Contemplating Retirement Income? Start Here

Nonportfolio strategies can deliver have a big payoff for retirees’ plans.

Our recent research on withdrawal rates drew a sobering conclusion: Because of low bond yields and high equity valuations today, new retirees who want to take fixed real withdrawals in retirement would do well to start with a lower withdrawal rate than the standard 4%.

We then went on to explore how retirees can adjust their withdrawal systems to support higher withdrawals. But what about strategies that can reduce the demands that retirees place upon their portfolios in the first place? Strategies that reduce expenses or boost non-portfolio income, like delaying Social Security or employing annuities, can be even more impactful than adjusting a portfolio or withdrawal-rate system and therefore should precede withdrawal rates in the retirement-planning process. Ultimately, the right combination of strategies will depend on the retiree’s own income sources, lifestyle considerations, and so on.

Strategy 1: Delay Retirement

The simplest way to achieve a higher withdrawal rate is to work longer and retire later. This helps in two ways. First, the retiree’s time horizon is reduced because each year worked leads to one year less in retirement. Second, the retiree has more years to increase the size of the portfolio, both by making additional contributions to the investment pool and by having a longer compounding period. While retirement “end dates” are not within retirees’ control, the start dates may be, and the payoff of delaying may be attractive.

Exhibit 1 below depicts the withdrawal rate pickup associated with delaying retirement by one to five years. While our base case (assuming fixed real withdrawals over a 30-year time horizon) suggests that a 3.3% withdrawal rate is safe from a 50% equity/50% bond portfolio, the retiree who delays one year can spend 3.5%. The one who delays a full five years can spend more than 4%. The following chart is conservatively created, in that it does not simulate the effect of additional retirement contributions.

Exhibit 1

Strategy 2: Calibrate/Reduce Expenses

Just as reducing the duration of retirement is one way to make a save in the face of what could be an inhospitable market environment for retirees over the next few decades, so is reducing actual expenses. Many retirement-planning programs rely on income-replacement rates to help calibrate anticipated spending in retirement–for example, an 80% income-replacement rate is a commonly cited benchmark. However, a more finely tuned approach that factors in expected changes in spending in retirement may be warranted and may help reduce estimated income needs. The following are some of the key factors that may influence retirement spending and allow for downward adjustments in retirement relative to working income.

Level of wealth: While 75% to 80% is often considered a reasonable rule of thumb for income replacement–the amount of current (working) income that a retiree will need in retirement–actual income replacement rates can vary widely. David Blanchett, formerly of Morningstar and now at PGIM, demonstrated that there can be huge variations in income-replacement rates among retirees depending on their levels of pre-retirement income. Based on Blanchett’s findings, higher-income, higher-saving households may well need just 60% (or even less) of their pre-retirement income during retirement, while lower-earning, lower-saving households may need closer to 90%.

Age/changes in spending over the life cycle: Research also points to how retiree spending changes dramatically over the retirement life cycle. That suggests that targeting a static real dollar withdrawal, as in the original 4% guideline developed by Bill Bengen, does not factor in variability in retiree spending, but the data indicate that spending is indeed quite variable for most retirees. In the book The Prosperous Retirement, financial planner Michael Stein described retirement spending as falling into three key phases: “go-go,” “slow-go,” and “no-go.” Financial planner Ty Bernicke identified a similar pattern in his researchResearch from David Blanchett identified a similar pattern–but with a twist. Blanchett found that retiree spending did indeed tend to decline throughout much of retirement for many older adults but that it began to trend up in the later retirement years. The culprit: higher out-of-pocket healthcare and long-term-care costs.

The tricky part is whether and how to incorporate aggregate retiree pending trends into an individual retiree’s spending plan. Just because the typical retiree’s spending declines through the middle years of retirement does not mean that it will for each and every retiree. Thus, a withdrawal plan that assumes a reduction in spending in the middle years of retirement runs the risk that the retiree may still be going strong at that life stage. From that standpoint, employing an age-based spending plan may introduce unwelcome spending cutbacks.

Healthcare and long-term-care coverage: The finding that retiree spending often trends up in the later years of retirement because of healthcare-related spending provides more of an opportunity to tailor withdrawals to a retiree’s actual situation. Specifically, retirees with ironclad healthcare and long-term-care plans that cover most out-of-pocket expenses wouldn’t need to incorporate higher spending later in life. For them, the risk of a negative healthcare spending shock is simply much less than is the case for the broad population of older adults. For retirees whose insurance coverage allows for more out-of-pocket expenditures and/or those who do not have long-term-care insurance, however, it is reasonable to expect that spending could well trend up later in life.

Strategy 3: Maximize Social Security

Social Security provides a lifetime stream of income that is unaffected by market conditions. Moreover, the program provides an annual inflation adjustment to that income based on the Consumer Price Index. Those characteristics explain why retirement experts often describe Social Security as the perfect annuity, and why maximizing benefits from the program is so crucial. While the increased benefit from delayed Social Security filing is not always as great as is touted and some retirees are indeed wise to claim earlier, delayed filing will still make sense in many situations, especially older adults who have longevity on their side. Moreover, married couples with different anticipated retirement dates and earnings records may find that claiming benefits at different times makes sense as a means of enlarging the couple’s lifetime payout from the program.

Strategy 4: Maximize Pension Payments

Pensions have been fading away for several decades. But for those retirees lucky enough to have one, they feature some of the same attractions of Social Security: guaranteed lifetime income that does not depend on market performance. A key fork in the road for people with pensions is whether to take the benefit as a lump sum or an annuity. While the annuity option can be attractive because it provides a retiree with a baseline of lifetime income without market risk, the health of the pension is an important consideration as well. For people with well-funded pensions and longevity on their side, opting for the lifetime annuity option can be an attractive way to reduce demands on the portfolio.

Strategy 5: Annuitize

If the combination of Social Security plus any pension income does not cover a retiree’s basic in-retirement living expenses, obtaining additional lifetime income through an annuity may be appropriate. Again, the goal is to increase income from nonportfolio sources so as to reduce cash flow demands on the portfolio.

Of course, annuities are a big basket that encompasses minimalist lifetime income products alongside more complicated, costly ones. The academic literature indicates that adding a very simple, low-cost income annuity, either immediate or deferred, can help improve the longevity of a retirement plan. For retirees concerned about outliving their assets with a too-high withdrawal rate, a deferred income annuity can be a particularly elegant solution. In contrast with an immediate income annuity, sometimes called a single-premium immediate annuity, which begins paying a stream of income immediately, a deferred annuity begins paying out at some later date. Such a product would potentially allow retirees to take a higher portfolio withdrawal rate because they are doing so over a shorter time horizon. And assuming the annuity payout is high enough, such a product would also provide piece of mind in that the withdrawal system is developed for a knowable time horizon–say, 20 years–and the annuity payments pick up after that. There are tax advantages associated with a certain type of deferred annuity, too. Retirees opting for what is called a qualified longevity annuity contract, or QLAC, can purchase it with traditional tax-deferred assets, thereby reducing the amount of the portfolio that will eventually be subject to required minimum distributions. In 2021, the maximum allowable QLAC amount is $135,000 or 25% of a tax-deferred account balance, whichever is less.

Strategy 6: Tap Additional Nonportfolio Cash Flow Sources

Finally, some retirees may also be able to lean on other nonportfolio sources of income. In this idiosyncratic category of cash flow sources are income from working as well as income from passive nonportfolio sources, such as property rentals or royalties. Additional nonportfolio cash flow sources may include cash values on life insurance as well as reverse mortgages. Retirement researcher Wade Pfau calls these “buffer assets,” meaning that they are most advantageous in periods when pulling from a portfolio is a bad idea because the holdings are depressed.


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