4 Tips to Deal With Inflation and Longevity in Retirement

In last week's post, Are You Kidding Yourself About Retirement?, I reported results from a survey prepared by the Society of Actuaries that showed Americans aren't planning far enough ahead when it comes to their retirement. In particular, I'm concerned that people aren't taking the appropriate steps to protect themselves against two important retirement risks: inflation, and outliving your assets.

So what should you do?

First, consider this. If you're retiring in your mid-sixties, there's a good chance your retirement could last for 20 or 30 years, given improvements in life expectancies. Think back 30 years to 1981. Inflation was more than ten percent that year, and more than six percent in 1982. We've also had four stock market meltdowns in the past 30 years: the crash in October, 1987; the S&L bust of the early 1990s; the bursting of the tech bubble at the beginning of this century; and the crash of 2008-2009. If you're heavily invested in the stock market in your retirement, you run the risk of your retirement savings dropping so low during a market crash that you'll outlive your savings.

So it's inevitable that you're going to encounter more periods of inflation and market meltdowns during your lifetime. But it's also highly likely you'll do a bad job of predicting exactly when these unfortunate events will occur -- people who try to time the market usually miss the mark. So then how do you develop reliable sources of lifetime retirement income to cover your living expenses, given that it's virtually certain you'll experience these events in the future?

Take a look at these four sources of retirement income, which can help protect you against inflation and the risk of outliving your assets:

Social Security is increased for inflation every year. It's a pretty good deal -- you get monthly income payable for your lifetime, guaranteed by the federal government for no matter how long you live, and no matter what happens in the stock market. It's smart to make this income as large as possible, which you can do by delaying the start of benefits, but no later than age 70.
Buy an inflation-indexed annuity from an insurance company. Like Social Security, you'll get a lifetime retirement income that's adjusted for inflation, no matter what happens in the stock market. Your income is guaranteed by an insurance company, however, so you'll need to pay attention to the strength of the company you choose. The initial annual payout rate for this type of annuity is roughly five percent of the purchase price if you retire at age 65 -- a little more if you're a single man, a little less if you're a single woman or part of a married couple.
Buy an immediate variable annuity, which is adjusted by investment returns in an underlying portfolio of stocks and bonds. This annuity also guarantees payments for life, with the possibility that you'll outpace inflation if your investments perform well. However, you also run the risk that your income will decrease if the underlying investments perform poorly. The initial payout rate ranges between six percent to more than seven percent, depending on whether you're part of a married couple or a single man.
Invest in a portfolio balanced between stocks and bonds, and withdraw at a rate considered to be "safe" -- meaning that the likelihood is low that you'll outlive your money. Four percent is considered to be a "safe" withdrawal rate, and with this method, you can give yourself increases for inflation each year. But this method offers no guarantee that you won't outlive your money, which can happen if your investments tank or if you live a very long time.

Each of the above methods has its pros and cons, so you'll need to examine them carefully before deciding which methods will work best for you. A combination of approaches might work well -- for instance, you could buy an annuity with part of your retirement savings, and then invest and draw down the remainder of your savings.

The good news is, there are methods you can use to protect yourself against common risks in retirement: inflation, stock market crashes, and the risk of living too long. This lets you focus on what's really important -- enjoying your long life.

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Steve Vernon

View all articles by Steve Vernon on CBS MoneyWatch»
Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Retirement Game-Changers: Strategies for a Healthy, Financially Secure and Fulfilling Long Life and Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck.

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