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 percent chance that one spouse will live to age 95 — compared to a 20 perfect 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.