Blue Water Capital Management
Blue Water Capital Management

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Specializing in retirement planning and personalized investment management.

Essential vs. Discretionary

Total Returns With the Essential vs. Discretionary approach (aka “Income Floor”, “Floor and Upside”), you start by dividing your estimated retirement expenses into “essential” (housing, food, clothing, etc.) and “discretionary” (travel, entertainment, gifts, etc.).  Then a portion of the portfolio is put into guaranteed products (income annuities) or very low-risk investments (bond or CD ladders) to cover the essential expenses.  The rest of your portfolio is invested to provide for the discretionary expenses.

By buying or building a guaranteed income product, you essentially create a minimum amount or “floor” of income.  Social security and pensions are guaranteed incomes that also count towards the floor.

Simple Example 1:  Brad and Kim desire to spend $9,000/month in retirement with $7,000 of that being deemed essential.  They won’t receive a pension, but their combined social security will total about $3,000/month.  They will still need to guarantee income of $4,000/month ($7K essential - $3K of guaranteed income).

Simple Example 2:  Emily desires $5,000/month of essential on total retirement spending of $7,500/month.  Emily won’t receive social security, but she has a pension that will pay her $6,000/month.  Emily does not need any more guaranteed income to meet her essential needs.

Taxes were purposely left out to simplify the examples in order to demonstrate the concept.  Obviously, having $6,000/month of income is not the same as being able to spend $6,000/month.  In real life, the tax considerations of the guaranteed income have to be accounted for.  Income from Roth IRAs will be tax-free, but pensions, social security, and income from IRAs will be taxed as ordinary income.  Taxable accounts can produce a combination of tax-free, ordinary income, and capital gains. 

Here are some other considerations for this approach:

  1. Guarantees can be costly.  You may need to use a lot of your assets to create the desired income stream.  You would then have a lower amount for the discretionary side.  This could put a lot of pressure on the portfolio (high withdrawal rate) in order to meet your discretionary expenses. 
  2. You are not guaranteeing a well-lived retirement.  Since only essential expenses are under the guarantee, a market crash could severely affect your lifestyle.  Sure, you won’t be destitute, but it could severely affect how much you enjoy your retirement.
  3. Guarantees usually don’t account for inflation.  You can elect inflation adjustments for income annuities or opt to use TIPs (Treasury Inflation Protected bonds) for a bond ladder, but most people do not because they can be very costly.
  4. Liquidity is diminished.  Income annuities are irrevocable, meaning you can’t collect for 2 years and then decide to get your money back.  Individual bonds and CDs are more liquid, but you may lose money by not holding them to maturity (bonds may have dropped in value, CDs will charge an interest penalty).