Key Takeaways
- The traditional three-legged stool (Social Security, pensions, personal savings) has weakened as private pensions cover only 15% of workers
- Social Security replaces approximately 40% of pre-retirement income on average, with the 2026 COLA increasing benefits by 2.8%
- The 4% withdrawal rule provides a baseline for sustainable portfolio income, though Morningstar's 2025 research suggests 3.9% for 90% success probability
- Reverse mortgages (HECM) allow homeowners 62+ to convert equity to income; 2026 lending limit is $1,249,125
- Income gap analysis identifies the shortfall between guaranteed income sources and total retirement needs
Sources of Retirement Income
Understanding the various sources of retirement income is essential for CFP professionals. Retirement income planning involves coordinating multiple income streams to meet client needs while managing risks. This section examines the traditional "three-legged stool" model, modern income sources, withdrawal strategies, and income gap analysis.
The Three-Legged Stool Model
The three-legged stool has historically represented the three primary sources of retirement income:
- Social Security - Government-provided retirement benefits
- Employer Pensions - Defined benefit or defined contribution plans
- Personal Savings - Individual retirement accounts and taxable investments
The Declining Stool
Unfortunately, this model has weakened significantly:
| Leg | Historical Coverage | Current Reality |
|---|---|---|
| Social Security | Universal for covered workers | Replaces only ~40% of income on average |
| Employer Pensions | Nearly 50% of private workers at peak | Only 15% of private workers today |
| Personal Savings | Supplemental | Now primary responsibility for most workers |
The shift from defined benefit to defined contribution plans has transferred retirement funding responsibility from employers to employees, making personal savings increasingly critical.
Social Security Benefits
Benefit Overview
Social Security provides a foundation of retirement income for most Americans:
- Benefits based on highest 35 years of indexed earnings (AIME - Average Indexed Monthly Earnings)
- Full Retirement Age (FRA) ranges from 66 to 67 depending on birth year
- Early claiming at 62 reduces benefits permanently (approximately 6.67% per year before FRA)
- Delayed credits increase benefits 8% per year from FRA to age 70
2026 Social Security Updates
| Parameter | 2025 Amount | 2026 Amount |
|---|---|---|
| Cost-of-Living Adjustment (COLA) | 2.5% | 2.8% |
| Average Retired Worker Benefit | $2,015/month | $2,071/month |
| Maximum Benefit at FRA | $4,018/month | $4,152/month |
| Earnings Limit (Under FRA) | $23,400 | $24,480 |
| Earnings Limit (Year of FRA) | $62,160 | $65,160 |
| Earnings Subject to Payroll Tax | $176,100 | $184,500 |
Income Replacement by Earnings Level
Social Security replacement rates vary significantly by income:
| Earnings Level | Approximate Replacement Rate |
|---|---|
| Low income | 55-75% |
| Average income | 40% |
| High income | 25-30% |
| Maximum earners | 20-25% |
Lower-income workers receive proportionally higher replacement rates due to the progressive benefit formula.
Employer-Sponsored Retirement Plans
Defined Benefit Pensions
Traditional pensions provide guaranteed lifetime income:
- Monthly benefit based on salary and years of service
- Employer bears investment and longevity risk
- Declining availability in private sector
- Still common for government and union workers
Defined Contribution Plans
401(k), 403(b), and similar plans require employee self-direction:
- Employee contribution limits for 2025: $23,500 (under 50) / $31,000 (50+) / $34,750 (60-63)
- Employer matching enhances savings
- Employee bears investment risk
- Distribution planning critical for income generation
Personal Savings and Investment Portfolio Withdrawals
The 4% Rule and Modern Withdrawal Research
The 4% rule (Bengen, 1994) suggested withdrawing 4% of portfolio value in year one, then adjusting annually for inflation. Modern research has refined this guidance:
| Withdrawal Approach | Rate | Key Assumption |
|---|---|---|
| Traditional 4% Rule | 4.0% | 30-year horizon, 50/50 portfolio |
| Morningstar 2025 | 3.9% | 90% success probability |
| Bengen Updated 2025 | 4.7% | With diversified stocks |
| Flexible Strategies | Up to 5.7% | Adjusts spending to market |
| 30-Year TIPS Ladder | 4.5% | Guaranteed real income |
Factors Affecting Sustainable Withdrawal Rates
- Time horizon: Shorter retirement allows higher rates
- Asset allocation: More stocks historically support higher rates (with more volatility)
- Spending flexibility: Willingness to reduce spending during downturns
- Guaranteed income: Social Security and pensions reduce portfolio withdrawal needs
- Sequence of returns risk: Early losses require lower withdrawal rates
Additional Income Sources
Part-Time Employment
Working in retirement provides multiple benefits:
- Supplemental income reduces portfolio withdrawals
- Maintains social connections and purpose
- Delays Social Security claiming (potentially increasing benefits)
- May provide healthcare coverage before Medicare eligibility
Rental Income
Real estate can provide passive income:
- Monthly cash flow from investment properties
- Potential appreciation
- Tax benefits (depreciation, 1031 exchanges)
- Management responsibilities and liquidity concerns
Annuities
Annuities convert savings into guaranteed income:
| Annuity Type | Feature | Best For |
|---|---|---|
| Immediate Annuity | Payments begin immediately | Current income need |
| Deferred Annuity | Payments begin at future date | Future income planning |
| Fixed Annuity | Guaranteed payment amount | Conservative investors |
| Variable Annuity | Payments tied to investments | Growth-oriented investors |
| Indexed Annuity | Returns linked to market index | Balance of growth and protection |
Incorporating guaranteed lifetime income through annuities can strengthen the retirement income plan by protecting against longevity risk.
Reverse Mortgages (HECM)
Home Equity Conversion Mortgages (HECM) allow homeowners age 62+ to access home equity without monthly payments:
| HECM Parameter | 2025 Limit | 2026 Limit |
|---|---|---|
| National Lending Limit | $1,209,750 | $1,249,125 |
Key HECM features:
- No monthly mortgage payments required (taxes and insurance still owed)
- Funds are not taxable income
- Does not affect Social Security or Medicare benefits
- Non-recourse loan (heirs never owe more than home value)
- Must maintain property and pay property taxes/insurance
Uses for retirement income:
- Line of credit for emergency funds or sequence risk buffer
- Monthly payments to supplement other income
- Lump sum for specific needs
Income Gap Analysis
Income gap analysis determines if guaranteed income sources cover essential expenses:
Step 1: Calculate Essential Expenses
Identify minimum monthly expenses:
- Housing (mortgage/rent, utilities, maintenance)
- Food
- Healthcare (premiums, out-of-pocket)
- Transportation
- Insurance
- Taxes
Step 2: Total Guaranteed Income
Sum all guaranteed income sources:
- Social Security benefits
- Pension income
- Annuity payments
- Required rental income
Step 3: Identify the Gap
| Category | Monthly Amount |
|---|---|
| Essential Expenses | $5,500 |
| Guaranteed Income | ($4,000) |
| Income Gap | $1,500 |
Step 4: Plan to Fill the Gap
Options to address income shortfall:
- Portfolio withdrawals (systematic withdrawal strategy)
- Annuitizing additional assets
- Part-time work
- Reducing expenses
- Delaying retirement
Coordinating Multiple Income Sources
Effective retirement income planning coordinates all sources:
| Income Source | Characteristics | Role in Plan |
|---|---|---|
| Social Security | Guaranteed, inflation-adjusted | Foundation/floor income |
| Pension | Guaranteed (if DB), may lack COLA | Core income |
| Portfolio Withdrawals | Variable, controllable | Flexible income/growth |
| Part-time Work | Earned income, may delay benefits | Bridge income |
| Annuities | Guaranteed, customizable | Longevity protection |
| Reverse Mortgage | Tax-free, tied to home | Supplemental/emergency |
On the CFP Exam
Expect questions on:
- Calculating income gap and identifying appropriate solutions
- Comparing guaranteed vs. variable income sources
- Applying withdrawal rate research to client scenarios
- Understanding Social Security benefit calculations and claiming strategies
- Evaluating annuity and reverse mortgage suitability
A 66-year-old client has $4,200/month in Social Security benefits and a $1,500/month pension. Their essential expenses total $7,500/month. What is their monthly income gap, and what strategy would most directly address it?
Which statement accurately describes the current state of the "three-legged stool" retirement income model?
A homeowner age 65 with a home valued at $800,000 is considering a reverse mortgage. Which statement about HECMs is correct?