Spend Without Worry in Retirement
The Irish poet and playwright Oscar Wilde once said that it’s better to have a permanent income than to be fascinating—a sentiment many retirees undoubtedly share. Unfortunately, the decline of traditional pensions in favor of 401(k) plans (and other defined contribution plans) has forced many retirees to figure out how to make a lump sum of money—sometimes a very large lump sum—last as long as they do.
A growing body of research suggests that many retirees have responded to this challenge by withdrawing far less than they can afford to spend based on the amount they’ve saved and their average life expectancy. Research 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.
Michael Finke, a professor of retirement at the American College of Financial Services, says research he conducted found that 80% of retirees are uncomfortable watching their nest egg get smaller. “To an economist, that’s a mystery,” he says. “Why did you save in the first place?”
Forgoing meaningful activities isn’t without cost, says Glen Franklin, director of customer research for Jackson National Life Insurance. Although you don’t necessarily need to go on an around-the-world cruise, he says, hobbies, travel and other activities that involve family and friends—and often increase spending—have been shown to reduce your risk of cognitive decline. “You live longer if you have purpose in life, and purpose isn’t free,” he says.
Still, the fear of running out of money is powerful and could be exacerbated by the recent increase in the inflation rate. While many economists believe the recent spike in prices is temporary, anyone who lived through the 1970s knows how devastating inflation can be, especially if you’re living on a fixed income. In fact, according to a recent Kiplinger–Personal Capital poll of retirees and near-retirees, 77% are worried about the effects of inflation on their financial security.
Fortunately, you can take steps that will help you pursue your retirement dreams without jeopardizing your retirement security. And as a bonus, some of these strategies will help you stay ahead of inflation, too.
Bending the 4% Rule
If you’re retired or approaching retirement, you’ve probably heard of 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.
The 4% rule is designed to ensure that you won’t outlive your savings, and it has withstood the test of time. But Bengen acknowledges that a prolonged period of high inflation could threaten his formula. And supporters of the 4% rule also point out that it’s a guideline, not a mandate, and may need to be adjusted—to 3.5%, for example—during down years in the market.
The downside to the rule is that it doesn’t account for the fact that your spending habits and expenses will change over time. Many retirees spend more money in the early years of retirement, when they’re healthy enough to travel and pursue other activities, then cut back in their seventies and eighties. If you’d prefer a withdrawal plan that more closely adheres to your retirement lifestyle, consider creating a retirement time line of your income and expenses. This exercise will help you determine how much you need to withdraw from your savings each year to close the gap, says Dana Anspach, a CFP and founder of Sensible Money, in Scottsdale, Ariz.
You can do this exercise on an Excel or Google Sheets spreadsheet. Once you’ve filled out your spreadsheet, you can calculate the gap between your guaranteed income and expenses, which will help you determine how much you need to withdraw from your savings each year. (If your income exceeds your expenses, you can add some of that money to your savings or increase your discretionary spending.)
This exercise allows you to make adjustments as your circumstances change. For example, if you pay off your mortgage a few years into retirement, you can subtract that cost from the housing column in your expense time line. You can also use your time line to determine whether you can afford to delay filing for Social Security.
You may need professional help (or a retirement software program) to get the most out of this strategy, because you’ll need to project your investment returns, as well as taxes. A planner can help you avoid projecting overly optimistic investment returns or underestimating your taxes. You can find a CFP who specializes in retirement at letsmakeaplan.org.
Anspach says about 75% of retirees she has worked with are “pleasantly surprised” to learn that they won’t run out of money in retirement. And even those who learn that their savings may fall short can use that information to make needed changes, such as downsizing or working longer, she says.
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Another advantage to this strategy is that it will help you deploy what’s known as the bucket system without putting too much money in low-interest accounts. With this strategy, you divide your savings among three accounts, or “buckets.” The first is a liquid account designed to cover living expenses for the next year or two, after accounting for a pension or annuity (if you have one) and Social Security. The second bucket holds money you’ll need over the next 10 years; it can be invested in short- and intermediate-term bond funds. The third bucket holds 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.
Most financial planners recommend investing the first bucket in ultra-safe investments, such as bank savings accounts and money market funds. That way, you won’t have to sell stocks or funds in a market downturn to pay the bills. If you’re worried about a stock market downturn, or you fear you’ll run out of money, it’s tempting to put more than two years’ worth of expenses in your cash bucket (or overestimate how much you’ll spend in two years). But unless you have enough money to launch your own space flight, stashing too much of your portfolio in cash accounts will increase the risk that you’ll run out of money in retirement. Because interest on those accounts is near zero, money invested in cash won’t keep up with inflation—a particular concern now, when inflation is rising—and will depress the returns of your overall portfolio.
Invest in an Annuity
Annuities come in many flavors, with varying degrees of complexity, but most offer a way to convert your investment into a monthly check—either now or sometime in the future—for as long as you live. If you own an annuity that covers your basic expenses, you may feel more comfortable spending money in your savings.
There are two problems with annuities in the current environment. First, payouts for single-premium immediate annuities, which typically provide monthly payments in exchange for a lump-sum investment, are tied to rates for 10-year Treasuries. Although the Federal Reserve Board has signaled that it may raise long-term rates as early as 2023, those rates are currently at historic lows. That means you’ll have to pay more for an annuity to generate a given amount of income than you would if rates were higher.
Advocates of annuitizing a portion of your savings argue that even under these circumstances, annuities provide a layer of security you can’t find anywhere else. Annuities also provide better returns than fixed-income investments, which have seen their yields pummeled by low interest rates, says David Lau, founder and chief executive officer of DPL Financial Partners, which distributes annuities and life insurance to financial planners. When you buy an annuity, the insurance company pools your money with that of other investors, and funds from investors who die earlier than expected are paid out to those who live longer. These “mortality credits” allow insurance companies to provide a higher yield than you’d get from fixed-income investments, Lau says.
The second problem is that if the recent increase in inflation is more than a temporary phenomenon, rising prices will erode the value of your monthly payments. You can buy an annuity with an inflation rider, but it will lower your initial payout by about 26%.
One way around this problem is to invest in an annuity that links your returns to a specific index, such as the S&P 500. Examples range from fixed-index annuities, which limit how much you can earn but protect you from losses, to buffered annuities (also known as registered index-linked annuities), which offer the potential for higher returns but don’t protect you from losses—although there’s a limit on how much you can lose.
These types of annuities are complex and are sometimes loaded with high up-front commissions that will dampen your returns. In recent years, though, companies such as DPL Financial Partners have developed commission-free indexed annuities. Because the annuities don’t have a commission, certified financial planners can offer them without running afoul of the fiduciary rule, which requires CFPs to put their clients’ interests above their own.
Lau notes that even investing in a plain-vanilla immediate annuity provides a way to increase your exposure to stocks, which offer one of the most effective ways to stay ahead of inflation (see Shield Your Portfolio From Inflation). If you have an annuity that covers your basic expenses, you don’t have to worry about selling stocks in a down market to pay the bills.
If long-term interest rates eventually move higher, payouts from an immediate annuity will increase, so you may want to delay making an investment. But if you’d like to start your income stream now, consider creating an annuity 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. Payouts are higher if you buy an annuity when you’re older, and if interest rates rise, you’ll be able to take advantage of them.
Many retirees are reluctant to buy annuities because in exchange for guaranteed income, you must give an insurance company a large sum of money that you usually can’t get back. One less-costly alternative is a deferred-income annuity, which provides 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 $1,568 a month, according to ImmediateAnnuities.com, compared with $485 a month if he were to start payments immediately. Deferred-income annuities offer some tax advantages, too, which we’ll discuss below.
Although deferred-income annuities are among the least-expensive types you can buy, Lau says they are often a hard sell because retirees worry that they’ll die before payments begin. One way to get over this hurdle is to view a deferred-income annuity as longevity insurance—a guarantee that even if you live to be 103, you won’t run out of money. And if you know you’ll start getting guaranteed monthly payments in your eighties, you may feel more comfortable spending money when you’re in your sixties.
Delay Filing for Social Security
If you’re concerned that inflation will erode your retirement savings, one of the most effective steps you can take is to delay claiming Social Security benefits. Here’s why: Unlike just about any other slice of your retirement portfolio pie, Social Security receives an automatic cost of living adjustment every year. Because of recent increases in consumer prices, the Social Security COLA could rise as much as 6.3% in 2022—the largest increase since 1982.
In addition to the annual COLA adjustment, you’ll get an 8% credit for each year you delay claiming benefits from full retirement age, or FRA, to age 70. (Your FRA is age 66 if you were born between 1943 and 1954; it gradually rises to 67 for younger people.) “That makes it one of the lowest-risk investments out there,” says Rhian Horgan, a former managing director at J.P. Morgan and founder of Silvur, a retirement-planning app for people older than 50.
Because of the delayed-retirement credits, there’s a powerful argument for postponing benefits even if inflation is zero, says Harold Evensky, a certified financial planner and chairman of Evensky & Katz/Foldes Financial. When inflation is rising, delaying benefits is even more advantageous because cost-of-living adjustments start increasing your benefits at age 62, even if you don’t claim them. If you can afford to wait until age 70 to claim, you’ll get a double benefit: the annual 8% delayed-retirement credits, plus the compounded increase from each year’s cost-of-living adjustment (when there is one). “The more you defer, the more money you have that’s inflation-adjusted,” says Jamie Hopkins, managing partner for Carson Group, a wealth management firm.
Advocates for seniors say the annual Social Security COLA is inadequate because it fails to reflect the disproportionate amount seniors spend on health care, which typically rises faster than the overall inflation rate. Even with that caveat, you’d have to look long and hard to find an affordable investment that provides an equivalent cost-of-living increase.
The promise of higher Social Security benefits after age 70 could provide you with the confidence to spend funds from your IRAs and other sources, during your early years of retirement. And even if you’re convinced you won’t live past your break-even age—the point at which you would come out ahead by delaying Social Security benefits (about 79 for most people)—postponing your claim could provide protections for your spouse, especially if he or she is the lower earner. A surviving spouse who is at least full retirement age can receive 100% of the deceased spouse’s benefit, so delaying benefits will increase the amount of money your spouse will receive after you’re gone.
Lower Taxes on Your Savings
When calculating your retirement budget, it’s critical to include an expense line for taxes, because a significant portion of your retirement savings will go to Uncle Sam. If most of your savings is in tax-deferred accounts, such as IRAs and former employers’ 401(k) plans, taxes could consume more than one-third of your withdrawals.
Even if you don’t need the money, you must start required minimum distributions from your tax-deferred accounts when you turn 72. These RMDs will be based on the total amount of money you have in all of your accounts at the end of the year, divided by a factor from IRS life-expectancy tables. The withdrawals will be taxed at your ordinary income tax rate; they could also trigger higher taxes on your Social Security benefits and higher Medicare premiums.
Legislation pending in Congress would change the age for taking required minimum distributions from 72 to 73 on January 1, 2022, and gradually increase the RMD age to 75 by 2032.
But while some seniors may welcome more time for their investments to grow, delaying RMDs won’t necessarily lower your tax bill. That’s because the eventual RMDs will be based on a larger balance, which increases the size of your taxable withdrawals and could push you into a higher tax bracket.
For that reason, some financial planners recommend taking withdrawals from your tax-deferred accounts well before RMDs kick in. By taking carefully curated withdrawals early in retirement, you’ll reduce the balance when you start taking RMDs, resulting in a smaller tax bill. You can use the money to pay some of your living expenses, which will allow you to delay filing for Social Security.
Other strategies to lower your RMDs:
Convert some of your IRAs or other tax-deferred accounts to a Roth IRA. You’ll have to pay federal and state taxes on any amount you convert, but once the money is in a Roth, withdrawals are tax-free, and Roths aren’t subject to RMDs. If you leave a Roth IRA to your children, they’ll be required to withdraw the money in 10 years, but they won’t pay taxes on the distributions.
Buy a deferred-income annuity. You can invest up to 25% of your IRA or 401(k) account (or $130,000, whichever is less) in a type of longevity annuity known as a qualified longevity annuity contract (QLAC) without having to take required minimum distributions when you turn 72. You won’t avoid taxes on the money forever. The taxable portion of the money you used will still be taxed when you start receiving income from the annuity. But the tax bite will be delayed if you postpone receiving income from the QLAC until you’re in your mid seventies or eighties.
Donate some of your IRA to charity. Retirees who are 70½ or older can donate up to $100,000 a year from their IRAs to charity. A qualified charitable distribution, or QCD, can count toward your required minimum distribution. A QCD isn’t deductible, but it will reduce your adjusted gross income (AGI), which can lower your taxes on items tied to your adjusted gross income, such as Social Security benefits and Medicare premiums. You can’t make a QCD to a donor-advised fund or private foundation, so make sure the charity is eligible before you transfer the funds.
The Safety Net of a Part-Time Job
Illustration by Julia Allum
One way to get over your fears of running out of money is to generate extra income in retirement. And one of the most effective ways to accomplish this goal is to find a part-time job. At a time when many companies are struggling to fill positions, it’s easier than ever to find something that will supplement your retirement income.
If you retire before age 65, when you qualify for Medicare, a part-time job that provides health care benefits is particularly valuable, says Rhian Horgan, a former managing director at J.P. Morgan and founder of Silvur, a retirement-planning app for people over 50. The Affordable Care Act guarantees that anyone can buy health insurance at the ACA marketplace, but the law allows insurers to charge higher rates for seniors. A plan that might cost a young person $300 a month could cost $900 or more for someone who is 55 or older, Horgan says. The American Rescue Plan, which was signed into law in March, will cut premiums in half for many seniors (and eliminate them entirely for those with low incomes), but unless Congress extends them, the subsidies will expire in 2022.
Even if your part-time job doesn’t come with health insurance, the extra income will help you pay for insurance, reducing the need to take money out of your savings. And if working as a barista or ballpark beer vendor doesn’t appeal to you, there are plenty of gig opportunities for older professionals. Examples include FlexProfessionals, which finds part-time jobs for accountants, sales representatives and others for $25 to $40 an hour, and Wahve, which finds work-at-home jobs for experienced workers in accounting, insurance and human resources (pay varies by experience).
If you’re tired of working, there are other ways to generate extra income in retirement. Seniors who own a vacation home can rent it out when they’re not using it. And if you rent your property for 14 days or less during the year, you don’t have to report the income on your tax return.
Tools for Generating Guaranteed Income
Most annuities offer the potential for guaranteed income in retirement and could provide higher returns than traditional fixed-income investments. For example, if you purchase an annuity with a guaranteed lifetime withdrawal benefit rider, you’ll receive a guaranteed payout each year for the rest of your life—or, depending on the rider, for the rest of your life and your spouse’s life—even if the account balance falls to zero. Here’s a rundown on different types of annuities, along with their advantages and drawbacks. (For more information, see kiplinger.com/kpf/indexedannuities.)
Single-premium immediate annuity. Also known as an immediate annuity. You typically give an insurance company a lump sum in exchange for monthly payments for the rest of your life, or a specified period.
- Pros: It’s easy to compare payouts from these products at websites such as Immediateannuities.com. You can find a monthly payment that covers your fixed expenses, such as your mortgage.
- Cons: With some exceptions, you can’t access the money you invested for unexpected costs, which is why most planners recommend investing no more than 25% to 30% of your savings in an annuity. And unless you buy an inflation rider—which will reduce your payouts—inflation will erode the value of your monthly payments over time.
Deferred-income annuity. In exchange for a lump sum (or multiple purchases), an insurance company will provide you with 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 $1,568 a month, according to Immediateannuities.com.
- Pros: These are much less expensive than immediate annuities. By locking in a guaranteed monthly payment for your later years, you may feel more comfortable spending during the early years of retirement.
- Cons: If you die before payments start, you—and in most cases, your heirs—receive nothing from your investment. You also need to make sure the insurance company will be around when your payments start. You can check an insurance company’s financial strength at A.M. Best, a credit rating agency.
Multi-year guaranteed annuity. Provides a fixed rate of return over a specific period of time (typically three to seven years).
- Pros: They typically pay a higher yield than certificates of deposit. Currently, five-year fixed-rate annuities have yields that range from 2% to 2.5%, compared with an average of 0.32% for a five-year CD.
- Cons: Most multi-year guaranteed annuities come with surrender charges of up to 15% if you withdraw the money before a specified period of time. If you need funds before the surrender period expires, you could lose money on your investment.
Fixed-index annuity. Your returns are linked to a specific index, such as the S&P 500.
- Pros: Depending on how the market performs, you could earn more than you would receive from a multi-year guaranteed annuity, and your investment is protected against losses.
- Cons: There’s a limit on how much you can earn, even when the market is going gangbusters. For example, if your contract has a cap of 6% over a specific period of time, you’ll earn a maximum 6% rate of return, even if the S&P 500 index soars 25% during that same period.
Buffered annuity. A buffered annuity has a floor, or buffer, that limits how much you can lose.
- Pros: Buffered annuities offer the potential for you to earn higher returns on the upside but limit losses on the downside. For example, if the annuity has a buffer of 10% and the index it’s linked to falls 4%, you lose nothing.
- Cons: You can still lose money. And like other types of indexed annuities, these products are sometimes loaded with fees that will depress investment returns.
Variable annuity. A type of deferred annuity that invests in mutual-fund-like subaccounts to create future income (usually in retirement).
- Pros: Earnings accumulate tax-deferred, which is appealing to investors saving for retirement who have already maxed out on tax-deferred retirement plans.
- Cons: Fees can be high, and you could lose money on your investments.
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