3 Steps to a Retirement Income Plan: Nobel Prize Winner Helps Out
Figuring out how much income you need during retirement and formulating a retirement income plan is the most important aspect of financial planning. Don’t believe me? Well, the theory is advanced by Robert C. Merton, recipient of the 1997 Alfred Nobel Memorial Prize in Economic Sciences and Distinguished Professor of Finance at the MIT Sloan School of Management.
Merton believes that the most important aspect of retirement planning is to estimate your retirement income and insure that it is adequate to cover your spending. He rejects the focus on net worth and savings formulas without first understanding spending needs and how to turn assets into income. As he said on the podcast, “Overwhelmingly, I’m trying to make the case that the thing that matters for retirement is the amount of income you get and not how big your pot is. Those are very different.”
In his article, “The Crisis in Retirement Planning,” published in the Harvard Business Review, Merton outlines a retirement-focused framework that divides income needs into three categories. He also defines how to invest money for each category.
Here is how he recommends you approach creation of a retirement income plan
1. Define your minimum guaranteed retirement income
When creating a retirement income plan, you first want to identify your baseline income needs. How much income is absolutely necessary for you and your household? How much income MUST you have to cover your necessities?
Not sure? We can help you out with this out.
Guarantee your retirement income for mandatory expenses
To cover your mandatory expenses (housing, food, healthcare, and everything else you deem necessary), you want to guarantee adequate income — for life.
“It’s important for people to start figuring out what income they will have that is inflation-protected and guaranteed for the rest of someone’s life. This will help protect a retiree from longevity risk, interest rate fluctuations, and inflation,” writes Merton.
Retirement income that is guaranteed for life includes Social Security along with defined-benefit pensions. But there are other ways to achieve more income in this category.
“To increase the amount of guaranteed income above and beyond those benefits, the pensioner would have to buy an inflation-protected life annuity from a highly rated insurance company,” says Merton.
Lifetime income annuities offer guaranteed payments for the rest of someone’s life. For example, let’s say a 60-year-old male purchases a $150,000 annuity today with 3% inflation protection. If he were to opt to start receiving payouts in 5 years, he would get around $700 a month for the rest of his life.
Having your needs covered can provide peace of mind.
2. Create conservatively flexible income streams
The next step in creating a retirement income plan is to look at a second category of retirement expenses — money to cover costs that are not strictly mandatory but that you would really like to afford.
Invest safely for money you would like, but not necessarily need, to spend
People who are uncomfortable with annuitizing their entire retirement portfolio can consider trading off some — but not all — of their guaranteed future income for alternatives offering more flexibility.
One way is with U.S. Treasury Inflation-Protected Securities (TIPS) can serve as a “flexible but still relatively safe” alternative for a small portion of the portfolio. TIPs offer a periodic payout of inflation-protected income for a fixed period of time, called a “maturity.”
Portfolio interest income from the securities is combined with principal at each bond’s maturity to create income payments, resulting in no remaining capital once the payout period ends.
3. Strategize to achieve desired additional income
Finally, you want to identify the nice to have expenses (again, we can help with this). Invest funds for discretionary expenses in accordance with your values and risk tolerance.
“People with defined-contribution retirement plans will typically find that their targeted mix of guaranteed and conservative incomes, in combination with personal assets such as their house, bank accounts, and savings, is enough to meet their retirement goals,” says Merton.
These individuals may be comfortable allocating all of their defined contribution accumulation for investments in financial products such as annuities and bond funds for additional guaranteed and conservative incomes.
“But some participants may find that their anticipated total income and assets will not be enough to finance the level of retirement income they desire,” he writes. “In that case they may wish to accept lower income now (that is, increase savings) or invest a portion of their [defined contribution] accumulations in risky assets that hold out the possibility of earning sufficient returns to permit achieving the desired higher retirement income.”
Why the Focus on Retirement Income?
Understanding retirement income is a more approachable and meaningful way to think about retirement planning.
What’s it take to live in a nice little town?
Merton said, “If I can visit you in your hometown and I said, ‘Hey, this is a nice town. I’d like to move here.’ Then, I looked at how you’re living and I said, ‘Well, I like the way you’re living. What would it take for me to live in your town like you?’ I doubt you’d say to me, ‘You need $3,637,550 in the bank.'”
“I think you’d say, ‘Well, if you want to live like me here, you have to be earning about so much a year, right?’ That’s how people would say. ‘You got to earn about that amount, you can live like me.’”
Social Security is defined by monthly income — not a lump sum
Merton gives another example of why thinking about income is easier than a pot of money. He said, “I’ll give you another example, social security around the world. When you retire, what do they give you? What do they tell you they have? Do they tell you, you have a pot of money accumulated? No. They tell you, they will pay you so much per month for the rest of your life, and they will adjust it for inflation, right? Once again, an income concept.”
Summary of the 3 retirement income categories
So, in summary, you want to first figure out your retirement spending in three categories:
- What you must spend
- What you would really like to spend
- Funds that would be nice to have, but aren’t at all necessary
And then, create a plan for accumulating and investing your assets for those categories.
- What you must spend should be covered by guaranteed income. This is income that will be there no matter what happens in the financial markets or how long you live.
- What you would like to spend doesn’t necessarily need to be covered with guaranteed income. However, it should be invested with minimal risks. Furthermore, your draw down plan should be well established.
- Discretionary — nice to have — spending can be invested with more risk.
Achieving all three categories of income takes careful planning. We at Retire Wise can help you define how much you will need and when. Wcan plan for different types of income streams to meet your various spending needs.
Sources/Contributors: Robert C. Merton, Kathleen Coxwell & Shawn Maloney