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Near-retirees, don't make this common mistake

If you're within five years of retirement and haven't yet developed a plan for your retirement paycheck, including strategies to protect it from stock market declines, you might be in for an unpleasant surprise when you finally decide to leave your job. Worse yet, if you're significantly invested in target date funds (TDFs), you could really have a rude awakening.

The problem is many 401(k) plan participants think if they just invest enough money in a TDF, that's all the "planning" they need to do. While that "Look, ma! No hands!" attitude might be sufficient when you're more than five years away from retirement (10 is even better), it's downright dangerous as you near the retirement finish line.

If you decide to invest your savings to generate your retirement paycheck, there's usually a one-to-one correspondence between the change in your account balance at the start of your retirement and the amount of your initial retirement income. For instance, a 10 percent gain in your investment account translates into a 10 percent increase in the part of your retirement paycheck that's generated from that savings.

While that's great news when the market goes up, it unfortunately affects your paycheck if the market goes down. So, a 25 percent drop in the value of your account just before retirement usually translates into a 25 percent drop in your retirement paycheck. Near-retirees in 2008-2009 who were fully invested in TDFs experienced losses in that magnitude.

As a result, many older workers decided to delay retirement, while others were forced to retire on a retirement income that was smaller than they had expected. The significant stock market drop in January of this year is evoking scary memories of the 2008 crash.

A better approach

If you're within five to 10 years of retirement, you should be learning about the various methods you can use to generate a retirement paycheck from your savings, how much income these methods will generate and what their pros and cons are. You should also be developing a strategy for when to start Social Security benefits for yourself and, if you're married, for your spouse.

One effective retirement planning strategy is to decide how much of your total retirement income you want to protect from stock market declines. Common retirement income generators (RIGs) that protect against stock market declines are Social Security, pensions, deferred or immediate income annuities, systematic withdrawal plans invested significantly in bonds and bond ladders.

Many retirees may not need to protect all or even most their retirement income if they can tolerate some fluctuations in their retirement income as an acceptable risk for the potential gain if stocks do well. One way to determine how much of your retirement income to protect is to estimate your essential living expenses and protect most or all of that income. Then invest the remainder of your savings to generate a paycheck that covers your discretionary expenses, such as travel, hobbies and gifts.

A deeper look

A recent report from the Stanford Center on Longevity (SCL) in collaboration with the Society of Actuaries (SOA) analyzed various methods you can use to protect retirement income in the period leading up to retirement. This report demonstrates the trade-off between the predictability of retirement income and the potential for gains from favorable stock market returns. (I was a co-author, with Wade Pfau and Joe Tomlinson.)

One analysis projects retirement incomes under expected, favorable and unfavorable economic scenarios for a married couple, both currently age 55 with $300,000 in savings at that age. They plan to retire and start their income at age 65.

When this couple invests fully in a TDF until age 65 and uses a systematic withdrawal plan (SWP) to generate retirement income, the amount of initial annual income under the unfavorable scenario is 37 percent less than the amount under the expected scenario. Clearly, this couple would experience a significant shock under the unfavorable scenario.

Instead, if the couple fully invested their assets at age 55 in a deferred income annuity (DIA) that starts at age 65, the amount of initial annual income at retirement under the unfavorable scenario is only 15 percent less than the amount under the expected scenario. While a drop of this magnitude isn't good news, it's not nearly as much of a shock as investing in a TDF.

The protection offered by a DIA has a price -- limited upside potential. In the above example, when the couple invests in the TDF and uses a SWP to generate retirement income, the amount of initial income at retirement under the favorable scenario is 62 percent higher than the income under the expected scenario. This would be a very pleasant surprise! The comparable increase using the DIA is only 18 percent.

Another disadvantage of a DIA is that once you commit, usually you can't change your mind and withdraw your money without severe restrictions or penalties, whereas you can always withdraw money from a TDF. As a result, most people won't want to devote a large portion of their savings all at once to a DIA.

The SCL/SOA study also modeled a laddered approach that devotes a portion of savings each year between ages 55 and 64 to buy a DIA that starts income at age 65. This approach projects retirement incomes under the unfavorable, expected and favorable scenarios that are less volatile than the full TDF approach but more volatile than buying the DIA at age 55. So, a laddered approach represents a possible compromise between the two methods.

Low-cost DIAs and immediate annuities aren't commonly offered in 401(k) plans, although you can access these products from an IRA. If you're approaching retirement and your 401(k) plan doesn't offer annuities, or if you're uncomfortable with annuities, an alternative is to determine the portion of your retirement savings (and resulting retirement paycheck) that you wish to protect from stock market declines. Invest those savings in your plan's bond fund or stable value fund, and invest most or all of your remaining savings in stocks. This might well result in a different asset allocation between stocks and bonds than your plan's TDF.

By the way, for the above analyses, the expected scenario is defined as the median scenario under a stochastic forecast. Both the unfavorable and favorable scenarios have a 10 percent chance of happening, according to the forecast. Before you dismiss these scenarios as unlikely, consider that before 2008, a crash of that magnitude was considered highly unlikely.

One more note: All projections of retirement income in the study were adjusted for inflation.

If you feel uncomfortable investigating these strategies on your own, you may want to find a qualified and unbiased financial planner to help you. Nobody said "do it yourself" retirement planning would be easy, but it's certainly better than trying to retire during a stock market crash.