Most retirees are now responsible for making their retirement savings last as long as they do, given that 401(k) plans have replaced traditional pension plans for many workers. Yet many people lack a basic knowledge of the critical issues involved. For example, 80 percent of retirement-age Americans failed a basic quiz on how to make their retirement savings last for life, according to a recent survey conducted by The American College of Financial Services of people age 60 to 75 with at least $100,000 in retirement savings.
If you think you might be part of that 80 percent, here are five questions aimed at helping you understand the key issues involved with managing your retirement savings. No scoring is involved, so you don't need to worry whether you pass or fail.
1. True or false: You should plan to make your money last until your predicted life expectancy.
False. Many people underestimate how long they're expected to live, which is one reason why planners and analysts recommend that you estimate your life expectancy. But that's only part of the problem. The bigger challenge is the uncertainty about how long you'll actually live. Your life expectancy isn't your destiny -- it's entirely possible that you'll live well beyond your life expectancy, or fall short.
Bottom line: Develop methods of generating lifetime retirement income that address this uncertainty.
2. True or false: It's best to start Social Security income at age 62, the earliest possible age.
False, for most workers. Social Security is one of the best deals around. It's payable for the rest of your life, no matter how long you live, so it addresses the uncertainty described above. Plus, it increases for inflation each year, and a portion of your benefit isn't subject to income taxes. But you can significantly boost your lifetime payout from Social Security by delaying the start of your benefits as long as possible (but no later than age 70, when you no longer earn additional income by delaying).
As a result, a smart strategy for a portion of your retirement savings might be to use it to live on while you're delaying the start of your Social Security income.
Exceptions to this advice: If you (and your spouse, if applicable) are in very poor health and don't expect to live very much longer, then taking Social Security early may be better for you. Also, strategies for Social Security can get complex for married couples. In some circumstances the lower-earning partner may want to start Social Security as soon as possible while the higher-earning partner delays as long as possible.
Bottom line: Any retirement plan should include a well-thought strategy for claiming Social Security benefits.
3. Choose the best answer: The optimum method for using your savings to generate retirement income is:
a) Invest your savings and withdraw only the interest and dividends (keep your principal intact)
b) Invest your savings and withdraw both principal and investment earnings (called systematic withdrawals)
c) Buy an annuity from an insurance company
d) Any of the above, depending on your goals and circumstances
D. No single answer applies to everybody, and all the retirement income generators (RIGs) described above have their pros and cons. They can each generate a different amount of retirement income, both initially and throughout retirement.
Bottom line: Understand the basics of the different methods so you can determine your best fit. It may be that a combination of methods might work for you.
4. Choose the best answer: With systematic withdrawals, the optimum withdrawal strategy is:
a) Withdraw a fixed amount of your savings each month and lock that amount in for the rest of your retirement so you can budget with certainty.
b) Apply a percentage to your remaining assets each year, so that your withdrawal in future years increases or decreases depending on your future investment returns.
B. It's not advisable to lock in a fixed withdrawal amount and ignore how your investments have performed since your retirement. If they perform poorly, you could exhaust your savings. On the other hand, if they do well, you could increase your withdrawal amounts.
A secondary issue is the safe withdrawal percentage. The American College survey indicated that 70 percent of Americans were unfamiliar with the oft-cited "4 percent rule" that offers guidance on how much of your savings you can safely withdraw each year. In that survey, 16 percent thought it would be safe to withdraw 6 percent or more, amounts considered unsafe by many planners. On the other hand, 20 percent were overly conservative, estimating 2 percent to be the safe rate.
The safe percentage can actually vary depending on your age. A percentage that increases each year can work well, and that strategy underlies the IRS required minimum distribution that applies to deductible IRAs and 401(k) accounts. Another good strategy is to recalculate your withdrawal amount each year, reflecting your investment returns.
5. Choose the best answer: Annuities are:
a) A costly investment vehicle with high commissions paid to an insurance agent or financial advisor.
b) A financial tool that can manage the uncertainty about how long you might live.
c) Both a) and b) can be true.
C. Annuities are probably the least understood and most reviled of financial products. A large part of the problem is that there are costly annuities out there that give all annuities a bad name. But you can purchase a low-cost retirement income annuity that pays you a fixed monthly paycheck, no matter how long you live. Immediate annuities have a place in the retirement income portfolio of some retirees, particularly middle-income retirees with modest retirement savings. While they aren't for everybody, it's also not the case that they are never appropriate.
Bottom line: Look past the emotional baggage associated with annuities, and understand their pros and cons relative to other RIGs. As with any other financial product or service, annuities come in good and bad versions.
Whether you're a "do it yourselfer" or you work with a financial planner, you'll do best by understanding these five basics of retirement income planning.