An income plan that's built to last

Once you've constructed that golden nest egg, you're not quite ready to retire. You still have to turn it into an income that will support you in style for decades to come.

By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money Magazine) -- You saved diligently throughout your career, plowing as much as you could into your 401(k) and other retirement accounts. Now you're looking forward to kicking back and relaxing, secure in the knowledge that your nice plump portfolio will carry you comfortably through retirement.

But are you really set for life? Or do you suffer from what Olivia Mitchell, University of Pennsylvania insurance professor and executive director of the Pension Research Council, calls the lump-sum illusion?

"People see that they have a hundred thousand dollars in their 401(k) and say, 'I'm rich,'" says Mitchell. But what you may be ignoring is that your savings, whether it's $100,000 or $2 million, will have to support you for 20, 25, even 30 or more years.

Therein lies what may be the biggest challenge of retirement planning: How do you take the money you've amassed in your 401(k)s, IRAs and other accounts and turn it into a reliable income to support a postwork life that could last almost as long as your career did?

Fortunately, creating a steady income that, along with Social Security and a pension, will fund a long retirement is well within your power.

Essentially, you have three choices.

You can manage your retirement portfolio entirely on your own, investing it as you see fit and drawing income as needed.

Or you can put it all into an immediate annuity, which will give you a guaranteed monthly income for the rest of your life. But both of those strategies have flaws.

So your best move may be to mix the two in a way that gives you security and flexibility. Here's how to create a winning combination. (This is adapted from the October issue of Money Magazine - read the full feature.)

The best of both worlds

The concept is simple. Put part of your retirement savings in an income annuity and then invest the rest in a diversified portfolio of stock and bond funds (or individual stocks and bonds, for that matter).

The annuity payments give you a steady month-to-month income that won't run out. The investment portfolio provides whatever additional income you need and a kitty for unanticipated expenses, plus the long-term growth that can help you keep up with inflation.

This combination has another advantage: It can improve the odds that you'll be able to live off your money for 30 or more years. To get a sense of how much the annuity can help, take a look at the graph above.

It compares how a 65-year-old man who wants to draw 4% from his portfolio in year one, increasing that amount each year for inflation, would fare by managing withdrawals on his own vs. putting some of his money in an annuity.

Until age 85, the manage-it-yourself method works just fine. But the older he gets, the greater the chance that his portfolio won't make it (although in real life, of course, he would probably scale back his lifestyle and cut back on withdrawals).

By contrast, if he stashes 25% of his retirement assets in an immediate annuity, his odds of falling short drop to just 5% at age 95. The reason: The annuity payments, by reducing the amount you have to pull from your savings, limit the damage to your investment portfolio during market downturns.

What's more, even if your assets were to run dry, the annuity checks would keep rolling in. That's not to say this combination approach is free of the problems that plague the other methods - you still lose access to a chunk of your money, for instance. But if your goal is to assure that you'll have income you can count on, it's a good way to go.

How to build your income plan

Once you have the blueprint for your retirement income plan - putting, say, 25% to 50% of your money in an immediate annuity and leaving the rest in a diversified stock and bond portfolio - you have to come to grips with some practical issues.

How to shop for an annuity First you'll have to settle on how much you're devoting to an annuity - the exact amount depends on how much guaranteed income you want beyond Social Security and a pension. After you do, buying one is fairly simple.

Aside from the different payment options, immediate annuities all work pretty much the same way. (You could buy a variable immediate annuity, but stick with fixed. Payments on a variable one can rise over time, but you're already getting growth potential from the rest of your portfolio.)

Insurers base your monthly payment on your age and prevailing interest rates. However, they also factor in commissions and other costs, not to mention a nice profit, which is why it's important to compare payments from several companies before buying. You can do that by going to, a site that offers quotes from a variety of insurers.

A small but growing number of 401(k) plans have also begun offering annuities through Income Solutions, an online service that sells annuities at more favorable institutional rates, although your employer must be enrolled in the program for you to take advantage of it.

How to invest the rest As you enter retirement, you need to strike a balance with the portion of your money that's not in an annuity. You want to invest aggressively enough to generate long-term growth, yet not so aggressively that your money could be decimated by a stock market meltdown.

To achieve that, you'll probably want to start with anywhere from 50% to 60% of your assets in stocks and gradually scale back until you're down to 20% to 30% in equities by age 85 or so.

Plan your income stream Living off your investments isn't as simple as selling a stock every time a bill comes due. You need a cash-flow strategy. When you rebalance your portfolio once a year, estimate how much spending money you'll need over the next 12 to 18 months at the same time.

Set aside that amount in a money-market fund that you can tap throughout the year. So if a run-up in the price of large-company growth stocks has made them too great a percentage of your portfolio, sell off some shares and plow the proceeds into your reserve account.

You'll get both the income you need and the portfolio mix you want.

Be tax smart Another consideration is which accounts you tap and in what order. The general rule is to leave tax-deferred accounts such as 401(k) plans and IRAs alone as long as possible to take advantage of tax-free compounding.

That means you should dip into taxable brokerage and fund accounts first, spending dividend and interest payments before selling shares of stocks and funds, because you'll owe tax on that money even if you reinvest it.

Next up: 401(k)s and traditional IRAs and, finally, any money you have in a tax-free Roth.

An exception to this pecking order: Once you reach 70 1/2, you'll first want to take required minimum draws from 401(k)s and IRAs. Otherwise you could be hit with hefty IRS penalties.

The main point: However you do it, it's crucial that you enter retirement with some sort of plan for estimating how much income you'll need from your savings and how you intend to get it. After all, while building a big lump sum may make you feel rich, living securely on that money is what proves you really are. Top of page