The key challenges of retirement income planning are to create an income that lasts a lifetime, keeps pace with inflation and allows enough flexibility to cover emergencies. While there are countless strategies to meet these challenges, they boil down to two fundamentally different approaches: the Probability based approach and the Safety-first approach.
The Probability based approach, favored by investment manager types, assembles a sizable portfolio during your career and you systematically draw from it during retirement to underwrite your lifestyle. This approach requires significant participation in the Stock Market, a sizable portfolio, and a plan to deal with inevitable stock market swoons. Some call this approach the “4% Solution” drawn from the work of Bill Bengen during the 1990s. Bengen examined rolling 30-year periods from 1926 and discovered that a Portfolio of 60% S&P 500 and 40% Intermediate Bonds could sustain an annual withdrawal rate of 4% (and each year upping the withdrawal by the inflation rate). For example, a $500,000 portfolio would prescribe a $20,000 withdrawal (in retirement’s first year ($500,000 X 4% = $20,000). If inflation was 3% in year two, the next withdrawal would be $20,600 ($20,000 X 3% = $600) and so on, each year raising the annual withdrawal amount by the preceding year’s inflation rate.
Bengen found that all 30-year periods, among the 100 or so he studied, avoided fully depleted the portfolio even with rising withdrawals matching inflation. By the end of some 30 periods, it was nearly fully depleted, whereas other 30-year periods could have sustained an 8% withdrawal rate without fully depleting the portfolio. It just depended on the market’s performances and the time sequencing of market downturns during the 30-year periods. Bengen assumed 30 years as a proxy for a retirement lifetime.
Many variations of “the 4% rule” have appeared over recent decades. Vanguard’s iteration suggests setting “guard rails,” allowing somewhat greater withdrawals than 4% during Stock Market booms, while requiring withdrawals less than 4% in years when the Stock Market doesn’t deliver.
The RMD variation follows the required minimum distribution percentages the IRS mandates from most qualified retirement plans. Here you make withdrawals somewhat less than 4% in retirement’s early years, and gradually increasing the withdrawal percentage each year as your life expectancy shortens.
Some 4% strategies suggest drawing 4% plus inflation “on a total return basis” each year, combining investment income along with capital gains (and investment principal, if necessary) from the entire portfolio. Other 4% withdrawal strategies exempt guaranteed buffer (emergency) assets from annual withdrawal considerations.
In contrast, The Safety-first approach (SFA) emphasizes guaranteed incomes as the centerpiece of retirement income planning. Payouts from defined benefit pension plans, Social Security’s benefits, and commercial annuities with guaranteed incomes are used to implement this approach. Here, withdrawals from Investment assets are used primarily to “inflation hedge” fixed incomes and to provide emergency/buffer funds.
The SFA employs commercial annuities to “risk pool” in generating lifetime guaranteed incomes. Insurance companies can guarantee life-time incomes because their actuaries know that everyone (as a group) dies at a predictable rate. This allows the company to spread the risk among populations of annuitants to cover the life-time income needs of even the longest lived. Immediate annuities, deferred income annuities, and longevity insurance (advanced life deferred annuities) in various combinations are the insurance products used to implement the plan. Each provides life income either immediately, or sometime in the near or distant future.
With insurance company guaranteed payout annuities. you exchange a lump sum of money for an insurance company’s promise to provide you a life-time income. For a given monthly income, the longer you delay receiving the income, the lower the cost. For example, in 2021, a 65 year could buy a life-time annual income of $6,340 for $100,000. In contrast, a 65-year-old could buy the same life-time income to begin at age 85 (20 years in the future) for only $16,000 today.
Because some who buy future income products do not live to receive the payments, these unused dollars are distributed among surviving annuitants. These income enhancements shared by survivors are called “mortality credits” and provide an important underpinning of guaranteed retirement income. Also, the IRS waives required minimum distribution (RMDs) requirements for qualified retirement plans up to $135,000 (in 2022), if incomes commence later than the RMD initial date of 72. These products are called Qualified longevity annuity contracts (QLACs). However, with QLACs, once the life-time income begins, the annuitant is subject to RMD requirements.
Every retiree has a retirement income plan. Often, the plan is by default where the retiree never actively creates a plan but simply withdraws funds from accounts randomly. Often, a retiree’s pension and Social Security benefits are such a large portion of his/her retirement income, that these two income sources (along with haphazard withdrawals from savings and investments) become “the plan” by default. This article provides you with the impetus to be an active participant in creating your own plan. The two approaches described here (Probability based approach and the Safety Approach) provide templates to consider. Retirees need to take the best of each approach for themselves to create a plan they can live with. Successful retirees will combine portions of both to reflect their needs for certainty, willingness to take risks, and legacy considerations. Good luck on your journey!