Be it medical technologies, better lifestyles, or a myriad other reasons, Americans are living longer. The Society of Actuaries recently updated its mortality tables, indicating that American men are living an average of two years longer and women are living 2.4 years longer. That’s great news because we all want to live long, fruitful lives!
However, it can become worrisome later in life when our earning potential is much lower and we begin to run out of money. That makes the longevity of retirement nest eggs a chief concern for those on fixed incomes like pensioners.
Living longer affects more than just pensioners as plan sponsors must also prepare to pay out over a longer period of time. That puts more pressure on them to evaluate the risk. In what could be considered a preemptive strategy, some plans are offering lump sum payouts to rid themselves of pension liabilities. The plans with ample funds are likely to keep offering payouts.
Assuming the pension is safe – which as we’ve seen is anything but guaranteed – what can pensioners do to keep from outliving their money? With so many dynamics at play, the answer is not easy.
Take the lump sum payout?
First off, if a pensioner is offered a lump sum, they need to decide if it makes sense to take it, versus keeping the funds with the plan sponsor, which again is no easy answer.
For instance, unmarried retirees may want to consider the lump sum payment, especially if they have children, or other beneficiaries. There’s a good chance that a retiree can use the lump sum to purchase an annuity that would replicate the pension income. Such annuity can be set-up to pay-out any remaining balance to beneficiaries at death, something not available with most pensions.
But things become more complex with a retired married couple. There are more people counting on the pension to live, and there could be beneficiaries in the mix too. Many pensions only pay spouses a portion of the lump sum payout. In situations like this, it’s vital to run the numbers with a financial professional.
One of the biggest questions to ask related to taking a lump sum payout is whether retirees think they can replicate, or even improve, the value of their pension income with annuities, investments, or a mix of both.
Important questions to ask
To be sure, these concerns are not exclusive to pensioners offered lump sum payouts, they apply to anyone who relies on a pension for income in their golden years. To make their money last, retirees should honestly evaluate the following criteria with family, beneficiaries and financial planning professionals.
Standard of living
Age and health status
Rising cost of living over time
Investment risk aversion (especially in the first few years of retirement)
The answers to these questions will be different for everyone.
Obviously, healthier retirees should plan for a longer retirement and understand how cost of living increases will affect their standards of living. This is especially important since medical costs are usually the largest costs of living, and all signs point to them increasing over time.
The fact that we’re living longer means a fixed level of income actually buys less and less over time, often resulting in retirees dipping into savings or other financial sources to survive. Most pensions don’t include cost of living increases. If someone retires at 60 and has a 30-year retirement, a 4 percent historical inflation rate means they might need more than twice the income to maintain their standard of living down the road.
All these factors combine to address an incredibly important piece of the retirement puzzle – the mix of financial instruments (and resulting risk profile) that will fund retirement.
Finding the right blend
Perhaps the biggest factor in whether or not a retiree outlives their money is their mix of financial instruments used to fund retirement. Obviously, the pension is a part of that, even if they choose to take a lump sum payout, because it will end up funding other investments. Whether they keep the pension or not, it’s important to find a suitable blend of investment vehicles that will both deliver the needed funds over time and match the client’s wishes, risk tolerance and priorities.
One option is an annuity, which can work for at least a portion of a retiree’s income because they provide a guaranteed stream of income over the lives of both spouses. Many annuities include protections like rising income options that are tied to the Consumer Price Index (inflation) or increases linked to the rate of return on a market index. These protections can allow for upward mobility while also guarding against adverse market conditions – the best of both worlds in a lot of ways.
Timing is also an important factor. For someone with a pension and healthy savings, one strategy might be purchasing an annuity but not triggering the income until later in life, when it might be needed due to cost of living increases. (That way, they can absorb inflationary hits and acquire mortality credits because they haven’t been taking payouts) delete. By purchasing the annuity early and deferring income, the retiree can take advantage of interest and mortality credits in the annuity over time. This allows for a smaller annuity purchase than would be needed if the retiree waits until he or she actually needs the income.
When choosing an investment strategy, the biggest factor to consider is the sequence of returns, specifically in the first five years of retirement.
The investment mix should lean towards mitigating risk, mostly because those first five years can make or break a retirement. Poor investment results can force retirees to dip into their savings and investments while they’re down. That scenario would leave the investment money little to no chance for recovery, with the most likely result being the retiree running out of money much soon than she thought.
Of course the retirement portfolio doesn’t have to be solely annuities and investments, a pension can be an important part too if it’s kept in place. And that may be a great option for some, depending on many factors, like their age and if they think the pension will continue to be around over time – which again is no guarantee.
Sensibility should be the rule, not the exception
So what’s the right mix? Like all retirement planning, it all depends on crafting a strategy that reflects a retiree’s wishes, priorities and risk tolerance.
No matter what a retirement portfolio includes, it’s vital for a retiree to have a reasonable spending plan in retirement, keeping costs manageable and maintaining a sustainable plan for how they’ll spend money. Setting reasonable expectations for how much to spend in any given year is perhaps the wisest planning a retiree can undergo.
Combined together, wise spending and sensible financial planning are two of the best ways for retirees to ensure they don’t run out of money. When done right, retirees will be able to make their pension income last and enjoy their (ever-increasing) golden years, regardless of cost of living increases and market conditions.