Income for Life - Retirement Planning

Income for Life - Retirement Planning Image

If you’ve saved diligently, you can still convert your nest egg into a reliable source of income that will cover your basic needs, along with those vacations you hope to take when it’s safe to travel again. But to reduce the risk of outliving your savings, you may need to revisit and revise some of the old rules of thumb.

Tapping Your Accounts

One of the biggest challenges facing retirees is figuring out how much they can withdraw from their IRA, 401k, plans, taxable accounts and other savings each year and still have enough to maintain their standard of living if they live into their nineties (or beyond). This prospect is so daunting that some retirees are overly frugal, scrimping on expenses even when they have plenty of money in their nest eggs. A study by the Employee Benefit Research Institute found that people with $500,000 or more in savings at retirement spent down less than 12% of their assets over 20 years on average.


One popular guideline is the “4% rule,” which was developed by William Bengen, an MIT graduate in aeronautics and astronautics who later became a certified financial planner. Here’s how it works: In the first year of retirement, withdraw 4% from your IRAs, 401(k)s and other tax-deferred accounts, which is where most workers hold their retirement savings. For every year after that, increase the dollar amount of your annual withdrawal by the previous year’s inflation rate. For example, if you have a $1 million nest egg, you would withdraw $40,000 the first year of retirement. If inflation that year is 2%, in the second year of retirement you would boost your withdrawal to $40,800. If inflation jumps to 3% the year after that, the dollar amount for the next year’s withdrawal would be $42,024.

The 4% rule assumes you’ll invest a hefty portion of your savings in bonds and cash—typically 40% to 50%—and the rest in stocks. A portfolio so heavily invested in fixed-income and cash may not generate sufficient returns to permit a 4% annual withdrawal rate, some planners say. “The 4% rule is under stress unlike anything we’ve seen in the historical data that we use to conclude that it works,” says Wade Pfau, professor of retirement income at the American College of Finacial Services.

You need the stock markets to outperform expectations for the foreseeable future for the 4% to still work. If there’s a downturn in the market, it would be very hard to offset that with enough income from safe investments.

Strategists for Goldman Sachs forecast that the S&P 500 index will generate average annual returns of 6%, including dividends, over the next 10 years. That’s a significant drop from the average annual return of 13.6% over the past decade, but well ahead of what analysts expect investors to earn from fixed-income investments. Goldman predicts that stocks have a 90% likelihood of outperforming bonds through 2030.

In order to get the kind of return [retirees] might have expected in the past, they need to have more in stocks. But while investing a higher percentage of your portfolio in stocks could deliver higher returns, it also exposes you to greater potential losses if the stock market undergoes a sharp and prolonged pullback.

Bengen says the 4% rule has held up during previous periods of market turbulence and economic turmoil, including the Great Recession of 2008 to 2009. An individual who retired in 2000 has already lived through two bear markets, he notes, but his research suggests that if the retiree had used the 4% withdrawal rule during that 20-year period, his portfolio would still be in good shape.

The biggest threat to his formula, Bengen contends, is a prolonged period of high inflation. Inflation as high as it has been in 2022 will errod retirees nest egg faster. Even supporters of the 4% rule withdrawal rate say it’s a guideline, not a mandate. If you’re able to reduce your spending, you may want to lower the amount you withdraw to 3.5% or less during down years in the market. The good news is that you may be able to take more out during years when your portfolio is performing well.

Cerainty at a Cost

No question, these are tough times for retirees who don’t want to take much risk with their portfolios. Bonds, cash and other low-risk investments are delivering such paltry returns that money invested in them won’t even keep pace with a low rate of inflation.

One alternative is to invest a slice of your savings in a single premium immediate annuity or a deferred annuity if not retired and still building your nest egg for retirement. In exchange for a lump sum, an insurance company will provide you with a monthly payment for a specified period of years or the rest of your life. You receive the largest amount each year with a life-only annuity, which stops payouts when you die. If you’re married, you also have the option of purchasing a joint-life annuity, which will reduce your payout but continue to provide income as long as either spouse is alive.

Annuities are particularly appealing if you’re worried about bear markets, because if the monthly annuity payments cover your basic expenses, you can leave your stock investments alone until the market recovers. An annuity could also enable you to invest more of your savings in stocks—an important consideration when returns from fixed-income investments are so low.

Picking the proper annuity for your situation is important and advise you work with an advisor to fit you to the proper type. Annuities can deliver a better return than you’d get by investing in fixed-income investments, because the longer you live, the more you earn. 

One alternative that could help with inflation and the different phases of retirement is to create an annuities ladder. Instead of investing the entire amount you want to annuitize at once, spread your investments over several years. For example, if you want to invest $200,000, you would buy an annuity for $50,000 this year and invest another $50,000 every two years until you have spent the entire amount. You can do the same with deferred annuities (see below). That way, the payouts will gradually increase as you get older, and if interest rates rise, you’ll be able to take advantage of them.

Become Your Own Pension Manager

An option that would allow you to hold on to more of your nest egg is to use the deferred income annuity, also known as a longevity annuity. With this annuity, you get guaranteed payments when you reach a certain age. For example, a 65-year- old man who invests $100,000 in a deferred annuity that starts payments when he turns 80 would receive about $1,640 a month, compared with $489 a month if he were to start payments immediately, this is where you can use the laddering. You can also buy a deferred annuity, known as a QLAC, in your IRA or 401(k), which also reduces your required minimum distributions when you turn 72. 

Filling Your Buckets

Many retirees use a strategy known as the bucket system to protect themselves from market downturns. With this system, you divide your savings among three “buckets.” The first is designed to cover living expenses for the next year or two, after a pension or annuity (if you have one), and Social Security. Because you need to be able to use the money in the first bucket at any time, you stash it in ultra-safe investments, usually a bank savings account or money market fund. The second bucket contains money you’ll need over the next 10 years and can be invested in short and intermediate funds. The third bucket is the money you won’t need until much later, so it can be invested in stocks or even alternative investments, such as real estate or commodities.

If you’ve spent a lot of time watching the news and are feeling pessimistic, you may be tempted to put several years’ worth of expenses in your cash bucket. But that strategy could actually increase the risk you’ll run out of money before you die, because putting money in bank savings accounts or money market funds these days is only slightly better than burying it in your backyard. Interest on cash accounts, even that offered by most online banks, is so low that the money you keep in cash will lag inflation and drag down the growth of your overall portfolio.

You should replenish your cash stash regularly from the other buckets, depending on how the market has performed. Reviewing your portfolio quarterly to determine whether your asset allocation has changed. For example, if your target allocation is 50% stocks and 50% fixed income and a stock market decline shifts it to 40% stocks and 60% fixed income, you would sell enough fixed income to bring your portfolio back to 50-50 and invest the proceeds in your cash bucket.

Add a Buffer

If having only one year’s expenses in cash keeps you up at night, consider adding a “buffer” to your portfolio that isn’t tied to the stock market, Pfau says. An income annuity can act as your buffer, because you’ll receive guaranteed monthly payments no matter how fierce a bear market becomes. If you own a home, another potential buffer is a reverse mortgage line of credit.

With this strategy, you take out a reverse mortgage line of credit as early as possible—homeowners are eligible at age 62— and set it aside. If the stock market turns bearish and stays that way for a while, you can draw from the line of credit to pay expenses until your portfolio recovers. You won’t have to pay the money back as long as you remain in your home.

Under the terms of the government insured Home Equity Conversion Mortgage, the most popular kind of reverse mortgage, the lower the interest rate, the more home equity you’re allowed to borrow. The maximum amount you can borrow using a HECM has also increased, from $726,525 in 2019 to $765,600 in 2020.

If you don’t need the money, your credit line will increase as if you were paying interest on the balance. If interest rates rise, your line of credit will grow even faster. 

A HECM reverse mortgage is a “non-recourse” loan, which means the amount you or your heirs owe when the home is sold will never exceed the value of the home. For example, if your loan balance grows to $300,000 and your home is sold for $220,000, you (or your heirs) will never owe more than $220,000.

The up-front costs for a reverse mortgage are higher than the cost of a traditional mortgage, so you shouldn’t take out a reverse mortgage unless you expect to stay in your home for at least five years. 

The loan will come due when the last surviving borrower sells, leaves for more than 12 months due to illness, or dies. If your heirs want to keep the home after you die, they’ll need to pay off the loan.

If you have an existing mortgage, you must pay it off first. Most borrowers use money from their reverse mortgage to retire the first mortgage. This will reduce the size of your line of credit, but you’ll eliminate one of your monthly bills, which will reduce the amount you’ll need to keep in your cash bucket.

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