Published October 26, 2012
Living forever has been the subject of many fairy tales and folklore. It’s something man has dreamed about since the beginning of time. While we may not be able to live forever, it is indisputable that we are living longer which means we are spending more years in retirement and need a proper plan to make sure our savings lasts as long as we do.
There are many factors to consider when developing a financial plan, and one that cannot be overlooked is longevity risk. Here are a few facts to keep in mind:
• Over the past 100 years, life expectancy has increased by 30 years. This is the most dramatic increase in life expectancy we have seen in history. (Source: CRS, Report for Congress)
• A 65-year-old woman has a 44.5% chance of living into her 90s. A 65-year-old man has a 50% chance of living to age 85. (U.S. Mortality Table)
• A couple, where each of them are age 65, have a 57% of one of them living until at least age 90. (Society of Actuaries)
To account for this risk, I ask my clients to think about how much they can spend each year and still have enough no matter how long they live. This has been one of the questions that financial planners have struggled with for decades.
The 4% Rule: Will it Work?
Several studies show varying rates for withdrawal so that you can make sure your investments last. The most common guideline, “The 4% Rule,” suggests withdrawing no more than 4% each year. Keep in mind, if you keep actual withdrawal amount constant and your portfolio goes down in value, the next withdrawal will be greater than 4%, which means you will be draining your principal more rapidly.
Depending on downturns in the market and how long you live, there is a good chance you will run out of money early. According to CNNMoney.com, “If you're unlucky enough to experience a large loss or period of paltry gains, especially early in retirement, the odds of your nest egg surviving three decades can easily drop from 90% to 60% or lower.” (Ask the Expert, 6/19/12)
A 40% chance of failure sounds pretty scary! The Journal of Financial Planning suggested that withdrawals begin at only 1.8%. You read that correctly. This withdrawal rate was determined after factoring in the recent volatility of the market. Using this withdrawal rate increases your chances of a successful retirement to well over 90%. However, you have to have a $2.8 million nest egg to receive an annual income of $50,000.
A Variation on the 4% Rule
The other option is to reduce or increase your withdrawals each year so that it is exactly 4% of your portfolio value. While this strategy has a higher success rate, it also means your income will fluctuate from year to year depending on market performance. Do you want to adjust your spending each year depending on what the market is doing? Maybe the better question should be whether or not you can adjust your spending. Most retirees have fixed costs that can’t be adjusted up or down from year to year.
Steps You Can Take
So, what are the steps you can take to protect your nest egg and make sure you do not outlive your investments?
Step 1: Don’t Lose Your Nest Egg - The most devastating factor to the success of a financial plan is the impact a market downturn has on your portfolio. This is particularly important in the early years of retirement. Several studies have shown that a downturn in the market at the beginning of retirement significantly increases the likelihood of running out of money. Moshe A. Milevsky, Associate Professor of finance at York University in Toronto, cautions: "Stocks can go up in the long run, but in the short run, the sequence of return volatility can ruin your portfolio at high withdrawal rates." Protecting your nest egg is job #1 when it comes to creating a successful retirement plan.
Step 2: Maximize Social Security Benefits - One of the most overlooked elements of a successful financial plan is maximizing Social Security benefits. Because of concerns about whether Social Security will be around in the future, many retirees claim their benefits as soon as they turn 62. As a result, their benefit is reduced by 25% compared to what it would be if they waited until 66 or 67. If they continued to defer benefits until age 70, their benefit would increase by 8% each year. (Now, that’s not a bad return on investment!)
If you live into your late 70s or longer, you will actually get more money by deferring benefits because the higher benefit will catch up and pass the amount paid out when benefits are triggered early. In addition to deferring benefits, there are various strategies that many people don’t know about (and aren’t told about) that would allow them to increase the benefits they receive. Exploring all of your options for claiming Social Security benefits is critical to maximize the amount of income you will receive during retirement.
Step 3: Setting Up Guaranteed Income Sources - In the old days, the only option to accomplish this was to purchase an immediate annuity that would guarantee only an income stream while you lived. A guaranteed growth rate was minimal or didn’t exist. You lost access to the funds. When you passed away the money and income stream vanished. As a result, most individuals chose to “take their chances” and invest in the stock market. This worked while the markets were up but the recent market volatility has punched holes in this strategy, as well.
The good news is that the recent market volatility has created a need for products that protect principal while still allowing your growth. To fill this need, new products have been developed which are making planning for retirement much safer and predictable. Today, you can allocate your “safe money” to Indexed Annuities that also include an Income Rider. By doing this not only are you able to participate in market growth (without the risk of loss), you are also able to guarantee a growth rate that at some point can be triggered to provide a lifetime income.
Some of the benefits of an Income Rider include the following:
• Guaranteed Growth: Income riders guarantee that your income value will grow by a guaranteed rate (usually between 5-8%) regardless of market conditions. At some point in the future, the income value can be triggered as a lifetime income stream.
• Higher Withdrawal Rate: Most Income Riders allow you to withdraw between 4-8% annually depending on your age when you trigger the benefit. These withdrawal rates are significantly higher than what you could safely withdraw on your own, and you are guaranteed that the money will never run out. This means you can create more income with less money. Being able to withdraw funds at 6% as opposed to 4% means that you can create 50% more income on the same amount of money.
• Access to Funds: You still have access to up to 10% of your account value each year, if needed. In addition, any remaining account value will pass to your beneficiaries so your hard-earned nest egg doesn’t just vanish.
The question is not whether or not we are living longer. The question is what are we doing about it. Have we adjusted our financial plans to account for this and have we taken the steps to setup our assets so that they will be there as long as we are? By taking the steps discussed above, you can sleep well knowing that your financial plan is designed for success now and in the future.
Matt Deaton is a partner at Acute Financial in Mesa, Arizona with extensive experience in asset management, marketing, and customer relations. He works closely with each individual to create a plan that meets his or her personal financial objectives. To contact Matt, visit www.acutefinancial.org or call (480) 223-2505.