My wife and I have substantial 401(k) balances and hope to retire in five years or so. But we’re not sure about how to turn our savings into income. We’re considering buying an annuity, but don’t know whether that’s a good move or whether we should be doing something else. What do you think?
—Ken R.
I think that you and your wife need a retirement income plan, a detailed strategy for figuring out how much income you’ll need to live the retirement lifestyle you envision and coming up with a realistic way to generate that income.
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Unfortunately, even after years of saving, most people seem to neglect this crucial part of retirement planning. A TIAA-CREF survey released earlier this year found that fewer than four in ten Americans had tried to figure out how their nest egg will translate into monthly retirement income.
The good news, though, is that coming up with a retirement income plan, whether on your own or with the help of an adviser, isn’t exactly a Mission Impossible, especially if you give yourself plenty of lead time, as you and your wife have wisely done. In fact, you can boil down the essentials of creating a retirement income plan to these three key steps.
1. Estimate how much income you’ll require. Assuming you’ll need 80% or so of your pre-retirement income in retirement may be an acceptable rule of thumb for determining what percentage of your salary you need to save during your career. But once you’re within five to 10 years of actually pulling the trigger on retirement, you want to get a more accurate sense of on how much you’re actually likely to spend after the paychecks stop.
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Don’t assume your spending will fall after you retire. Almost 40% of retirees found that their actual expenses were somewhat or much higher than they expected they would be when they first retired, according to the Employee Benefit Research Institute’s 2015 Retirement Confidence Survey.
The best way to get a realistic fix on your retirement spending is to create a retirement budget using an online budget worksheet like the one you’ll find within Fidelity’s Retirement Income Planner tool. In addition to having slots for 49 different expense items, this worksheet also allows you to designate whether a specific expense is essential (as opposed to discretionary). This feature can come in handy as it gives you a sense of how much flexibility you have should you have to cut back on spending in the future. And while no budget, no matter how detailed, can predict with absolute certainty how much you’ll spend—for example, health care expenses, as these two health-care costs calculators show, can become a major wild card as you age—having your budget in digital form makes it easier to fine tune as your spending needs change during retirement.
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2. Decide how much of that income you’d like to be guaranteed. Research shows that many people like the feeling of security that comes from knowing that all or most of their basic living expenses will be covered by guaranteed sources of income like Social Security or a traditional check-a-month pension. To see how much income you might receive from Social Security, you can go to the Social Security Administrator’s Retirement Estimator tool.
Keep in mind, though, that you can boost your monthly Social Security check by 7% to 8% for every year you delay taking benefits between the ages of 62 and 70. (You may see an even larger increase if you also work during the years you postpone collecting.) Married couples may be able to boost the amount they collect over their joint lifetime by upwards of hundreds of thousands of dollars by employing one or more “claiming strategies,” which you can explore by going to Financial Engines’ Social Security calculator.
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If, like most people, you find that there’s a gap between the income required to pay for life’s essentials and the payments Social Security and other assured sources provide, you might consider putting some (but not all) of your savings into an immediate annuity. A 65-year-old man investing $100,000 in an immediate annuity would receive roughly $565 a month for life, a 65-year-old woman would get about $545 monthly and a 65-year-old couple (man and woman) would receive about $480 a month as long as either is alive.
Another option is a “longevity annuity,” a type of annuity that for a relatively small upfront payment delivers large monthly checks in the future, providing assurance that you’ll still have steady income in addition to Social Security late in life even if you overspend early on. For example, a 65-year-old man would invests $25,000 in a longevity annuity would receive about $1.030 a month for life starting at age 85 and a 65-year-0ld woman would get roughly $860 a month. If you like the idea of a longevity annuity and want to fund it with money from an IRA, 401(k) or similar account, you’ll want to be sure that the annuity meets the Treasury Department’s criteria for designated QLACs, or Qualified Longevity Annuity Contracts, as longevity annuities that meet those criteria also give you a valuable tax break when it comes to RMDs, or required minimum draws. You can get quotes based on your age, sex and how much you wish to invest for both immediate and longevity annuities by going to the annuity calculator in RDR’s Retirement Toolbox.
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3. Start with a reasonable withdrawal rate—and be prepared to change it. Once you’ve figured out how much of your retirement expenses you’ll cover through guaranteed income, you can rely on draws from your nest egg for the rest. The big question then becomes much can you afford to withdraw each year without running too big a risk of outliving your savings?
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Traditionally, many retirees relied on the 4% rule, which essentially holds that if you limit your initial draw to 4% of your savings and then adjust that dollar amount for inflation each year, there’s a high probability that your savings will last at least 30 years. Given the low investment returns projected for the years ahead, however, some retirement experts believe that an initial withdrawal rate of 3% makes more sense.
Whatever withdrawal rate you decide to start with—and I think anywhere between 3% and 4% is reasonable for a 30-year-plus time horizon—be prepared to raise or lower withdrawals in subsequent years based on market conditions as well as how much you actually spend. For example, if your nest egg’s balance dips precipitously due to a market setback and/or because unexpected expenses forced you to pull more from your retirement accounts than you planned, then you may need to scale back withdrawals for a few years to give your nest egg a chance to recover. Conversely, if a string of outsize market gains boosts the value of your retirement accounts, you may be able to spend more freely for a few years.
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You can assess whether your current level of spending is sustainable by going to a retirement income calculator that uses Monte Carlo analysis and plugging in such information as your account balances, how your savings are invested and your planned annual withdrawals. If the calculator estimates that you have less than an 80% or so chance that your nest egg will last, then you can re-run the numbers to see how making changes like spending less, investing differently or taking on part-time work might boost your odds of success. Going through this exercise every year or so and making changes as necessary can help you avoid having to make more radical (and painful) adjustments to your lifestyle later in life.
There are plenty of other ways you can refine and improve your retirement income strategy, ranging from doing some lifestyle planning to get a better sense of how you’ll actually live once you retire to giving your portfolio a check-up to make sure it’s properly positioned for retirement. But if you get the three steps I’ve outlined above right (or even mostly right), you can be reasonably confident that you’ll have the retirement income you need for as long as you’ll need it. (8/10/15)
Walter Updegrave is the editor ofRealDealRetirement.com.If you have a question on retirement or investing that you would like Walter to answer online, send it to him atwalter@realdealretirement.com. You can tweet Walter at @RealDealRetire.
