In response to a question from a reader named “Karen,” earlier this week I wrote the first of a three-part series about strategies for deploying net worth in the years leading up to retirement. The first article addressed how Karen and her husband, “Bob,” could meet their short-term goals:
- Maintain an adequate emergency fund.
- Buy medical insurance to supplement Medicare.
Now for their long-term goals:
- Build a diversified portfolio of retirement income that covers their basic and discretionary living expenses for the rest of their lives.
- Develop strategies to address long-term care expenses.
- Coordinate these goals with their strategy for deploying home equity.
Let’s look at that first goal and consider how they can use their net worth to build their retirement income portfolio. Here’s a basic two-step strategy:
- They should cover their basic living expenses with sources of retirement income that won’t drop when the market crashes and will last the rest of their lives, no matter how long they live. These sources include Social Security, pensions (though this option isn’t applicable for Karen and Bob) and low-cost lifetime payout annuities guaranteed by highly rated insurance companies. They could use a portion of their retirement savings to purchase these annuities.
- They could invest their remaining savings substantially in the stock market for growth potential, using a systematic withdrawal method to generate cash flow to pay for discretionary living expenses.
It’s important to note that there’s no one-size-fits all approach to building retirement income portfolios. So this article describes one strategy that recent research from the Stanford Center on Longevity (SCL) supports.
Start with Social Security
Karen and Bob should begin by estimating the Social Security income each will receive once they begin drawing benefits. Their situation is typical for married couples their age: The husband worked all his life and was the primary wage-earner, while Karen took time off in mid-career to stay home full-time with their children.
In this situation, the optimum strategy calls for Bob to delay the start of his Social Security benefit until age 70. This maximizes the expected payout he’ll receive over his lifetime and will increase Karen’s survivors benefit if Bob passes away first.
The optimal time for Karen to begin drawing her earned Social Security benefit doesn’t lend itself well to simple rules of thumb. The optimal time ranges from her full retirement age (age 66) to age 70. To determine the best strategy for her, Karen should use a Social Security calculator or work with a financial planner.
Karen also needs to keep in mind that at her current age, she has paid into Social Security for only 25 years. But her earned Social Security benefit will be calculated using a 35-year average of her earnings, which means plugging in zeros for the number of years short of 35.
For every year she continues to work, Karen will increase her earned Social Security benefit, until she’s paid in for 35 years, if she works that long. And even if she starts her Social Security benefit at age 66 but keeps working, her benefit will be recalculated each year to reflect the additional year of earnings and will increase each year because of that.
The best way to enable delaying Social Security benefits for either Karen or Bob is for one or both of them to continue working to pay for current living expenses. However, if either Karen or Bob stops working before the ideal age to start their Social Security benefit, a smart strategy calls for withdrawing money from their savings to cover living expenses in order to delay starting Social Security benefits.
Ideally, Karen and Bob will determine the optimal ages for them to start their earned Social Security benefits and estimate their Social Security income at that time. If they anticipate retiring before these ages, they’ll want to set aside a portion of their retirement savings to make up for the Social Security benefits they’re delaying. These savings should be invested in short-term accounts, such as bank accounts or money market funds because they’ll be withdrawn in the next few years.
Build out the guaranteed income
If Social Security alone doesn’t cover Karen and Bob’s basic living expenses, they’ll want to use their retirement savings to buy lifetime payout annuities, so that, when combined with Social Security, they’ve covered their basic living expenses. Consider these annuities as a personal pension, given that neither one has earned a traditional pension benefit from an employer. In essence, Social Security and the annuities become the “bond” part of their retirement income portfolio.
It’s risky to stay fully invested in target-date or balanced funds right up to retirement, so Karen and Bob should start deploying a portion of their retirement savings now into annuities that will hold their value in the next few years, even if the stock market drops. Possibilities for them to explore include:
- Karen’s TIAA-CREF plan at work should allow her to purchase guaranteed annuities at favorable group rates and help her estimate these amounts.
- They can also buy payout annuities that defer payment for a few years until they retire. Possible sources to purchase low-cost, competitively bid annuities include Income Solutions, ImmediateAnnuities.com, Fidelity Investments or Vanguard. One downside to this type of annuity is that once you commit your savings to the annuity, you can’t later change your mind and withdraw your money.
- If it’s important for Karen and Bob to reserve the right to withdraw their savings in the future, they can consider lifetime annuities that give them this right, such as Guaranteed Lifetime Withdrawal Benefits or Fixed Index Annuities. This liquidity feature comes at the cost: lower expected lifetime payouts, compared to the annuities described previously.
To protect each other in the future, Karen and Bob should consider buying joint-and-survivor annuities that continue the income as long as either one is alive.
Invest the rest of savings
After Karen and Bob have devoted sufficient savings to building their guaranteed retirement income, they can invest the rest of their retirement savings to grow through their retirement date and beyond. When they retire, they can use a systematic withdrawal plan to determine their annual withdrawals to pay for their discretionary living expenses. One possibility is that once they attain age 70-1/2, they can use the IRS required minimum distribution to determine their withdrawals from IRA and 401(k) accounts.
The SCL research mentioned above supports substantial stock market investment -- 75 percent or more -- for this portion of their retirement savings. The theory is that since they’ve protected their basic retirement income with Social Security and annuities, they can afford a high allocation to equities, which gives them potential for growth.
The hope is that they can withstand the potential volatility of stocks because they’re using this part of their retirement income just to fund discretionary living expenses.
One thing to note: When all of Karen and Bob’s retirement income is considered, however, the overall allocation to equities is much lower than 75 percent. In any case, they should feel comfortable with the allocation to stocks with this portion of their savings and might consider using a balanced fund or target-date fund that allocates about 50 percent to equities.
But suppose Karen and Bob estimate their retirement income from all of the above sources and they come up short. Now what? One possibility is to see how they can reduce their living expenses. For example, they could consider downsizing to reduce their housing costs or rent one of their spare rooms to a friend or college student needing a place to live.
Another possibility is to consider using a portion of their substantial home equity to generate retirement income. I’ll address this strategy in my final article on Karen and Bob’s situation, which outlines strategies for their two remaining long-term goals: preparing for their frail years and how to deploy their home equity. These strategies should be coordinated with building their portfolio of retirement income. The third article will also discuss how Karen and Bob can find professional financial advice if they need it.
As you can see, Karen and Bob have a lot of work to do to learn about their options, estimate their basic and discretionary living expenses, and then devise and implement their strategies. It’s good they’re starting now, in the years leading up to their retirement, to give themselves time to fully explore their options.