Essential vs. DiscretionaryWith 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.
- 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.
- 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.
- 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.
- 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).