RETIREMENT INCOME DISTRIBUTION METHODS:
When it absolutely, positively has to last your entire lifetime
“Will your retirement income last as long as you do?” – 2011 TIAA-CREF bulletin
“Retirement: Make your savings last as long as you do” – USA Today, December 12, 2011
“Make your nest egg last as long as you do” – Financial Finesse, October 12, 2011
What is this retirement voodoo that “lasts as long as you do?”
Retirement planning is a relatively new financial activity, one that has really only developed within the past two or three generations. The first generation (those born around the beginning of the 20th century) experienced longer life spans, the first iterations of government-sponsored plans like Social Security and the rise of industrial employer pensions. The next generation (born in the 1920s through the onset of World War II) retired in the heyday of generous Social Security and Medicare benefits, along with stable pensions and the opportunity to supplement these retirement sources with privately accumulated funds.
Presently, the Baby Boomers (those born between 1946-1964) are approaching retirement age, and finding that the retirement income resources of previous generations are significantly altered. Because of changing demographics (a much larger cohort of retirees in proportion to workers), the actuarial premises of Social Security are unsustainable. For similar reasons, company pensions are also fading from the financial landscape. Now, the primary burden for providing retirement income rests squarely on individual savings.
The following is an overview of several prominent retirement income strategies, emphasizing the philosophies behind them, and highlighting their perceived strengths and weaknesses. While each strategy has some unique features, all approaches are attempts to address the main issue in retirement: Sufficient income that lasts as long as you do.
STRATEGY #1: Live on Earnings, Conserve Principal.
This income distribution method is easy to understand: Your retirement income is the profit – income, interest, dividends, capital gains – that you receive from your retirement assets. Perhaps the oldest version of retirement income distribution, this simple approach has several positive features. First, by never touching the principal, you are assured the money will never run out. Second, conserving principal provides an inheritance for heirs, another important end-of-life financial issue. This approach can provide a high level of certainty, both to retirees and heirs.
But for many retirees, the principal required to generate a sufficient income may be substantial. If the principal earns 5 percent annually, a $100,000/yr. retirement income requires $2 million in principal. Conserving principal also means the greater portion of one’s wealth will not be enjoyed by the owner during his/her lifetime; $2 million must be conserved to continue providing $100,000 each year. And remember: Anytime principal is diminished, income will also be negatively affected.
STRATEGY #2: Devise a Drawdown Plan.
Recognizing that retirees will not live forever, some financial experts recommend a strategy that systematically distributes both earnings and principal. This approach, frequently called a “drawdown” or “spend down,” delivers a significantly larger annual income in comparison to a strategy that conserves principal.
Using the $2 million accumulation earning 5 percent from the previous example, a retiree could receive $125,000 in annual income for 29 years. That’s a 25 percent increase in retirement income from the same accumulation. Selecting a fixed drawdown amount also adds certainty to the retirement budget, which helps other retirement planning.
But there is a potential problem: About the fourth month of the 30th year, the money runs out. This means your retirement income may not last as long as you do. And even if it does, a successful drawdown leaves no principal to pass on to heirs.
These challenges highlight two critical elements in devising a drawdown plan: A projection of how long payments will be made, and what rate of return can be expected from the invested principal. While there are many methods of arriving at a drawdown number, the following are prevalent approaches today:
The Four Percent Drawdown Rule. In the October 1994 issue of the Journal of Financial Planning, William P. Bengen, a certified financial planner and author, published research on historical market behavior and concluded the following: A person who placed his retirement accumulation in a hypothetical stock and bond portfolio, and started by withdrawing 4% of the balance, then increased this withdrawal by the current inflation rate each year, could expect his accumulated nest egg to “easily last over 30 years” (per a March 5, 2012, Wall Street Journal article), even with fluctuations in principal. For a retirement starting at the ages of 65-70, this retirement income rule-of-thumb could likely last as long as a person does.
Over the past 17 years, Bengen’s projection has held up, and he told the WSJ he believes his rule still holds, even with some severe market fluctuations. Bengen has a few cautions: A long stretch of low returns and inflation could be problematic, especially for those just starting retirement.
Go to Monte Carlo. Bengen’s 4-percent-drawdown approach is a very broad projection of returns and longevity. For a deeper analysis, retirees may want a Monte Carlo assessment of their retirement income plan. This approach, named for the Monaco resort town renowned for its casinos, was first used in the 1940s by scientists working on the atomic bomb. A Monte Carlo program analyzes a range of possible outcomes and determines their probability of occurring. It shows the extreme possibilities—the outcomes of going for broke and for the most conservative decision—along with all possible consequences for middle-of-the-road decisions.
The strongest benefit of a Monte Carlo analysis is it provides a format for concisely comparing what might be considered apples and oranges – different time frames, different incomes, different investment risk levels. Retirees can weigh their financial priorities, such as security, inheritance, income, etc.
Most financial service companies have proprietary retirement income programs that incorporate Monte Carlo technology. Like any other computer-driven analysis, the value of the Monte Carlo method is dependent on the accuracy of the data used in analysis, and it must be noted that even events with the highest of probabilities are not guarantees.
STRATEGY #3: Annuitize.
The simplest way to establish a secure retirement income is to pay someone else to assume responsibility for investment risk and the length of payments. Annuities are contractual agreements from insurance companies that promise to deliver an income that will last as long as you want – even as long as you live.
One prominent advantage of an annuity is the lifetime income feature. Regardless of what happens to the economy, or how long one lives, a lifetime annuity is a contractual promise to continue delivering a regular income. This certainty not only stabilizes one’s finances, it also eliminates investment risk. Going back to the 1960s, economists have produced studies asserting that annuitizing is the most efficient strategy for delivering retirement income. And unlike other retirement income strategies, the longer one lives, the better the return.
However, the greatest obstacle for most prospective annuity purchasers, especially when considering a lifetime income option, is the complete surrender of their principal. In exchange for assuming all the risk of providing a retirement income, the insurance company takes full control of the invested principal. Consider this example:
Using rates quoted in March 2012, a 65-year-old male retiree with a $2 million nest egg could secure a $139,000 annual annuity income for life. If a retiree lived to 100, his $2 million investment would provide almost $4.9 million in income, delivering an annual rate of return of better than 6.6 percent.
On the other hand, if the retiree dies in an automobile crash two months after establishing the annuity, the insurance company does not refund the unused principal (unless the retiree included a return-of-principal provision in the annuity, which would decrease the monthly income payments).
A Blended Approach
Each of the retirement income strategies mentioned above has strengths and weaknesses, and each financial household has unique retirement issues. It is impossible to make generic recommendations that favor one income approach over another. In reality, many retirees select a combination of these strategies to address their income needs. With some competent assistance from your team of financial professionals, these approaches give you options that can optimize both retirement income and financial certainty.
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Disclosure: Our content is meant for educational purposes only. While it’s our goal to help you learn about building a life of prosperity, we do not intend to provide financial advice. Please consult your financial, tax or legal advisor before making any investment or financial decisions.