow the returns

Another common approach is for investors to attempt to balance outflows to investment returns. Think of it as matching your water consumption to the incoming rain, and you can see just how hard that is. When it’s pouring, you feel like a genius flush with income. But as soon as the rain stops, you’re left without enough income to cover the bills.

There are plenty of very intelligent investors who fit into this category and don’t simply sit back and passively check the rain gauge. Instead, they obsess about weather forecasts in terms of expected returns in order to plan their finances or frantically migrate their lakes to more favorable climates to perpetually chase the rain. Not only can the taxes and fees related to moving so much money wipe out your hard-fought gains, but even when it works it can also get exhausting. When you picture your own retirement, would you rather be fishing or stressing about the weather forecast every day?

Spend the average

And then there are the investors who recognize that rain is unpredictable and focus on balancing their spending with long term average portfolio returns. For years, this idea of spending the average return of your investments in retirement was the state-of-the-art advice given by professional financial advisers. So since the average inflation-adjusted return for US stocks since 1926 was 7.5%, it was not uncommon for people to assume that they could treat that as dependable income and spend 7.5% a year in retirement.

That was until William Bengen noticed a lot of retirees going bankrupt and wrote a famous paper which proved that the true safe withdrawal rate for that portfolio in the worst case was actually closer to 4%. By thinking in terms of averages rather than dynamic systems with changing seasons of deluge and drought, far too many lakes were running dry.

So if dividend spenders are too conservative, average return spenders are too aggressive, and active investors are wearing themselves out, how does one determine the correct safe consumption rate for their own lake?

It’s all about managing water levels.

How water management works


Like managing a lake, the trick to maintaining retirement income is not just balancing the predictable inflows and outflows, but building a thoughtful reservoir that can benefit from and survive unpredictable economic events while providing consistent downstream flow in good times and bad.

Sound complicated? Just look at the above image and focus on the spillway. Picture yourself at the controls with the ability to open the gates or close them completely. That’s you controlling your annual expenses to manage your investing account balance.

If you’re an early retiree who needs the lake to last for many decades, your goal should be to keep the water level relatively constant. Sure, your account value will go up and down with the markets, and that’s ok because the lake is deep enough to absorb the natural variability without issue. As long as your spending rate is sufficiently low, the lake will remain within a permanent sustainable range to meet your needs for many generations. That’s how perpetual withdrawal rates work. They’re a little on the conservative side because they’re designed to last a lifetime — and beyond.

For retirees of normal age, it gets a little more interesting. Since you don’t need the water to last indefinitely, you can feel a lot more comfortable opening the spillway to a faster pace. Most traditional retirement studies assume a 30-year retirement, which means that as long as the lake lasted at least 30 years in the worst case on record then your spillway management was deemed a complete success. That lake-draining plan over a set timeframe is how safe withdrawal rates work. Safe withdrawal rates are always a little higher than perpetual withdrawal rates because you’re intentionally depleting the lake over time.

How big is your lake?


To help answer the question of how large your own lake needs to be, retirement researchers have done a lot of legwork to study historical scenarios to see how they all worked out even in the very worst timeframes. For example, here’s my own Withdrawal Rates chart illustrating all of the sustainable withdrawal rates for a portfolio of 60% large cap blend stocks and 40% intermediate bonds (the most common combination studied when you read about the topic) for every start year in the United States since 1970.

Safe and perpetual withdrawal rates for 30 years

There’s admittedly a lot going on, but for now focus on the orange line. That’s the worst case on record. Imagine lake conditions during a decades-long drought while the city below demanded insanely more water every year just to survive. That’s not too far off from market conditions and inflation in the 1970’s that contributed to that baseline.

The two highlighted datapoints show the safe and perpetual withdrawal rates that we talked about over a 30-year retirement. They represent the initial percentage of the portfolio that someone could have withdrawn and adjusted for inflation every year while still having their lake survive without completely running out (the SWR) or staying at the same original level (the PWR). Picture it as setting the spillway to one initial rate and simply adjusting it over time by downstream inflation regardless of what happened with the weather. If you ever hear someone talk about “the 4% rule”, the orange SWR number for this particular set of assumptions is where that comes from.

With that number in hand, your own personal lake size simply comes down to your spending needs*. If you need your portfolio to supply $2,000 a month, then that’s $24,000 a year. Divide $24,000 by 0.041 (the 4.1% SWR), and that means that in the worst case we have on record you needed $585,000 to last 30 years.

(*) Note that this is totally separate from other income like pensions or social security. So if you have a portfolio of $585,000 and social security income of $2,000, then your total retirement income is $4,000.

For older retirees, also pay attention to the curvature of the lines. If your own expected lifespan is closer to 15 years instead of 30, then the safe withdrawal rate was 5.5% instead of 4.1%. When your lake doesn’t need to last as long, you can be a little more free with the spillway controls.

Safe and perpetual withdrawal rates for 15 years

One way to think about that difference is that a retiree with the same $585,000 could spend more and be fine. But the more interesting thing to me is that it means a retiree with the same $2,000 per month spending needs could be just fine with less savings. Revisiting our calculation:

($2,000 * 12) / 0.055 = $436,000

Of course, theoretical savings are all nice in theory but some people are planning for an immediate retirement with what they have right now. Let’s say you have a 15-year timeframe and $350,000 in savings. You can also run the numbers backwards to find a monthly budget.

($350,000 * 0.055) / 12 = $1,604

To be clear, there are absolutely no guarantees that the future won’t offer a new worst case weather catastrophe that may lower the safe number for new retirees. But by looking at historical worst cases, that’s a great starting point for conservative planning. Just be sure to consult with a professional about how taxes and rules like required minimum distributions from retirement accounts affect the numbers. Then add what remains to any other fixed income you have at your disposal, and you have your monthly retirement budget.

Advanced water management


I could talk about this for days, and it’s impossible to cover every possible issue on this topic in one article. But for those interested in more lake design options beyond the basics, there are many great resources here at Portfolio Charts. Here are a few places to start.

  • Not every portfolio has the same withdrawal rates. Maybe your lake is in a country outside the US with very different weather. Or perhaps you’re interested in diversifying water spots beyond simple US large caps and intermediate bonds to better hedge against drought in any one location. Try the Withdrawal Rates chart, and you can study the unique safe and perpetual withdrawal rates for any combination of assets in a dozen different countries. Don’t blindly follow the 4% rule if it doesn’t apply to you!
  • Perhaps you noticed that the spillway manager in the above examples was pretty hands-off and never changed the water withdrawal rate even when it might have made sense to cut back a little in the dry years. While maintaining a constant standard of living is a good baseline for study, responsibly controlling discretionary spending can go a long way towards making your money last longer and utilizing it to its fullest extent. To explore the effects of variable spending strategies on portfolio survivability, try the Retirement Spending chart.
  • And for more articles dedicated to portfolio theory in the drawdown phase of life, head to the Insights page. Scroll down to Topics, and check out the Retirement section. There’s a good collection of articles that will not only help people new to the concept but also challenge those who think they have it all figured out. Retirement finance is way more sophisticated than simple rules of thumb that some people take for granted without actually understanding how it all works. But once you learn it for yourself, it opens up exciting possibilities you may not even know exist.

And of course, if you ever have a question you can always ask your favorite son-in-law, investing blogger, or perhaps even a professional financial adviser. Even the most educated investors sometimes need a hand, so don’t be afraid to ask.

One glass at a time


No matter where you currently are in your own investing journey, there’s no better time than today to start thinking about your retirement. The first step is simply to start building up some liquid reserves to work with. And if you ever feel a bit overwhelmed with the systems side of proper water management, keep in mind that you’re definitely not alone! We’ve all been there. But you can definitely do it.

So to John, I hope that helps answer your question. To all of the other potential future retirees out there, I hope it sets you on the right track to success. And to anyone interested in moving from an income mindset to a holistic investment management philosophy, I hope you have a new perspective to think about.

The next time you’re in the kitchen filling a glass of water, take a moment to look at it closely. Think about what it means to have your thirst tied so closely to a single water source, and imagine being able to meet your own water needs without worry.

Does that sound empowering?

Then drink up, take a deep breath, and start filling your lake. Eventually you’ll be able to turn off the tap permanently and you won’t even notice.


Did this make you thirsty for more investing knowledge?