4 Ways To Avoid Outliving Your Nest Egg
In a recent survey, 57% of CPA financial planners said their clients’ top retirement concern was depleting their nest egg too soon. So how can you lower the odds of running out of money before you run out of time, especially given forecasts for low investment returns in the years ahead? Here are four strategies.
1. Die early. I’m not advocating this option, nor am I trying to be glib. I mention it because, whether they admit it or not, this is the strategy many people are effectively relying on. I say this for two reasons. First, research shows that most retirees underestimate how long they’ll live, often by five or more years. Second, people tend to overestimate how much they can withdraw from their nest egg without it running out. Combine those two miscalculations, and an early exit from this mortal coil is the only way many people will avoid finding themselves relying on Social Security and little else.
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Obviously, this isn’t a very attractive, or realistic, option—so you’ll want to check out the three strategies below. While you’re at it, why not also rev up a life expectancy calculator? You’ll come away with a better sense of just how many years you might spend in retirement, which will help you make a more informed decision about how to spend down your savings.
2. Withdraw from savings at a “safe” pace. The problem with this strategy is that you might not like—or be able to live on—what’s considered a safe withdrawal rate. Back when the financial markets were churning out generous annual returns, the 4% rule was considered a reasonable method for drawing on savings. If you had $1 million saved, you withdrew 4%, or $40,000, the first year of retirement, and then increased that amount for inflation each year—$40,800 the second year, $41,,600 the third, etc., assuming 2% inflation. Following that rule would generally give you a 90%-or-so success rate of your nest egg lasting last at least 30 years.
But with interest rates so low and many investment pros forecasting lower returns in the years ahead, research suggests retirees who want their money to last three decades or longer might have to limit their initial draw to 3%, if not less. Even if you have a nest egg large enough to allow you to manage on a 3% withdrawal rate, sticking to a “safe” withdrawal rate has another shortcoming: if the financial markets perform well, you could end up with a huge pile of cash late in retirement. That might not seem like a problem, but it would mean you unnecessarily stinted early in retirement when you might have been able to enjoy yourself by spending more. In short, while this strategy may be able to help you avoid running through your dough too soon, the cost may be living more frugally than it turns out was necessary.
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3. Buy an immediate annuity. Economists love immediate annuities—aka income annuities—because they’re an efficient way to turn savings into lifetime income. You hand over a lump sum to an insurer and in return you get a monthly payment no matter how the market performs and no matter how long you live. A 65-year-old man would receive about $550 a month for life for $100,000 based on today’s rates. (To see how much you might get for different amounts at different ages, check out this annuity calculator.) That’s more than you could generate for life with the same amount of risk investing on your own. Why? Because in addition to interest and return of a portion of your principal, each annuity payment effectively contains an extra little amount known as a “mortality credit”—essentially, money transferred from annuity owners who die early to those who live long lives.
So what’s the downside? Well, to get the highest possible payment from an immediate annuity, you agree to give up access to your money. Which means it’s no longer available for emergencies, or to pass on to heirs. (There are other versions of annuities that give you various degrees of access to principal, but their payments are typically lower and/or they may come with steep fees.) Given that drawback, converting all (or probably even most) of one’s nest egg into an immediate annuity isn’t a practical solution for most people. And, in fact, lots of research shows that while people like the concept of lifetime income, they’re not nearly as keen about buying immediate annuities.
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4. Take an eclectic approach. The idea behind this strategy, which is the one I recommend, is to capture as much of the upside as possible and avoid as much of the downside of the options above. Start by doing a retirement budget that separates your outlays into two categories: essentials and discretionary expenses. Then try to cover as much of your essential retirement expenses with assured income sources like Social Security and pensions (if you have one). If those sources alone aren’t enough to pay most or all your essential expenses, you may want to consider devoting a portion of your nest egg to an immediate annuity to cover of the shortfall. You can then rely on draws from the remainder of your savings to cover whatever remains of essential expenses, plus discretionary outlays (travel, entertainment, etc.). You’ll still want to limit your initial withdrawal to a reasonable amount to avoid going through your stash too quickly, say, 4% or so. But if you’re covering most of your essential expenses from Social Security, pensions and (if needed) annuity payments, you should have flexibility to adjust withdrawals as needed.
And, indeed, flexibility is the key to this strategy. As your retirement needs and market conditions change, so should the amount you draw from assets if you want to avoid running through your savings too soon or being left with a big pile of cash in your dotage. By going to a good retirement income calculator once a year and plugging in your current savings balance and how much you plan to spend over the next 12 months, you can get a sense of how long your savings might last given your planned withdrawal rate, and whether you need to make an adjustment up or down. In short, as you did during your career, you’ll have to roll with the punches a bit and make tweaks as you go along.
There are other refinements you can make to hone this approach. For example, you may be able to boost the size of your Social Security payments by claiming at a later age or increase the amount you and your spouse collect over your lifetimes by coordinating when you take benefits. And if you don’t feel the need to devote savings to an immediate annuity now but want to assure you’ll have adequate income down the road should your savings dissipate more rapidly than you expect, you can always consider buying a longevity annuity. According to a longevity annuity calculator, a 65-year-old man who invests, say, $20,000 in a longevity annuity today could begin collecting $450 month for life starting at age 80 or $850 monthly at 85.
Until we figure out a way to predict investment returns and exactly how long each of us will live, any approach to creating sustainable income is going to have drawbacks. But by starting with a reasonable plan, monitoring your progress and making small tweaks as you go along, you’ll reduce your chances of depleting your nest egg too soon and, more important, better enjoy your retirement, however long it may be. (5/20/15)
Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at email@example.com.