Feel like giving yourself a raise in retirement? How do you spend more when you don’t know how long retirement is going to last and what markets are going to do in the future?
Spending more each year in retirement means considering a range of investments and financial products specifically designed to give investors options for creating an income. Most retirees leave a lot of spending on the table by not creating a retirement income strategy. They claim Social Security at 62, invest in the money market, then spend the required minimum withdrawal from their retirement savings. These retirees are falling victim to the endorsement effect. They think the government is telling them how to plan a retirement income strategy using rules that were created for a completely different purpose. You can do better.
Let’s start with the first mistake—claiming at age 62. We’re all a little overwhelmed by the complexity of Social Security claiming strategies. Don’t be. If you’re working with a client who has enough assets to see a financial advisor, they’re going to live longer than the average retiree that Social Security uses to calculate how much income should increase with every year that you wait to claim. How much longer? More than you might think.
A recent study by the Social Security Administration shows that the longevity gap between the top half and the bottom half of earners has been widening in recent decades. The top earning half of workers born in 1912 lived about a year longer than the bottom half. Among workers born in 1937, that gap widened to five years. And gains in longevity have increased in a nearly linear fashion by level of income. The top 10% earning men born in 1940 gained six years of longevity compared to men born in 1920 according to a study by Barry Bosworth at the Brookings Institution.
Insurance companies already know that rich people are living longer. The new 2012 annuity longevity tables show that a couple at age 65 has a 43% chance that one spouse will live to age 95—compared to a 20% chance if you use Social Security mortality tables. That’s a big difference, and it means that higher-income clients get a better deal from deferring Social Security because the income bump isn’t based on their actual expected longevity—it’s based on the longevity of the general population.
So step one is to defer claiming Social Security until age 70 to maximize your discount-priced inflation-adjusted annuity from the government. There are a number of strategies for creative claiming and withdrawing qualified money to cover expenses if you retire before Social Security income starts. That also brings up the easiest way to maximize a retirement paycheck—wait a few years to retire. If we’ve gained over five years in longevity compared to our grandparents, then we won’t be able to live as well in retirement unless we save more or spend less or get much higher investment returns (not likely).
Step two is to decide how much of a portfolio to invest and how much to annuitize. Let’s review the theory here. You have no idea how long you’re going to live. If you want to make sure you don’t run out of money, the options are to be very conservative with spending or to annuitize. Annuitization pools the risk (among retirees) of living a long time.
This means (theoretically) that if you don’t want to run out of money, the highest retirement paycheck comes when your investment assets are within an annuity wrapper because your spending is based on the average longevity of annuitants. If you withdraw assets systematically from a 401(k), you’ll either need to spend less to avoid running out of money if you live longer than average, or spend more and take the risk of running out of gas by hitting the spending accelerator too hard early in retirement.
One of the ways I like to think about a retirement income strategy is by creating a baseline that essentially minimizes your retirement paycheck. You can do this by buying an inflation-protected single premium immediate annuity (SPIA), which is a rare animal but serves a useful purpose for guiding expectations. Inflation-adjusted SPIAs provide a level paycheck with the same purchasing power over a lifetime. What do you pay for this security? It costs about $100,000 to buy around a $300 monthly paycheck, or about a million dollars to buy $3,000 a month in current purchasing power at age 65.
That’s one expensive paycheck, but don’t blame the insurance companies. They’re just investing in things like inflation-protected treasuries (TIPS) that are providing essentially no real return over time. Take away inflation protection by buying a conventional SPIA and you can maximize your paycheck today (boosting your million dollar paycheck by over $1,000 a month), but you’ll be exposing yourself to the possibility that inflation will eat away purchasing power as you get older.
Think of it this way. You can either have a smooth spending path over time from age 65 into old age, or you can have a downward-sloping spending path with a SPIA. How much will your real (inflation-adjusted) spending go down each year? That depends on inflation. Modest inflation means that you might just see your spending decline gradually. That might even fit well with most retirees’ lifestyle goals. High inflation will mean a sharper drop in real spending over time. If inflation stays low, financial planner and researcher Joe Tomlinson has estimated that (as currently priced) conventional SPIAs will be a much better deal for most retirees than an inflation-adjusted SPIA. If inflation rises, that’s a different story.
So retirees can get a boost by accepting some inflation risk. They can also get a boost by accepting investment risk. A number of retirement simulations starting with the famous William Bengen 4% rule article show that greater stock allocation can increase the optimal spending rate from assets. Of course, greater risk should also increase the possibility that a bad sequence of returns, particularly early in retirement, is going to lead to a much smaller paycheck later in retirement.
Guarantees from a variable annuity can provide protection against a bear market early in retirement, but they still bear significant risk of reduced purchasing power late in retirement if the step-ups don’t keep pace with inflation. You can’t get something for nothing. Risk in retirement means a greater possibility of higher spending at the expense of a possibility of spending less than the baseline inflation-adjusted SPIA.
In a recent analysis in the Journal of Financial Planning, David Blanchett of Morningstar compares the effectiveness of some basic annuitization strategies in retirement. He assumes that a retiree invests half of assets in conventional stock and bond investments and half in some type of an annuity. In a simulation comparing a range of retiree goals (and using current annuity prices), he finds that the conventional nominal SPIA tends to dominate either inflation-adjusted SPIAs or deferred income annuities (DIAs) for a range of investor goals and preferences. And for the goal of maximizing a safe withdrawal rate, nominal DIAs and SPIAs were the winners. What do DIAs have to do with maximizing retirement income? Blanchett assumed that retirees would place 10% of their portfolio in a deferred income annuity that starts making payments at age 85. DIAs are a cheap way to buy a big income later in retirement because many retirees will have died before they’re old enough to get the benefits. This makes a DIA look more like an insurance product since many who buy insurance never get a claim. This insurance cuts off the risk of a big spending shortfall in old age.
According to American College professor Wade Pfau, the certain future income from a DIA gives a retiree “a clearer planning horizon. Rather than worrying about 30 to 40 years of planning, you can give yourself a fixed 20 year time horizon.” This means that retirees can also take greater investment risks with the rest of their portfolio, and can spend more optimally each year.
Duncan Williams, financial planning program director at William Paterson University, and I have estimated how much retirees with the same level of risk tolerance can withdraw each year in order to maximize their expected utility. Using utility as a guide allows us to weight decreases in spending more heavily than increases to better capture the pain of a shortfall.
We find that the optimal retirement paycheck for a retiree with a million dollar portfolio is $63,000 if claiming Social Security at age 65 and spending out of an investment account. We can increase that to $70,000 by simply deferring Social Security to age 70 and spending down the million dollars. One reason this strategy works is because the higher Social Security gives us a bigger safety net. The higher income floor means we can optimally increase our spending rate because the consequences of a shortfall are less dire. According to Williams, “by maximizing Social Security we’re retaining the risk of superannuation until Social Security kicks in, in exchange for a higher guaranteed paycheck until we die. It’s virtually costless to take that risk because we’re probably not going to run out of money before age 70. But a 32% higher guaranteed income gives a bigger cushion later in life and therefore makes us willing to spend more on our lifestyle early in retirement.”
Add on a DIA to claiming Social Security at age 70 and we can ramp up optimal spending even more to $77,000 a year. Again, this is because we can now feel more comfortable spending a higher percentage of our savings each year early in retirement. This may increase the chance of running out of money, but the consequences are even less dire now that we know the deferred income annuity will kick in to supplement income later in life.
So what’s the best way to maximize a retirement paycheck? Social Security deferral provides the biggest payout, but private annuities are a key to our ability to feel comfortable spending more in retirement. Annuities also provide the advantage of a real retirement paycheck that has important psychological advantages over spending down investment assets. And don’t diss the DIA. While Blanchett finds that DIAs lag SPIAs in many of his simulations, a slightly more competitive market for DIAs might just make them the most valuable player in the income maximization game.
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