We spend most of our life saving for retirement (hopefully), but what happens when you retire?
How do you turn that nest egg into actual income? Let’s take a look at the pros and cons of several retirement income strategies:
The 4% “Safe” Withdrawal Rate
The traditional approach has been that you can safely withdraw about 4% of the initial value of your retirement savings and increase that amount each year with inflation.
For example, if you retire with $1 million, you would withdraw 4% or $40,000 in the first year and increase those withdrawals with inflation each successive year.
Pro: It’s simple and based on real world scenarios. It was first devised by financial planner William Bengen in the early 1990s after he studied every 30-year period starting with 1926 and concluded that this was the highest safe withdrawal rate, assuming a simple portfolio of 50% large cap U.S. stocks and 50% intermediate term bonds.
This was later backed up by three finance professors at Trinity University in what is known as the “Trinity Study.”
Con: It may no longer be safe.
In a research study titled “The 45 Rule is Not Safe in a Low-Yield World,” authors Michael Finke, Wade Pfau and David Blanchett argue that none of those historical periods had the current combination of low bond rates and high stock valuations, neither of which bode well for their respective future investment returns.
Bengen based his calculations on average real returns of 2.6% on bonds and 8.6% on stocks, but the study points out that "if we calibrate bond returns to the January 2013 real yields offered on five-year TIPS, while maintaining the historical equity premium, the failure rate jumps to a whopping 57%.”
Add in the possibility of higher inflation and longer average life spans, and you could face a significant chance of running out of money in retirement using the traditional 4% "safe" withdrawal rule.
The 7% “Optimal” Withdrawal Rate
One of the critics of the 4% rule, Wade Pfau, has also argued that some retirees may be willing to take a larger risk of depleting their savings or reducing their income later in retirement in exchange for more income early in their retirement while they’re relatively young and healthy.
Pfau proposes a 7% initial withdrawal rate as a more “optimal” balance between the competing demands of higher income and preserving retirement savings.
Pro: A 7% withdrawal rate would provide almost twice as much income as the traditional 4% rule. For example, a million-dollar portfolio would produce $70,000 of income vs $40,000 under the 4% rule.
Con: Pfau admits that a 7% withdrawal rate is not “safe” as it had a 57% chance of failure over 30-year time periods.
Annuitization
By purchasing an income annuity, you trade a lump sum of money for an income that’s guaranteed by an insurance company for as long as you live. Annuities can be purchased that provide inflation adjustments, the ability to access some of the principal, and death benefits to a survivor, although those features generally reduce the income payments to you.
You can also get a deferred income annuity that pays out at a later date for a much smaller lump sum payment.
Pro: This provides the highest income stream without the risks of high withdrawal rates.
According to the annuity site immediateannuities.com, a 65-year-old male in California could get a guaranteed annual income of over $63,000 for life with a $1 million lump sum payment.
That’s over 50% more than he would get with a 4% withdrawal rate and without the market risk.
Con: You typically lose access to your principal and the ability to grow it and pass it on to your heirs.
The guarantee is also only as good as the health of the insurance company, although they are generally reinsured.
Living Off Investment Income
Rather than withdrawing principal and risking depleting your nest egg, you can simply live off the dividend and interest income.
Pro: You don’t have to worry about running out of money and your nest egg is likely to continue to grow throughout retirement.
Con: With 10-year treasury notes paying less than 3% and the S&P 500 yielding less than 2%, this strategy would provide the lowest total income. Your income would also fluctuate with interest rates and dividend yields.
“Spend Safely in Retirement Plan”
The Stanford Center for Longevity and the Society of Actuaries studied 292 different retirement strategies to come up with their “ideal plan,” which consists of delaying Social Security benefits to age 70, withdrawing 3.5% of your nest egg from age 65 to 70, and then using the IRS required minimum distribution tables to determine withdrawals from all your retirement accounts starting at age 70.
Pro: This strategy avoids the risk of running out of money without the sacrifice of principal involved with buying an income annuity or the sacrifice of income involved with living off just investment income.
Con: Your income will fluctuate with your retirement account balances throughout retirement.
So which strategy is best for you?
There is no one right answer. It largely depends on what you value and how you weigh the various pros and cons of each.
If you’re not sure, you may want to consult with a qualified and unbiased financial planner before you retire to help you devise a retirement income strategy.
Your employer may even offer this for free as part of a financial wellness program.
In any case, make sure your decision is an educated one. After all, you only have one shot at retirement.
