To make your retirement money last, base your spending on what you have. Forget about what you’re used to spending. Now, you have to live on the resources you have—Social Security, perhaps a pension, and your savings.
If you have accumulated only a modest amount of wealth (such as $100,000 or less), live on your Social Security and pension payments (if any) and keep your savings for large expenses. Because retirement will involve uneven and unexpected expenses, hold onto the limited savings you have and live on Social Security payments and any pension. Having cash to fall back on when you really need it will give you peace of mind.
If you have accumulated substantial savings and retire around 65, invest your money in a conservatively diversified portfolio and draw down no more than 4% per year of your retirement portfolio’s initial value. The 4% figure is designed to make your money last through all of your expected life span. It can be adjusted upwards for inflation each year.
If you think you'll have a long retirement (30 to 40 years), consider using two lifecycle funds. Half your portfolio would go in a lifecycle fund for current retirees and cover the first 20 or so years of your retirement. The other half of your portfolio would go in a lifecycle fund with a target date 20 years after you retire, which would cover the second half of your retirement. This way, you could have a stable source of income for the early retirement years while capturing the long term potential of stocks for your later years. This kind of arrangement would be easy for you to manage as well.
If you incur large expenses, or encounter financial turbulence and lose money in the financial markets, reduce your spending to conserve your remaining assets. Roll with the financial punches, and preserve your long term financial viability.
We discuss the mechanics of drawing down your portfolio. It's a lot easier if you invest in something simple like a lifecycle fund.
If you have substantial savings and want a predictable payment each month, consider buying a lump sum immediate fixed or inflation adjustable lifetime annuity with some of your savings. Annuities deservedly have a bad reputation for complexity and high fees. But a lump sum immediate fixed annuity, or a lump sum immediate inflation adjusted annuity, provides a predictable payment each month and could give you some peace of mind. Remember, however, that the money used to buy the annuity won’t be retrievable if you need it later on, and your heirs won't inherit any of the money used to buy the annuity. In addition, the insurance company issuing the annuity may go out of business. A fixed annuity can be ravaged by inflation. Anyone with a long life expectancy who wants an annuity should focus on an inflation adjusted annuity. Also, beware of the potentially high tax costs of using appreciated stocks to buy an annuity.
We also discuss an alternative to an annuity: U.S. Treasury securities. U.S. Treasury securities can also give you a guaranteed fixed stream of income for a long period of time (10 or 30 years). If you substitute U.S. Treasury securities, your income will be a bit lower compared to an annuity. But you will retain access to the principal used to buy the securities, and your heirs will inherit whatever you don't use. And you don't have to worry about the U.S. government going out of business.
We present SAMPLE PLANS for managing your retirement finances. One plan is for retiring on Social Security and an investment portfolio. The other plan is for retiring on Social Security, an annuity and an investment portfolio. These plans should give you an idea of how to make your money last. They aren't right for everyone—retirees have a wide variety of wants and needs, and should tailor their finances to their individual situations.
The hardest financial challenge you will probably face in retirement is making your money last. Here are our suggestions.
After you retire, base your spending on what you have. If you’ve been careful and built up a substantial amount of wealth, you may live quite well in retirement. If you have only a modest amount of savings, adjust to reality and ratchet down your spending. Spend too fast, and you'll end up broke.
A. Retirement on a light wallet: conserve cash and live on your guaranteed payments
If you’ve saved $100,000 or less, your best strategy for making your money last is to work as long as possible, while delaying the time when you start taking Social Security benefits. (See our discussion of boosting your benefits.) Once retired, live on Social Security and any pension you get. Work part-time if you can. Hold your limited savings in reserve for medical care and other large expenses. You’ll have to live modestly, but you’ll have an important cash reserve to fall back on when large expenses come up.
If you have a 401(k), IRA or other retirement account, take only the minimum required withdrawals each year. Leave as much as possible to compound on a tax deferred basis even during retirement. Don’t spend your minimum required withdrawals. Save them, instead. The minimum required withdrawals are just the tax code’s way of making you pay taxes on the money in the retirement accounts. They have nothing to do with how much you can safely spend in retirement. Remember that if you withdraw money from a retirement account for an expense (such as medical care), you may have to pay taxes on the withdrawal unless the financial institution managing the account withholds a sufficient amount of taxes for you. If taxes aren't withheld, don’t spend the entire withdrawal or the tax man will be knocking on your door.
If you have something like $50,000 to $100,000 saved up, consider keeping most of it in a lifecycle fund designed for retirees, so that your investments stay diversified. Even in retirement, it helps to maintain investment diversification, and a lifecycle fund is the easiest way to do it. If you have less than $50,000, look for safe investments that might more or less keep pace with inflation—inflation adjusted U.S. Treasury bonds or Savings Bonds might be good choices. Other possibilities are credit union or bank CDs, or short term bond mutual funds. If you really don’t have much in savings, don’t risk it in the stock market.
Living on your guaranteed payments like Social Security and a pension will not get you to a villa on the Amalfi coast of Italy. But if you play your cards carefully, you can enjoy a little financial security, perhaps something you haven’t had before.
B. Retirement on a Pot of Savings
If you’ve been diligent and fortunate enough to save a nice pile of doubloons in time for retirement, you’ll then have the question of how much you can spend without going broke. Here's a fairly simple approach.
1. If you have built up substantial savings and retire at 65, draw down no more than 4% of the beginning value of your retirement portfolio in your first year of retirement, and adjust your withdrawals for inflation in subsequent years.
If you have accumulated savings of a few hundred thousand dollars or more, you can spend a fair amount of your shekels over the course of your retirement, and still have a reserve for medical care and other large expenses. However, with life expectancies getting longer and longer, retirement money has to last a long time. That means you can’t spend a lot at any one time.
For example, if you retire at age 65 and don’t expect to live beyond 90, a reasonable plan is to start by taking out 4% of the value of your portfolio in your first year of retirement. That 4% ideally should be used for both living expenses, taxes and any special expenses like travel. The rest of your assets should be invested in a diversified portfolio with a fairly large percentage in stocks and the rest in bonds. The ratios discussed in our model plans for your age bracket give you a general idea of what’s suitable. The second year of retirement, you can withdraw the same amount as in year 1 plus an additional amount equal to the rate of inflation. The third year, you’d take the amount from year 2 and add a further adjustment for inflation. Subsequent years follow the same pattern.
For example, if you have retirement assets of $1,000,000, you'd withdraw $40,000 for the first year’s living expenses. (You’ll also have whatever Social Security and pension you may have, so your actual cash flow for year 1 living expenses is likely to be higher than $40,000). In year 2, assuming inflation is at its approximate historical average of 3%, you would withdraw $40,000 (the same amount as in year 1), plus $1,200 more for the inflation adjustment (40,000 x 3% = 1,200), for a total of $41,200. Then, in year 3, your withdrawal would be $41,200 (as in year 2), plus $1,236 for inflation of 3% again (41,200 x 3% = 1,236), for a total of $42,436. Future years’ withdrawals would be calculated in a similar way. If you use this 4% standard, you should have a very good chance of not running out of money in your final years.
If you retire earlier than age 65, you should reduce the 4% figure, because you have a longer life expectancy to cover. The extent to which you reduce the withdrawal rate will depend on how early you retire. If you retire at 60 and want to finance a 30 year retirement (i.e., you don’t expect to live beyond 90), you would be wise to reduce your withdrawal rate to 3.5% per year. If you retire at 55, and you want to be prepared for a 35 year retirement (until 90), a 3% withdrawal rate is advisable. (You can use a calculator provided by T. Rowe Price, a mutual fund management firm, at http://www3.troweprice.com/ric/RIC/ to run the numbers for various retirement ages.)
A 3% to 4% withdrawal rate may seem low. But if you’ve done a good job building up your net worth, adjusting your retirement contributions for inflation over time, you’ll have a pretty good nest egg. A large net worth multiplied by 3% or 4% will give you a good looking number. A small net worth multiplied by 10% will still be pretty small. Ultimately, what matters is the number of dollars you have, not the percentage of your net worth you take. Food, clothes, cars, heat, travel, entertainment, etc. are priced in dollars, not in a percentage of your net worth. Build up your wealth, and you’ll do fine with a 3% to 4% withdrawal rate.
2. What if you retire before age 62?
Before 62, you won’t be immediately eligible for Social Security. You may be tempted to withdraw larger amounts from your retirement portfolio, with the idea of cutting back on the withdrawals when you do start collecting Social Security. Be careful. Your larger early withdrawals reduce the amount of capital available to reap stock market gains in later years, which could be costly in the long term. It's safer to try to get by with a measured withdrawal rate than to deplete your capital early.
Let’s say you retire at 60. As indicated above, a withdrawal rate of 3.5% would be prudent. The safe move would be to stick to this level and upgrade your lifestyle once you start collecting Social Security. Retiring early can be fun, but it doesn’t come with any free lunches.
Another way to make your money last if you are able to retire early is to use two lifecycle funds. Let's say you are fortunate enough to retire at 55. Put half of your portfolio into a lifecycle fund for people who are already retired to cover your current living expenses. You would withdraw it at the 4% withdrawal rate we have discussed, which presumes a 20-25 year retirement. The other half of your portfolio would go into a lifecycle fund with a target date in or around the year you reach 75. That way, part of your portfolio is invested fairly aggressively to capture the long term growth potential of stocks. The money from the second lifecycle fund would cover you in case you live to, say, 90 or 95. A dual portfolio like this might make the process of managing your retirement money pretty easy.
3. What about budget-busting expenses?
Expect to have uneven expenses. As we all know, life is full of uneven expenses. That doesn’t change in retirement. Medical expenses, overseas travel, a new roof, kids in need of a downpayment, grandkids in need of college tuition money, and more, can bust your budget. When that happens, reduce your spending so that your remaining assets will hopefully last the rest of your life.
To illustrate the point, let's assume a married couple lives comfortably on $25,000 a year in Social Security and $40,000 a year from their retirement portfolio for a total of $65,000. Then, one of them becomes seriously ill and needs to move to a nursing home. That will cost somewhere in the range of $50,000 to $75,000 a year, potentially more than their $65,000 a year. Like most people, they have no long term care insurance, so they’ll have to tap into their retirement portfolio. We'll assume it takes 20% of the portfolio to cover the unexpected expenses. The couple should reduce their regular withdrawals by 20% below the amount they'd otherwise have withdrawn. That compensates for the reduction in the size of their portfolio, and restores their chances for making their money last.
Another approach would be to begin with a lower withdrawal rate. Instead of 4% for a retirement starting at age 65, use a 3.5% or even 3% figure. That way, you’ll automatically build up a buffer as you go along, before you incur the unexpected expenses. While this approach may not be enough if you incur catastrophic expenses (like the cost of a year or two in a nursing home), it gives you more leeway.
4. When you hit market turbulence, be flexible about drawing down your retirement portfolio
The one thing that's a certainty in the financial markets is that they will fluctuate, sometimes in dramatic and painful ways. For example, let’s assume there is a spike in inflation. The Federal Reserve Board will raise interest rates, and the stock market is likely to nosedive at first (because the stock market hates interest rate increases). Even though you might be tempted to withdraw more from your investment portfolio in order to compensate for the increased level of inflation—and could do so in line with the 4% formula if you retire at 65--restraint would be wise.
If you make a large withdrawal to compensate for the increased level of inflation in the early years of this cycle, you’ll be reducing an already shrinking portfolio. That will hinder your ability to profit from future market upswings. The less capital you withdraw from your portfolio during the market downswing, the greater your ability to capture gains from subsequent market upswings. The market drop may be severe, and withdrawals to compensate for inflation can take a large toll on your net worth. Experience tells us that the stock market rebound after a period of inflation may take a decade or more. Look back at the inflation scare of the 1970’s—inflation rose from 3% or 4% at the beginning of the decade to 10%, 11% and even 13% at the end of the decade. The Dow Jones Industrial Average rose to about 1050 at the end of 1972, and then dropped sharply, losing half its value by December 1974 (after adjusting for inflation). It didn’t recover on an inflation-adjusted basis for 13 years, until 1987. Then, the market promptly swooned again, falling back almost 23% in a single day (Oct. 19, 1987). Not until 1990, 18 long years later, did the market truly recover its 1970’s losses on an inflation-adjusted basis. Maintaining a 4% withdrawal rate in the face of such a sharp and lengthy stock market decline could put your long term financial security at serious risk.
If you’re operating under the 4% standard and the stock market drops sharply, scale back to 3.5% or even 3%. If you retired early using the 3.5% standard, drop back to 3% or less. Tightening your belt isn’t fun, but trying to make a go of it on just Social Security is less fun. Thrifty squirrels do better in winter.
During times when the stock market booms, keep your withdrawal rate at the 4% or 3% starting level and adjust upward only for inflation. The effectiveness of the 3% to 4% level assumes that the stock market will sometimes boom. If you increase the rate of your withdrawals when times are flush, you will mess up the plan.
The mechanics of drawing down your portfolio are fairly easy if you have invested in lifecycle funds. First, find out what required withdrawals must be made from your 401(k) account(s) and IRA(s). Those payments count first against your 3% to 4% withdrawal rate because you are required by law to take them. If possible, arrange for the required withdrawals to be paid to you on a monthly basis. Direct deposit into a checking account or money market account would be convenient. If the required withdrawals from retirement accounts exceed your 3% to 4% retirement spending rate, reinvest the excess. Don’t spend it. The amount of required withdrawals from retirement accounts has nothing to do with ensuring that your money will last. The requirement for withdrawals from retirement accounts is simply the tax law’s way of making you pay some taxes.
If you need additional cash beyond these required withdrawals to reach the 3% to 4% level, calculate the remaining annual amount needed to reach your 3% to 4% rate and divide by 12. That gives you the monthly amount for these additional withdrawals. Then, instruct the mutual fund staff to liquidate enough of your lifecycle fund to provide the desired amount of cash on a specified day of the month (like the first day of the month). For the sake of convenience, they can wire the money to your bank account (or credit it to your money market fund).
If you have invested in a mix of non-lifecycle mutual funds that you chose on a do-it-yourself basis, you will have to instruct the mutual fund staff how much to liquidate from which funds. Again, first find out the amount of required withdrawals from your IRAs and other tax deferred accounts. Arrange for monthly payments to be made to you, if possible.
Then make withdrawals of any additional cash you need from your taxable funds. (Let the assets in your tax-deferred accounts like your IRAs grow on a compounded basis free of taxes, except for mandatory withdrawals). If your withdrawals change the diversification of the your assets, you should rebalance the portfolio annually. For example, if you make most of your withdrawals from a bond fund, you should shift some money from stocks to bonds in order to preserve the appropriate diversification.
If you are in a low tax bracket, you might consider starting to make small withdrawals from tax deferred accounts sooner rather than later. Waiting until age 70 and ½ to begin making mandatory withdrawals might result in taxation at higher brackets, if the mandatory withdrawals would be large. In such a scenario, making small withdrawals sooner could result in lower overall tax liabilities for you. However, unless you’re pretty sure you’ll save on taxes this way, however, it’s better to keep the tax-deferred accounts as untouched as long as possible. Once the money is outside a tax shelter, the interest, dividends and realized capital gains it generates will be taxed on an ongoing basis. And you may be tempted to spend it too quickly since it will be readily accessible.
If you built your retirement portfolio by investing in individual stocks and bonds, you’ll have to manage the process of drawing down the portfolio closely, deciding which assets to sell and which ones to hold for the future. The conventional wisdom of selling assets in taxable accounts first may need some modification here. One advantage of investing in individual stocks is you have some control over taxes. If you don’t sell a stock, no taxes will be due even if it increases in value (except for any dividends it pays). If you have stocks in taxable accounts that you consider good long term investments, you may be better off holding them rather than selling them to generate funds for living expenses. If held for more than a year, the gains on these stocks will be taxed at favorable long term capital gains rates. The assets in your tax deferred accounts will be taxed at higher ordinary income rates when they are withdrawn (in other words, favorable long term capital gains rates do not apply to assets withdrawn from retirement accounts, even if those assets have been held for more than a year). That could take away some of the benefit of keeping the assets in the retirement account. If you estimate that the rate of future growth of the stocks in your taxable accounts is about the same as or faster than the future growth of the assets in your tax deferred accounts, you may be better off taking living expenses from tax deferred accounts now and keeping the stocks in the taxable accounts for future growth. Whether or not this strategy works depends on your financial situation, but it’s something to keep in mind.
If you are a do-it-yourselfer with individual stocks and bonds, be sure to rebalance the portfolio to maintain its desired diversification during the process of drawing down funds for living expenses. In other words, if you sell off a fair amount of stock one year for living expenses, you may have to shift some assets from bonds to stocks in order to maintain the appropriate percentage of your assets in stocks. As you did when you were building your wealth, you should also rebalance the account as well if the stock market booms or busts, so that you maintain the appropriate allocation in stocks, bonds and other investments. If all this talk of rebalancing has your stomach doing the Twist, consider shifting your assets into a lifecycle fund. That way, the mutual fund’s staff will do the rebalancing, while you practice your flyfishing technique.
Pointers: (a) after reaching age 70 ½ you’ll have to start making minimum withdrawals from 401(k)s and traditional IRAs—count them as part of the regular annual withdrawals and reinvest in a taxable account any amounts that exceed your 3% to 4% retirement spending rate; (b) you will not be required to withdraw funds from Roth accounts and can simply pass them onto your beneficiaries (who will, however, have withdrawal requirements; but they will at least inherit the entire account), and (c) also, stop reinvesting dividends in taxable accounts and use them for living expenses; you have to pay income taxes on the dividends, and if you reinvest them and then sell other assets for money to live on, that only means more income taxes due. Use dividends and interest from taxable accounts, along with required withdrawals from retirement accounts, for living expenses first before selling other assets for living expenses. The only reason to reinvest dividends and interest is if they exceed the amount you are taking for this year’s living expenses. In that case, reinvest the excess for the future.
If you want to leave something for your heirs, draw down your assets at a lower rate or put the inheritances in a separate portfolio that you don’t touch. You can either lower your withdrawal rate to 2.5%, or even 2%, per year whatever suits your purposes. Or you can separate your assets into two portfolios—one to live on and one to hold the inheritance for your heirs. The advantage of having two separate portfolios is that the assets destined for your heirs could be invested aggressively for long term growth. The portfolio you will live on can be invested more conservatively and drawn down at a 3% to 4% per year rate. That way, your heirs could end up inheriting more.
7. Consider the Option of an Immediate Annuity
Annuities are controversial in the financial planning area. Insurance agents and stock brokers love them because of the high commissions paid for selling one. Investors are often confused by the convoluted features of many annuities, and may not realize that annuities often have high sales commissions and other expenses. Investors may also not understand that deferred annuities include significant penalties for early withdrawal. Annuities can provide you with a lifelong stream of income; deferred annuities provide you with a tax-sheltered vehicle where your money is invested and grows without taxation, until the gains are paid out to you.
The ordinary investor should avoid annuities, except for a lump sum immediate lifetime annuity with either fixed monthly payments or inflation adjusted monthly payments. Such an annuity will give you a stream of predictable income for the rest of your life. Other types of annuities are too complex and confusing. Don’t buy annuities with a variable (i.e., investment) component or deferred annuities (whose costs can be substantial yet hard to figure out). Someone who is wealthy may be able to benefit from complex annuities. But ordinary investors have a serious risk of being sorry if they invest in something like a variable deferred annuity. As we said before, keep it simple.
A lump sum immediate lifetime annuity with fixed or inflation adjusted monthly payments is a contract where you invest a lump sum of money, and get a promise of lifetime income in return. To take a hypothetical example, if you retire in your mid to late 60’s and spend $100,000 on an immediate fixed annuity for you and your spouse, the two of you may get something in the range of $550 to 600 per month for the rest of your lives, depending on the features of the annuity and the level of market interest rates. Thus, you cannot run out of money (unless the insurance company issuing the annuity becomes insolvent, which is a risk to consider).
The point of buying an immediate annuity is to have a stream of predictable payments. Most of these annuities provide fixed payments, with no inflation adjustment. A few come with inflation-adjusted payments. The inflation adjusted annuities start off with lower monthly payments than those with fixed monthly payments (e.g., 25% to 30% lower), and you may not catch up to the level of the fixed payments for a number of years, depending on the rate of inflation. The inflation adjustment provides peace of mind, because a standard fixed payment annuity inevitably will deteriorate in value due to inflation. If you’re in good health and your family has a history of longevity, buying an inflation-adjusted annuity would probably be a better choice, even though you’d get lower payments at first.
Lump sum immediate annuities, of course, have disadvantages. After you purchase one, you cannot retrieve the money used to pay for it. All you will get is a stream of monthly payments. Immediate annuities aren’t like bank CD’s where you can close the account and retrieve your principal with the payment of only a modest early withdrawal penalty. If it turns out that you need the money used to buy the lump sum immediate annuity while you’re alive (for medical expenses or other expenses), you’re out of luck. It’s gone. If you die relatively early, you will effectively lose some or all of the lump sum used to buy the annuity. You heirs don't get anything. The insurance company that sold you the annuity gets the money, instead of your heirs. These are reasons why you shouldn’t invest all of your assets in an annuity.
Depending on your age, monthly payments from a lump sum immediate fixed annuity might be equivalent to about 5.5% to 6.5% per year (assuming early 2007 interest rates). This amount exceeds the 3% to 4% withdrawal rate that would be sensible if you were managing your money on your own, but that’s because the insurance company “inherits” part of your lump sum payment in case you die early. Also, the insurance company doesn’t increase the monthly payment for inflation (whereas you increase your 3% to 4% withdrawal annually for inflation). Thus, the insurance company can offer a higher monthly payment up front. If you kept your money and drew it down at a 3% to 4% annual rate, you'd give yourself an inflation adjustment every year. And if you died early, your heirs would get the remainder. If you’re willing to give up the lump sum, with its inflation adjusted withdrawals and its potential as an inheritance for your heirs, in exchange for a larger fixed monthly payment, a lump sum immediate fixed annuity may be a reasonable choice for you.
The payments on an immediate inflation adjusted annuity aren’t likely to be much different from a 4% or 3.5% standard for withdrawals from your retirement portfolio. That shouldn’t be surprising, since the economic considerations underlying the inflation adjustment feature are about the same whether you buy the annuity or manage the money yourself. With the annuity you would receive monthly payments for the rest of your life, however long that is. If you manage the money yourself, you could conceivably run out, although keeping the withdrawal rate down to the 3% to 4% level makes that unlikely. As with immediate fixed annuities, if you buy an inflation adjusted annuity and die relatively early, you lose (and the insurance company “inherits”) the money used to buy an inflation adjusted annuity. If you're interested in an annuity and expect to live longer than average, an inflation adjusted annuity may be the better choice for you.
If you are interested in an annuity, you shouldn’t invest your entire retirement portfolio in it. Remember those unexpected expenses—medical care, a car, re-roofing the house, etc.? You’ll need a pool of cash and other financial assets that can easily be converted to cash. Even if your health is good, don’t invest more than 50% of your portfolio in an annuity.
The remainder of your portfolio can be invested in a lifecycle or conservative lifestyle fund. This provides some inflation protection. Over long periods of time, such as ten years or more, the stock market has a good chance of keeping up with inflation. However, as we discussed above, stocks can give you nasty shorter term losses when inflation initially flares up. A conservative diversification, such as a lifecycle fund for retirees would provide, gives you some protection against the initial downswing in stocks, since much of a lifecyle fund's assets are invested in relatively stable assets like bonds and money market funds. The lifecycle fund also provides a degree of long term protection against inflation, since some of the fund's assets are invested in stocks (which have a good chance of keeping pace with inflation over the long term).
If inflation accelerates, a fixed annuity could become largely worthless over time. Inflation is the financial archenemy of retirees. It has been pretty tame in the last 25 years (1982-2007). Nevertheless, the dollar has lost more than half its value in that time. A fixed annuity would have suffered a comparable loss in value. Imagine reaching your late 80's and your fixed annuity has lost half its value; not fun.
Looking a little farther back, the 1970’s were a nightmare scenario for retirees. Inflation roared like a tiger. Fixed income assets, like annuities and bonds, lost significant value, and the stock market lost about half its value, adjusted for inflation, at one point in the 1970's. Stocks eventually recovered (although it took them until 1990 to recover permanently on an inflation adjusted basis). Fixed annuities never recovered (you’d need disinflation for that, and there hasn’t been significant disinflation in the U.S. since the 1930’s). An annuity bought in 1970 would have lost over 70% of its value by 1990. A person who retired in 1970 and had a 20-year retirement would have lost a lot of standard of living if he or she had put everything into fixed annuities. The Federal Reserve Board supposedly has a preference for a small amount of inflation (about 1% to 2% per year), because of a fear that stable or dropping prices could produce economic stagnation. Thus, it is likely that you would confront significant inflation over the course of a 20 or 30 year retirement. With just 2% annual inflation, the dollar would lose about 1/3 of its value in 20 years, and around 45% of its value after 30 years. Anyone who plans a long retirement and wants an annuity should seriously consider an inflation-adjusted annuity.
If your health is poor when you retire, an annuity isn’t a great idea because you may not live long enough to get much value from it. Nursing home bills, together with things like private duty nursing and other costs not covered by insurance, can reach six figures within a matter of months (you read it correctly: six figures within a matter of months). People in poor health should conserve cash.
Also consider the tax aspects of buying an annuity. If you'd have to pay for an annuity by selling appreciated securities like stock, you could take a substantial, double whammy in taxes. First, you'd have to sell the stock in order to get cash to pay for the annuity, which would mean capital gains taxes on the sale. Then, the income from the annuity would be taxed at ordinary income tax rates, which could be much higher than long term capital gains rates. You might be significantly better off just selling off your appreciated stock bit by bit to get funds to live on. You'd pay capital gains taxes once, probably at long term capital gains rates, and then the remainder would be yours to spend free of further taxes. The difference could be substantial since long term capital gains taxes are 15%, and ordinary income tax rates could be as high as 35%. Paying the 15% and using the rest to buy an annuity whose income is taxed at 33% or 35% is a pretty stiff price to pay for the certainty of a monthy check, while losing access to your capital. If you could manage your money yourself, you'd need to sell less of the appreciated stock to generate the same amount of aftertax income, and would have the rest of your stock in reserve for the future.
An annuity is subject to the risk that the insurance company behind it may go out of business—in which case you have a serious problem. Annuities by definition pay their benefits over the course of many years, perhaps more than 3 decades. That’s plenty of time for a poorly run insurance company to go under. Buy only from a highly rated insurance company. You can check the credit ratings of insurance companies at A.M. Best Company (www.ambest.com) and Weiss Ratings Inc., which is now TheStreet.com Ratings (http://www.thestreet.com/tsc/ratings/tsc_ratings_lha-insure.html). These rating services cover a large number of insurance companies. Look at both of these services so that you have a first and second opinion on each company. Getting two opinions is worthwhile since an annuity is supposed to last the rest of your life. Other rating services like Standard & Poors, Moody’s Investors Service and Duff & Phelps Credit Rating Co. cover some, but not all, insurance companies.
Be sure to get competing quotes from several insurance companies. Don’t be surprised if the quotes are rather different from each other—the companies may have differing cost structures, investment philosophies, and other considerations, so some price variation is likely. But don’t necessarily accept the most favorable quote. Compare the quotes against the companies’ credit ratings. If the better quotes are from the less well rated companies, be careful about accepting them. There won’t be a pot of gold at the end of the rainbow if the company isn’t there for you 20 years from now. A financially solid company is to be preferred over a poorly rated company, even if the latter offers a better quote.
If you meet with an insurance agent to look into a lump sum immediate annuity and the agent tries to steer you into something more complex or incomprehensible, be wary. The insurance industry has an unfortunate history of unscrupulous companies and fast talking agents who put their own interests in profits and commissions ahead of their clients’ interests in getting good value. Not all insurance agents and not all insurance companies are untrustworthy. But unless you are financial sophisticated, you will probably have a hard time telling the honest ones from the crooks. If you have trouble getting information about the annuity you want, end the conversation and walk out the door.
If this discussion of annuities seems overly detailed and long-winded, that’s because annuities are complex. They can be difficult for an ordinary investor to understand and evaluate. If you don’t feel comfortable with the advantages and disadvantages of an annuity—even a relatively simple one like a lump sum immediate annuity--then take a pass. An annuity is not necessary and you shouldn’t buy one if you can’t get comfortable with the idea.
8. Treasury Securities: an Alternative to an Annuity
If you don't like the limitations of an annuity (no access to the money used to buy it, loss of inheritance by your heirs, and risk of collapse of the insurance company selling the annuity), here's an alternative. Take the money you'd otherwise use for an annuity and use it to buy U.S. Treasury securities. If you want to lock in a fixed stream of income for a long time, buy either 10-year Treasury notes (which will have fixed interest payments for 10 years) or 30-year Treasury bonds (which will have fixed interest payments for 30 years). Such an investment will be like an annuity, providing predictable payments (although the interest will be paid every six months instead of monthly; but you can learn to live with that). Unlike the insurance companies that sell annuities, the U.S. government has no risk of collapse and will be able to pay its obligations. (Yes, projected federal deficits are frightening, but the U.S. government is still widely viewed in the financial markets as one of the least risky borrowers in the world.) If you invest in 30-year Treasury bonds, you will have guaranteed payments for life (unless you're one of those very few people whose retirement lasts more than 30 years). If you need to retrieve the money used to buy the Treasury securities, you can always sell some or all of the securities to raise money. When you die, the Treasury securities are included in your estate to be passed on as directed by your will.
The disadvantages of this approach are: (a) it will pay somewhat less than a fixed annuity (somewhere around 20% to 25% less with the interest rates of early 2007); and (b) if you buy 10-year Treasury notes, the amount of your interest payments will be locked in for only 10 years, and you'll have to reinvest the principal in new Treasury securities at the end of the first ten years at whatever interest rates are prevailing at that time.
It's true that the principal value of Treasury securities vary as interest rates fluctuate up and down, and you could lose money on your principal if you sell at a time when interest rates have risen. It's also true that your interest payments aren't adjusted for inflation and both the principal and interest will diminish in value over the years because of inflation. But a fixed annuity also deteriorates in value due to inflation and you cannot retrieve the principal used to buy it. The somewhat uncertain principal value of the Treasury securities is still pretty good compared to the retrievable value of the money you used to buy the annuity (which is zero, zip, nada).
This approach involves tradeoffs (lower income for you, but you retain access to your principal and you can count on the government to pay). If you like it, you can buy Treasury securities from a stockbroker (which will require you to pay a commission or other charge). Or else, you can purchase them directly from the U.S. Treasury through a program called Treasury Direct (at www.treasurydirect.gov). There's no commission charge if you purchase directly from the Treasury, but you can only buy whenever the Treasury is conducting an auction--in other words, you can't buy any time. Auctions for 10-year notes are held every month or two. Auctions for 30-year bonds are held once every six months. To buy at an auction, you'd open an account with Treasury Direct and submit a "noncompetitive bid" in the auction (a noncompetitive bid simply means you'd get the highest yield, or return, that is awarded to the competitive bidders, who are usually financial pros; don't worry, you're being treated fairly here). If you don't want to wait for an auction, buy from a stockbroker.
9. What would all this look like?
Sample plans for retirement spending are much more difficult to develop than model plans for saving, because there are many different ways to approach the use of your retirement assets. If you haven't saved much, the plan is simple: live on your Social Security and any pension you have, and hold your savings for the large expenses. If you've saved substantial amounts, here are a couple of sample plans to help you put all the pieces together. We assume the couple retires around age 65 and wants to be prepared for a 25-year retirement. These plans aren’t right for everyone; feel free to modify them or to develop your own plan.
a. Sample Retirement Plan 1: Social Security and a Lifecycle or Lifestyle Fund
This plan is for a couple living on Social Security and gradual withdrawals from a $1 million retirement portfolio. They also bring their trusty emergency cash fund with them into retirement. It never was part of their investment portfolio, and remains separate now.
1. Emergency Cash Fund: $35,000. The emergency cash fund is your old best friend. Don’t forget about it in retirement. We assume that this couple has $30,000 a year in Social Security benefits, and uses the 4% withdrawal formula. That results in an annual income of $70,000 in their first year of retirement. Six months worth of their annual income would be $35,000. While this couple won’t experience any abrupt halt in their income, they’ll still have large expenditures like overseas trips, cars and medical expenses. An emergency cash fund can be quite handy for dealing with those expenses.
2. Insurance: Medicare A, B and D, homeowners insurance, auto insurance, and an umbrella policy. They would have been wise to purchase long term care insurance earlier in life, such as their 30’s or 40’s. Buying it in their 60’s can be quite expensive (i.e., thousands per year). But moving to an assisted living facility or nursing home can also be quite expensive. There’s no easy choice when it comes to deciding in your 60’s whether or not to get long term care coverage. Look at the alternatives and do what maximizes your comfort level.
3. Home fully owned. Like many people today, this couple sold the large suburban house in which they raised their family and used some of the money from the sale to buy a smaller home for cash. The rest of the money went into their $1 million retirement portfolio. They have also wisely paid off their credit card debt, and have not taken out any home equity loan or line of credit on their new home.
4. Portfolio invested in a lifecycle or conservative lifestyle fund. To make money management easy for themselves, they put their $1 million portfolio into a lifecycle fund for retirees. The mutual fund staff will take care of portfolio allocation and rebalancing for them; and will send them monthly checks for the amount they have chosen to withdraw. Their total annual withdrawals start at $40,000.
b. Sample Retirement Plan 2: Add an Annuity (or U.S. Treasury Securities)
This plan is for another couple with $1 million in retirement savings that wants an annuity. They use $300,000 of their savings to buy a lump sum immediate fixed annuity. Thus, they will live on Social Security, annuity payments and gradual withdrawals from the remaining $700,000. They also bring their trusty emergency cash fund with them into retirement.
1. Emergency Cash Fund: $35,000. The emergency cash fund is your old best friend. Don’t forget about it in retirement. While this couple won’t experience any abrupt halt in their income, they’ll still have large expenditures like overseas trips, cars and medical expenses. An emergency cash fund can be quite handy for dealing with those expenses.
2. Insurance: Medicare A, B and D, homeowners insurance, auto insurance, and an umbrella policy. This couple would have been wise to purchase long term care insurance earlier in life, such as their 30’s or 40’s. Buying it in their 60’s can be quite expensive (i.e., thousands per year). But moving to an assisted living facility or nursing home can also be quite expensive. There’s no easy choice when it comes to deciding in your 60’s whether or not to get long term care coverage. Look at the alternatives and do what maximizes your comfort level.
3. Home fully owned. Like many people today, this couple sold the large suburban house in which they raised their family and used some of the money from the sale to buy a smaller home for cash. The rest of the money went into their retirement portfolio. They have also wisely paid off their credit card debt, and have not taken out any home equity loan or line of credit on their new home.
4. Immediate Fixed Joint Annuity. At interest rates prevailing around the beginning of 2007, this couple could, for $300,000, get an immediate fixed joint annuity (i.e., one that would pay the same monthly amount as long as at least one of them remains alive) of $1550 to $1600 a month, or $18,000 to $19,000 a year. When they both die, no further benefits would be paid to their survivors. This annuity is not adjusted for inflation, so its value erodes over time.
(Treasury securities alternative: buy $300,000 of 30-year Treasury bonds. Lock an income of approximately $14,000 a year (at early 2007 interest rates). While the income is lower than an annuity, this couple can sell some or all of the bonds if they need money for large expenses. And their survivors will inherit the remaining bonds when they pass away.)
5. Portfolio invested in a lifecycle or conservative lifestyle fund. To make money management easy for themselves, they put their remaining $700,000 into a lifecycle fund for retirees. The mutual fund staff will take care of portfolio allocation and rebalancing for them; and will send them monthly checks for the amount they have chosen to withdraw. They withdraw 4% a year, starting at $28,000.
Buying an annuity increases their immediate income to the level of $76,000 to $77,000 a year (as compared to $70,000 a year in Plan 1). But they cannot recover the money used to buy the annuity should they need it for medical bills or other expenses. Also, the annuity payment will not increase for inflation, and when they die, their survivors will not inherit anything from the annuity. Those are the risks of choosing the annuity and its predictable payments.
The Treasury securities alternative provides about $72,000 a year in income, and allows the couple to retain access to the principal used to purchase the bonds, if they need it for large expenses. Their survivors inherit the remaining bonds when they pass away.
As you can see, different choices produce different results and risks. There’s no single perfect answer for everyone. Think about the alternatives, and do what seems right for you.
10. Now, do I hire a financial planner?
The potential complexities of handling your retirement assets may lead you to wonder whether or not to hire a financial planner. Many people entering retirement could benefit from having a financial planner, especially if they have substantial assets and individualized needs that a financial planner can focus on. Not everyone will need a financial planner—a person with a pension, Social Security and a modest amount of savings doesn’t need a financial planner. Just try to live Social Security and the pension, and invest the savings conservatively so that it will be available for unexpected expenses. There is no reason for such a person to get tangled up in annuities or the like.
Of course, knowing as much as possible yourself about financial matters gives you a better chance of getting the most from a financial planner. Learn what you can on your own. You’ll be better able to deal with a financial planner, if you decide to hire one. And you may find out that you don’t really need one, after all.
Tax and estate planning issues are naturally a part of retirement finances, and may require hiring a tax accountant and a trusts and estates attorney. Financial planners might help you deal with the financial aspects of these questions. But don't rely on them for definitive advice. Very little about the laws governing trust and estates, or taxation, is simple or obvious. If you have a problem, make sure you consult the right expert.
Please go next to our closing thoughts.