How to Avoid Running Out of Money in Retirement

Young couple calculating budget

Life expectancies have been rising in modern times. While this is generally a wonderful thing, it can be problematic when doing retirement planning: You may worry about running out of money after you retire. Relax; there are ways to proactively deal with this fear.

Several academic studies address strategies for retirement planning. One recommends that you add more of a stock component to your portfolio after retirement, contrary to the conventional approach. Another suggests you could focus on saving steadily, rather than concentrating on how much money you should accumulate. Yet another study involves a dynamic approach -- adjusting up or down the rate at which you should withdraw money from your portfolio every year in retirement.

Buying an annuity is a tried-and-tested approach that enables you to count on a regular payment for as long as you live. And, of course, adequately budgeting for spending is a practical exercise that will help you prepare for retirement.

Want to avoid running out of money in retirement? Read on to see what the academics and financial industry experts say.

Gradually hike up your stock exposure

Conventional wisdom states you should dial down your stock exposure as you advance in age. But an academic study turns that idea on its head: Rather than cutting down on stocks in your portfolio after retirement, you should hike it up.

According to Wade Pfau, professor of retirement income at the American College, and Michael Kitces, a partner with the Pinnacle Advisory Group in Columbia, Maryland, instead of going for a downward slope in terms of your equity exposure, you should actually go for a 'U'-shape approach, with the stock component of your portfolio gradually going up post-retirement.

This way, when market returns are not good in the early years of retirement, you will add more stock exposure to your portfolio and can benefit later in your retirement after the market rebounds. And in case the market returns are good early on, the higher stock exposure in your portfolio means that you are ahead of the game and prepared for the later stages of retirement.

Pfau says, "Starting with a lower stock allocation and then gradually increasing it helps to provide bigger downside protection. In the worst-case scenario, the damage toward retirement is going to be less than created with other asset allocation strategies."

Focus on saving steadily

Those still in the workforce can avoid running out of money in retirement by saving steadily throughout their careers.

In another study by Pfau, he found that you are likely to be better off by focusing on saving at a steady rate during your working years, rather than on a withdrawal rate after retirement. The conventional approach is to try to accumulate a certain target wealth amount that will help you withdraw at a specific safe and sustainable withdrawal rate -- say, 4 percent -- from your portfolio in retirement.

Pfau says, considering that a portfolio of stocks and bonds tends to be volatile, it means you can't safely say where you will end up. "Instead, look at savings rate, which, because of its mean reversion, tends to be much less volatile in terms of what consistently works historically," says Pfau.

There is no universal savings rate that applies to everyone, and you can figure out what works for yourself. However, a baseline of 16 to 17 percent might be a good starting point, Pfau finds.

Another disadvantage with focusing on a safe withdrawal rate is that this rate, if it is set during a time when portfolios are benefiting from a long bull market, is not likely to be sustainable.

Periodically adjust your withdrawal rate

Once you set up a certain withdrawal rate, the conventional retirement approach is to stick to it throughout retirement, over a period of time that could be as long as 35 years.

David Blanchett, head of retirement research with Morningstar, the Chicago investment research firm, says, "The two unknown variables when it comes to building an income strategy are how long you are going to live, and what the market returns are. If you knew both of these variables with absolute certainty, you could know exactly the amount you could take from your portfolio."

He says that retirees would be better off readjusting their withdrawal rate periodically in a dynamic manner, rather than sticking to a specific withdrawal rate.

The way to do this is to reassess your withdrawal rate at some defined interval, typically once a year, based on factors such as how long you expect to live, your current spending and plans for future spending.

These three triggers should motivate you to reassess your withdrawal rate: if the market drops, if you change the allocation in your portfolio, or if you have a life event that changes your expectations on retirement.

Set upper and lower limits for withdrawals

Mutual fund giant Vanguard's dynamic approach to portfolio withdrawals is based on a combination of two tactics: a) starting off with a specific dollar-amount withdrawal and adjusting it for inflation each year, and b) withdrawing a specific percentage of your portfolio annually.

In what Vanguard calls a "ceiling and floor" approach, the fund company says you could withdraw a specific percentage of your portfolio each year, setting upper limits, or a ceiling, and lower limits, or a floor, based on what you spent in the previous year.

If you find that your defined withdrawal would result in an amount that's, say, higher than a ceiling of 5 percent more than your prior year's withdrawal, then you would withdraw only up to the ceiling amount. Similarly, if you find that the defined withdrawal amount falls below a minimum floor you set, then you would withdraw at least the floor amount.

For example, you withdrew $30,000 from your portfolio in 2014 and find that your 2015 withdrawal would be $30,300 based on a 1 percent rate of inflation. Instead of going with this defined withdrawal, you would instead, based on a 2.5 percent floor, withdraw $30,750, hiking up the 2014 withdrawal by 2.5 percent.

Ivory tower approach may not work in real world

Although academics may spout theories about how best to deal with retirement issues, these studies may have some significant shortcomings as far as how you can actually use them to plan your retirement.

Bonnie-Jeanne MacDonald, a fellow of the Society of Actuaries and a researcher with Dalhousie University's economics department, says that academics are inclined to model things based on assumptions that may be hard to determine. She notes, "It is really hard to model things like taxes and government transfers (such as Social Security) and government credit. So, when academics are evaluating one strategy over another, they almost always do not take that into account when it could be quite important."

For instance, the amount of income retirees will need to maintain their standards of living, expressed as a percentage of their pre-retirement income, is often geared to a one-size-fits-all approach based on certain assumptions, MacDonald concludes in a study sponsored by the Society of Actuaries.

And some of the studies that look at how people draw down their money in retirement are based on a cohort of people who grew up in the Great Depression -- and that level of conservatism may not hold up in the future.

Don't confuse eligibility with ability to retire

To get a better idea about Americans' retirement preparedness, the Employee Benefit Research Institute has been surveying individuals on their retirement confidence annually for more than 20 years. And one of its findings is that people consistently don't take the first step to avoid running out of money in retirement.

Dallas Salisbury, EBRI's president and CEO, says that, surprisingly enough, less than 40 percent of the survey respondents going into retirement have calculated how much they expect their expenses and income will be in retirement. This is important because the traditional approach that called for 75 percent to 80 percent replacement of pre-retirement income is based on an era when long-term care insurance policies were very good and more readily available than they are today. And people believe that Medicare pays for more than it actually does.

"The No. 1 thing to do is to make sure that you have done a thorough assessment of what your expenses are likely to be and how much income you will need to cover those expenses," says Salisbury. That way, you may find that even though you are eligible to retire, having reached a certain age, you may not actually be able to retire.

Annuities help reduce uncertainty

One approach that retirement researchers advocate to deal with the uncertainty of how long you will live is to buy a private annuity from an insurance company so that you get a defined income for life after you retire. The drawback: Most annuities do not provide inflation protection unless you specifically get one that does.

Social Security payment is an annuity that most Americans expect to receive, and it generally offers a cost-of-living allowance annually. You can get a benefit as early as age 62, but the longer you wait, the higher the payout. Because you receive "delayed retirement credits" past your full retirement age -- between 66 and 67 for those born after 1943 -- it may make sense to wait until age 70 to collect, when you get the maximum benefit. You could use your own savings for a while instead of opting for Social Security as soon as you are eligible.

Also, think through the retirement decision. Rather than retiring and then trying to get back into the labor force if you decide you need more money -- at which point you will likely only find a lesser job -- you might be better off sticking it out longer in your primary occupation and retiring only when you determine that you are truly ready to do so.

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