Sound Investing 9: Making It Last

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Plan to make your assets last


“Live long and prosper”

When we save and invest, we are always trying to gain a degree of control over a future that is inherently uncertain. One of the biggest uncertainties is how long we will live. Average life expectancy is some help, but it is only an average. For example, if a man and a woman are both 65, on the average the woman can expect to live to age 84 and the man to age 81, based on current US mortality rates. (The gender gap is smaller at age 65 than at birth because the men have already survived some of their most dangerous years, when they have higher mortality from such causes as accidents and acts of violence.) But people should plan for the possibility of living long beyond the average, at least 90 or 95. Fortunately, retirement portfolios can continue to grow after retirement begins. In fact, they typically grow much more during retirement than in the accumulation phase leading up to retirement.

In order to finance a long retirement, our 65-year-old couple should still have a diversified portfolio. If they invest too much in stock, they could lose too much of their nest egg in a severe bear market, just when they need it to live on. But if they don’t invest in stock at all, their savings may not grow enough to finance a long retirement. Many planners recommend an allocation of as much as 50% stock for those who are in the early stages of retirement. As always, time horizon is an important consideration. Elderly retirees who expect to spend down their assets in the near future should not risk them in the stock market. On the other hand, financially secure seniors who expect to leave most of their assets to their heirs have a longer horizon and can better afford to ride out the volatility of the markets.

Retirees may also wish to adjust their asset allocation to take into account income from other sources besides investments, such as a pension or immediate annuity. A lifetime income stream has a substantial present value that may be added to one’s investments when calculating total financial assets. A pensioner who wishes to have 40% of total financial assets in stock might put more than 40% of invested assets into stock, to offset the pension as an uninvested fixed-income asset.

Safe withdrawal rates

Once you reach the point of living off an accumulated nest egg, how much can you safely withdraw from it each year? That’s another area where sophisticated mathematical tools are useful. If we know the allocation of your portfolio and the number of years you want to plan for, we can calculate a withdrawal rate that has a high probability of making your savings last. For example, if you have 50% in stock, 40% in bonds and 10% in cash, and you want your savings to last for 30 years, many mathematical models suggest an initial withdrawal rate of 4%. That means that in the first year you can withdraw an amount equal to 4% of your retirement savings, then increase the dollar amount by the rate of inflation each year.

A withdrawal rate of 4% may sound very low. That would mean that you need $250,000 in investments just to take out $10,000 the first year. But a nest egg that large is not an unreasonable goal for an ordinary household, when you consider the power of compounding (see the discussion of getting time on your side).

Recently, a number of analysts have questioned the simple 4% rule, arguing that it relies too heavily on average historical returns and neglects current economic conditions. If you retire at the end of a bear market, when stock prices are low relative to corporate earnings, then you can probably sustain a higher rate of withdrawal, since chances are good that stock prices will rise over the course of your retirement. But if you retire at the end of a bull market, your portfolio may not get too much larger than it is already, so a very conservative withdrawal rate may be called for. One rule of thumb is to withdraw more than 4% a year if the Price/Earnings ratio of the S&P 500 when you retire is below its historical average (about 16), but withdraw less than 4% a year if P/E is above its historical average. The bull market that preceded the crash of 2008 had an especially high spike in P/E (over 40), leading some analysts to warn those who retired at the peak that they could run out of money if they took annual withdrawals of more than 2%!

Some mutual fund companies now offer special funds to manage your withdrawals for you. Some of them adjust the mix of investments to sustain a given withdrawal rate, while others adjust the withdrawal rate to make the funds last for a given number of years. These funds cannot guarantee that you won’t run out of money, but they reduce that risk.

Savings rates reconsidered

Recognizing that unfavorable economic conditions can easily reduce the amounts available for retirement income, you shouldn’t assume that your retirement will be secure if you are on track to accumulate a nest egg of a certain size or intend to withdraw a set percentage each year. That doesn’t mean you can’t plan with some confidence of success, however. Wade Pfau argues that your savings rate before retirement is a more reliable predictor of your retirement income than the size of your nest egg at retirement or your withdrawal rate after retirement (Journal of Financial Planning, 5/2011). To see why, consider two workers. John wants to accumulate a nest egg of $500,000 and then withdraw $20,000 a year (4%) for life. The trouble is that he doesn’t know what savings rate is necessary to get there, since it depends on whether he is investing in good times or bad; nor can he know that a 4% withdrawal rate will be sustainable under the economic conditions in retirement. Jane on the other hand doesn’t worry about hitting particular numbers, but just saves at a rate of 13% per year. If economic conditions are better before retirement than after, her savings do surprisingly well, so she can get by with a relatively low withdrawal rate in retirement. If conditions are better after retirement than before, her nest egg will be smaller, but growth during retirement will allow her to compensate by sustaining a higher withdrawal rate. Her chances of success are excellent under a variety of conditions.

Looking back over the last century, the savings rate necessary to support a comfortable retirement has varied somewhat, but it hasn’t varied as much as the savings rate necessary to accumulate a nest egg of a given size, or as much as the withdrawal rate necessary to live on a nest egg of a given size. The prudent savings rate has been within a range of 11% to 15%, with the higher part of the range providing the greatest probability of success.

Immediate annuities

There is a way of insuring a lifetime income while spending a little more than the conventional percentage of savings, such as 4% per year. You can take a lump sum and convert it to an immediate fixed annuity (not to be confused with the deferred variable annuity discussed in the posts on expenses and taxes). The issuer of the annuity, usually an insurance company, assumes the risk that you will live beyond your average life expectancy, because it has to keep paying you no matter how long you live. The company makes that up from somebody else who dies sooner than expected. The advantage for you is that the annuity can give you a higher payment than you can safely give yourself. The downside is that the money you use to buy the annuity isn’t available to your heirs (unless you accept a reduced payment in return for a guaranteed number of payments). If you die in the first year, the insurance company has your money. If you want to preserve your estate for your children, then you shouldn’t spend your whole nest egg on an annuity. You might want to compromise, by annuitizing part of your savings and holding onto the rest. The higher the proportion of your savings you annuitize, the higher the guaranteed income you can expect to receive, but the smaller the estate you can expect to leave.

When you buy a large annuity at one time, you could be locking in a low income because of low interest rates at the time of purchase. Your income could also be eroded by inflation. You can deal with the second problem by buying an inflation-protected annuity. Your initial payment will be smaller, but it will rise with inflation. You can deal with the timing problem by laddering your annuities, buying a series of smaller annuities over a period of years. As interest rates fluctuate, lower-rate annuities have a good chance of being balanced by higher-rate annuities.

Some planners argue that once you have secured a lifetime income with fixed annuities, then you can afford to be more aggressive with the rest of your investment portfolio, favoring stocks over bonds. On the average, retirees who adopt that strategy will probably end up with a larger estate. But outcomes will differ greatly depending on stock market performance. If you may need to use your nest egg for yourself, such as to buy into an expensive retirement community or assisted living facility, then you may want both a guaranteed annual income and some conservative, wealth-protecting investments.

Longevity insurance

Still another approach to making your money last is a relatively new insurance product called longevity insurance. This is an income annuity with a long deferral period, typically 20 or 30 years. You might buy it at age 65 but schedule payments to start at 85. You would do this if you expect your nest egg to cover you pretty well unless you live beyond 85. It costs a lot less than an immediate annuity because it will pay out for a shorter time, and maybe not at all. If you live an unusually long life, you’re covered. If you die young, the loss to your estate is smaller than if you bought an immediate annuity.

Multiple sources of income

Hopefully you will have other sources of retirement income besides investments. Financial planners sometimes talk about the “three-legged stool” supporting retirement: Social Security, pension and personal savings. Increasingly they are talking about some form of continuing employment as a fourth leg. So your own investments don’t have to carry the full load. But investment earnings are becoming increasingly vital, now that fewer employers are offering traditional pensions and the Social Security system is facing a possible cash-flow problem as the baby-boomers retire. Although more workers expect to remain in the labor force longer, the economy may be hard-pressed to create employment for both older and younger workers. That is all the more reason to incorporate the principles discussed here into your life plans, so that the investment leg of the stool will be on a solid foundation.

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