Whether you are approaching retirement or actually already hopefully enjoying this time of your life, you need to know how to make sure that your income will be sufficient and also last as long as you live. Since life circumstances are never totally predictable due to future variable unknowns, (such as: how long you will actually live, healthcare costs, inflation, future spending needs, taxes, etc.) you will need to develop a personal income strategy that will give you the best chance of maintaining your income for the duration.
To do this, your accumulated savings must be sufficient to replace income that will be needed, but unfortunately many retirees will have saved less than the required amount, especially since future investment returns may be lower than they have been in the past.
The Puzzle--
What is the amount of annual income that can be drawn from Savings that can be sustained during your retirement years?
It is essential to figure out how much you can afford to withdraw from your savings each year. The number of years for this calculation depends on your assumptions regarding life expectancies for you and (if married) your spouse. Some other assumptions may need to be included that will affect the calculation: the investment returns that your remaining unused savings will earn during retirement, the amount of any part-time work earnings during some of your retirement years, the age you choose to start Social Security benefits, and your planned ages to partially and/or totally retire.
Puzzle Piece #1--Life Expectancy--
Unless you are informed by a physician that there is near certainty that you have a health condition that will shorten your life expectancy, it is impossible to know with any certainty how long you will live. If you consult the government’s life expectancy table for your age, it might tell you that people your age will live “on average” another 30 or 40 years. While such a number can be used for planning the amount of withdrawals that can be sustained over time from your savings, the fact remains that you are likely to live for either a shorter or longer period than the specific age that the average calls for.
If your health and lifestyle characteristics are representative of the average person your age, you will have a 50% chance of living less time than the average person lives. Obviously, larger withdrawals from savings can be made and afforded if they are needed for a shorter period of time.
However, since living for a shorter period of time is always easier to accomplish financially than living for a longer period, it is better to plan for future withdrawal levels that can be sustained for a period of time that is comfortably beyond your “average life expectancy”. This will help assure that your income from savings will last for as long as you live. We often recommend using ages between 85-90 for menand ages between 90-95 for women for this piece of the puzzle.
Puzzle Piece #2--The Ages You Partially and/or Totally Retire--
When you retire is usually a critically important factor in determining what level of income can be safely withdrawn from savings each year. Earlier retirement can be difficult to achieve, because there will be less time for creating savings and a longer period for savings withdrawals to fund retirement years.
Any income that can be earned during a period of partial retirement will help conserve accumulated savings. This can enable you to take larger subsequent savings withdrawals to supplement income and/or extend the length of time that your savings will last.
Obviously, the longer you wait to retire, the greater the chance that your savings will be sufficient to cover your future financial needs.
Puzzle Piece #3--When to start Social Security Benefits--
For most future retirees, social security will be the sole pension income benefit received throughout retirement. For each year that you wait to start your benefit after age 62, the benefit amount increases by approximately 8%. You can defer receiving benefits until age 70, which is the age when benefits must begin to be received. If one waits until that time to start, the monthly benefit amount will have increased by approximately 64%. Deferring your start date will potentially increase savings withdrawals if you are retiring during this time, but future withdrawals can be lower due to higher social security payments.
Unless health considerations suggest your life expectancy may be shortened, it is usually better to wait as long as possible to claim your social security benefit, especially since medical care and healthier living habits have been improving the odds that you will live longer than indicated in most life expectancy tables that rely on older historical data.
Puzzle Piece #4--What Investment Return will Savings Earn?--
If investment returns are lower than what you assume will be earned during retirement, you will exhaust savings sooner if you do not reduce the number and/or amount of future planned withdrawals. It is best not to overestimate the return that retirement savings will earn during one’s retirement years. In doing this, it is important to take into account what your net returns will be after consideration for any income tax liability that would reduce the amount available to you. If you can cover your withdrawal needs using a conservative rate of return, you will have more certainty that a period of lower investment returns will not keep you from having the income you need for the duration of your retirement years.
In the past, historical investment data supported the assumption that a retirement portfolio that is invested in fairly equal portions in both stocks and bonds would earn somewhere around 8% per year on average during one’s retirement years. However, we know that past performance does not provide a guarantee that similar results will be achieved in the future.
With today’s fixed income investments (such as Treasury Notes) yielding historically low returns along with potentially lower stock market returns, it seems safer to plan using a lower investment return assumption for calculating the total savings accumulation that will be available for future savings withdrawals.
This will provide you with greater assuredness that all will go well, knowing that you have been conservative in using assumed returns that are lower than what past history would suggest for the investments that comprise your retirement savings. It should also enable one to feel less anxiety when you experience some inevitable periods of lower than desired returns.
To accomplish this, it is helpful to assume an overall investment return that is no more than 2% to 3% above assumed long-term inflation. Hopefully, future investment returns will be achieved that will be higher than this conservatively chosen assumption, that will permit an increase, if desired, in the amount and duration of future income distributions.
Puzzle Piece #5--What Impact Will Inflation Have?--
Since 1928, inflation has averaged a little more than 3%. Over the past 65 years we have seen it vary from its current low near 1% up to the 13.5% that was experienced in 1980.
The effect that inflation has on accumulated savings must be taken into account in determining future investment returns. Like taxes, inflation will reduce the net value of any savings that are accumulated. It will also increase the amount of annual income needed in future years to compensate for rising costs.
Using a conservative inflation assumption that is higher than 3% when calculating a sustainable level for income withdrawals will provide an extra margin of safety for the future.
The Solution--Putting All the Pieces Together--
Considering the interaction of these variables and calculating the net effects to determine income withdrawal rates that can be sustained throughout your retirement years is not an easy task or puzzle to solve. Working with an experienced financial advisor, who has the appropriate financial knowledge of the issues and tools to do the mathematical calculations correctly, can save you a lot of time and enable you to avoid some unnecessary errors.
If you take the required time to carefully consider the various assumptions and scenarios that are possible for your individual situation, you will be able solve this puzzle. In so doing, you will also be able to ascertain the amount of retirement savings you are likely to accumulate, as well as the level of annual income that is likely to be available during your retirement years.
Greg Tinaglia
(Updated 06.29.2016)