I. Estimate your annual need for investment income.
A. Add up how much you spent over the past twelve months. Get this from your checkbook or your bank statements.
1. Subtract unusual huge purchases, such as an outlay for a new car. (You should add back an annual amount to save up for the next car if you buy it outright).
2. Subtract monthly items that will disappear due to lifestyle changes, like if you sell your house, stop commuting to work, or if Medicare will reduce your health insurance bills.
3. Add any large future things you want to budget for, like an increased budget for travel.
4. Subtract expected income from non-investment sources, such as pensions and Social Security. After making these adjustments you now have a figure that is your "annual need for investment income."
5. Divide your annual need for investment income by twelve to determine your monthly need, which you will withdraw from your investment account each month. In order to estimate how long your money will last, run simulations, using a financial calculator found on the Internet, assuming various different assumptions for the inflation rate and your investments' rate of return.
II. Set aside enough money in risk-free investments that will provide as much as five years of income during stock market meltdowns.
A. Multiply your "annual need for investment income" (calculated earlier) by five to tell you how much money to set aside in risk-free investments - enough to provide five years of income, if needed, so that you can avoid having to sell stocks for retirement income when stock prices are very low.
B. Invest your risk-free money in either bank CDs (with at least 1/5 of the money accessible each year) or a money market fund. Normally, tax-sheltered money (IRA, 401K, 403B) can also be invested in TIPS (U.S. Treasury Inflation-Protected Securities) or a TIPS mutual fund. Currently (April, 2012), TIPS are priced unattractively for new investors and should be avoided, but that is likely to change as rates on US government bonds recover to more normal levels.
III. Invest the balance of your investment money in a diversified portfolio of stocks (with no one stock initially accounting for more than 3% of the total), or low-expense broad-based stock market index funds.
A. Your monthly income depends on how much you arrange to be sent to you. You can arrange to have a mutual fund liquidate shares, as needed, to send you checks, monthly.
B. Your investment income does NOT depend totally on how much in dividends or interest you receive. It depends on your total return, which includes dividends, interest and capital gains.
C. Total return from stocks has averaged 9 - 10% over the past 50 years and past 100 years, based on growth of the American economy. Even so, there is no telling how stocks will do in any particular year or decade and some years stocks will go down in value. Declines of around 60% from the previous high were experienced in 2007-2008 and 2000-2002. However, future long term growth of the American economy is likely to continue to yield ever higher stock values and dividends, and those with sufficient patience will reap the rewards.
D. Avoid all high-fee mutual funds and closed-end funds. Avoid all leveraged funds. Any and all funds should be low-fee broad-based index mutual funds.
IV. Start monthly withdrawals for retirement income. Withdraw from stocks and stock funds in normal times and when stocks are dear, but not when stocks are cheap - like in 2008. In such times, withdraw from your risk-free reserve fund.
A. Withdraw all monthly retirement income from stocks and stock funds, unless we are in a "bear market" for stocks.
B. Switch to make your monthly retirement income withdrawals from your risk-free reserve funds when stocks enter a bear market. A bear market is generally defined as a 20% or more decline in the S & P 500 below its previous peak. If you don't follow the financial news, you will usually know when we are in a bear market from seeing the news headlines. Once you ascertain that a bear market has started, cease withdrawing your monthly retirement income from your stock market account or stock funds and switch to withdrawing that monthly amount from your risk-free reserve. Keep checking the level of the S & P 500 at least at the beginning of each calendar quarter. When the S & P 500 goes above that 20% decline point from the previous high, which you calculated previously, switch back to making your monthly retirement withdrawals from the stock or stock fund account, again. In this way you avoid selling your stocks when stock prices are cheap and your stock holdings can participate fully in the subsequent recovery.
V. Income tax considerations should be kept in mind both before and during retirement
A. Maximize holdings of stocks in taxable accounts, rather than tax-sheltered accounts to take advantage of the low maximum tax rate on dividends and long-term capital gains.
B. Interest earning investments should be directed to tax sheltered IRAs, 403Bs (teachers' annuities), and 401Ks, as much as possible.
1. Interest from fixed income investments is taxed fully, whether in a taxable account or when withdrawn from a sheltered retirement account.
2. Stock gains and dividends also are taxed fully when withdrawn from a sheltered retirement account and you miss out on the reduced maximum tax rate.
V. Confront Inflation
A. Avoid investments in long-term bonds, except for considering tax-sheltered (IRA, 401K, 403B) investments in TIPs or TIPs funds when their valuations are reasonable.
B. Interest - earning investments in money market accounts, bank CDs and TIPs will not be hurt by inflation.
C. Stock investments will not be hurt by inflation, in the long run, as costs, selling prices, dividends, stock prices, and the value of assets owned by the companies you invest in will all rise with inflation.
D. Adjust your monthly investment income need once a year, based upon expected inflation, your past twelve month's spending and your future plans. THE END