I frequently hear this question from people who have never worked with a professional wealth planner. They imagine that when they retire, they should live solely off the income from their investment portfolio. This concept became outdated with the development of personal financial planning.

WHAT IS THE PROBLEM WITH THIS APPROACH?
If you limit spending to investment income, then you will be motivated to invest in income-producing securities and avoid securities that derive most of their return from appreciation. You will favor bonds and neglect stocks. There are two problems with this approach:

It may not result in enough return to cover your living costs for the rest of your life. U.S. long-term corporate bonds have earned 6 percent over the last 70 years. However, large company stocks, as represented by the S&P 500 index, earned 11 percent over the last 70 years—a 5 percent difference (Source: 2011 DFA Matrix Book for the years ending December 31, 2011). This difference can add up. Over a 25-year time period, $1 million earning 6 percent will grow to over $4 million, while it would have tripled to over $13 million with an 11 percent investment. The difference is greater when taxes are considered, as bond interest is taxed at ordinary income rates, which can be more than twice the rate on stock dividends and capital gains.

Your income and spending will not be adjusted for inflation, resulting in a decrease in your lifestyle. Assume that you earn 4 percent on a $1 million bond, or $40,000 per year. This allows you to spend $40,000 in year 1. You will earn the same $40,000 in year 11. However, the income will be worth less than $30,000, after adjusting for 3 percent annual inflation.

WHAT IS THE SOLUTION?
Develop a projection of the growth and spending of your wealth over your lifetime. This approach will require you to be clear about your goals and numbers:

Goals
Where do you want to go and how do you want to allocate your wealth? Here are some sample goals:

• “I want the check for my funeral to bounce”: slang for “I want to maximize my lifestyle as long as possible.”
• “I want to maximize my lifestyle, but I want to retain a sizable cushion for medical costs or other unexpected emergencies.”
• “I want to leave $1 million to each of my children and $500,000 to each of my favorite charities.”

Numbers
What are your specific numbers for:

• Preferred lifestyle cost
• Cushion for emergencies and contingencies
• Gifts and bequests to family and charities

When you have a rough idea of these components, sit down with a professional trained in financial coaching and analysis, who can help you refine your goals and numbers into a written plan. With this type of projection, you no longer need to worry about just spending investment income. Consequently, you will be free to invest in higher-returning investments. A financial plan accounts for lifestyle costs that adjust for inflation. You will not need to guess if you will have the required cushion for emergencies or bequests at the end of your life.

Although you cannot predict how long you are going to live, that should not prevent you from proactively managing the use of your wealth. Planning can help you to maximize your lifestyle, your chosen legacies and your security and confidence in where you are headed.