How Much Do You Know About Retirement Income? Try This Quiz
Do you have a credible retirement income plan? A TIAA-CREF survey earlier this year found that only four in 10 Americans had seriously looked into how to convert their savings into post-career income. To see just how much you know about creating income that will support you throughout retirement, answer the 10 questions below. You’ll find the correct answers—and a scoring guide—just below the quiz.
1. Based on projections in the Social Security trustees report released last week, the trust fund that helps pay Social Security retiree and disability benefits will run out of money in 2034. That means…
a. that the Social Security system will go bankrupt in 2034.
b. that Social Security will stop paying benefits that year.
c. that payroll taxes coming into the system will still be able to pay about 79% of scheduled benefits.
d. that Congress needs to do something between now and 2034 to address this issue.
2. Given the low investment returns expected in the future, what initial annual withdrawal rate subsequently increased by the inflation should you limit yourself to if you want your nest egg to last at least 30 years?
a. 3% to 4%
b. 4% to 5%
c. 6% to 7%
d. 7% or higher
3. An immediate annuity can pay you a higher monthly income for life for a given sum of money than you could generate on your own by investing the same amount in very secure investments. That is due to…
c. mortality credits.
d. fancy accounting.
4. A Roth IRA or Roth 401(k) …
a. is a better deal than a traditional IRA or 401(k) since distributions can be tax-free.
b. is a worse deal than a traditional IRA or 401(k) since you’re paying tax on your contributions upfront rather than postponing taxes until you withdraw your funds in retirement.
c. may or may not be a better deal depending on the particulars of your financial situation.
5. Starting at age 70 1/2, you must begin taking annual required minimum distributions (RMDs) from 401(k)s, IRAs and similar retirement accounts (although if you’re still working, you may be able to postpone RMDs from your current 401(k) until after you retire, if the plan allows). If you miss taking your RMD in a given year, the IRS may charge a tax penalty equal to what percentage of the amount you failed to withdraw?
6. Many retirees focus heavily on dividend stocks to provide steady and secure income throughout retirement. How did the popular iShares Dividend Select ETF perform during the financial crisis year 2008?
a. It gained 3%.
b. It stayed even.
c. It lost 7%.
d. It lost 33%.
7. To avoid running through your savings too soon, you should spend down your nest egg so that it will last as long as the remaining life expectancy for someone your age.
8. If your Social Security benefit at your full retirement age of 66 is $1,000 a month, roughly how much per month will you receive if you begin collecting benefits at age 62? How about if you wait until age 70?
9. With yields so low these days, bonds and bond funds, no longer deserve a place in retirement portfolios.
10. A new type of longevity annuity called a Qualified Longevity Annuity Contract, or QLAC (pronounced “Cue Lack”), allows you to invest a relatively small sum today within your 401(k) or IRA in return for a relatively high guaranteed lifetime payout in the future. For example, a 65-year-old man who invests $25,000 in a QLAC might receive $550 a month starting at age 80, or $1,030 a month starting at 85. Putting a portion of your nest egg into a QLAC also allows you to…
a. tell people at cocktail parties that you own a “Cue Lack” and watch as they nod knowingly as if they know what that means.
b. Worry less that overspending early in retirement will exhaust your nest egg since you can count on your QLAC payments kicking in later on
c. postpone taking RMDs on value of the QLAC (and avoid the income tax that would be due on those RMDs) until it actually begins making payments.
1. c or d. I’ll accept either (or both) as correct. Although the trust fund’s “exhaustion date”—2034 in the latest report—gets a lot of press attention, all it means is that we’ll have run through the surplus that accumulated over the years because more payroll taxes were collected than necessary to fund ongoing benefits. When that surplus is exhausted, enough payroll taxes will still flow in to pay about 79% of scheduled benefits. That said, I doubt the American public will stand for a system that eventually calls for them to take a 21% haircut on Social Security benefits. So at some point Congress will have to act—i.e., find some combination of new revenue and perhaps smaller or more targeted cuts—to deal with this looming shortfall, as it has addressed similar problems in the past.
2. a. In eras of more generous stock and bond market returns, retirees who limited their initial withdrawal to 4% of savings and subsequently increased that draw for inflation had a roughly 90% or better chance of their nest egg lasting 30 or more years. Hence, the oft-cited “4% rule.” But later research that takes lower investment returns into account suggests that an initial withdrawal rate of 3% or so makes more sense if you want your money to last at least 30 years. Truth is, though, whatever initial withdrawal rate you start with, you should be prepared to adjust it in the future based on on market conditions and the size of your nest egg.
3. c. Some annuity owners will die sooner than others. The payments that would have gone to those who die early and that are essentially transferred to those who die later are called mortality credits. Thus, mortality credits are effectively an extra source of return an annuity offers that an individual investing on his own has no way of earning.
4. c. While it’s true in theory that a traditional 401(k) or IRA makes more sense if you expect to face a lower tax rate when you make withdrawals in retirement and you’re better off with a Roth 401(k) or Roth IRA if you expect to face a higher rate, in real life the decision is more complicated. The tax rate you pay during your career can vary significantly, which means sometimes it may go to go with a traditional account, other times the Roth may make more sense. It can also be difficult to predict what tax rate you’ll actually face in retirement, making it hard to know which is the better choice. Given the uncertainty due to these and other factors, I think it makes sense for most people to practice “tax diversification,” and try to have at least a bit of money in both types of accounts.
5. d. That’s right, there’s a 50% tax penalty for not taking your RMD—and that’s in addition to the regular tax you own on that RMD. You can plead your case and ask the IRS to waive the penalty—and sometimes the IRS will. But clearly the better course is to make sure you take your RMD every year rather than putting yourself at the IRS’s mercy.
6. d. Tilting your retirement portfolio heavily toward dividend-paying stocks and funds can leave you too concentrated in a few industries. The main reason iShares Dividend Select ETF lost 33% in 2008 was because of its heavy weighting in financial stocks, which got hammered in the financial crisis. If you want to include dividend stocks and funds in your portfolio, that’s fine. But don’t overdo it. A better way to invest for retirement income is to build a portfolio that mirrors the weightings of the broad stock and bond markets and supplement dividends and interest payments by selling stock or fund shares to get the income you need.
7. b. Life expectancy represents the number of years on average that people of a given age are expected to live. (This life expectancy calculator can help you calculate yours.) But many people will live beyond their life expectancy; some well beyond. So if arrange your spending so that your nest egg will carry you only to life expectancy, you may find yourself forced to stint in your dotage. To avoid that possibility, I generally recommend that you plan as if you’ll live at least to your early to mid-90s.
8. c. For each year you delay taking Social Security between the age of 62 and 70, your benefit increases by roughly 7% to 8% (and that’s before cost-of-living adjustments). If you also work during the time you postpone taking benefits, your payment could rise even more. To see how much delaying benefits and other strategies might boost the amount of Social Security you (and your spouse, if you’re married) collect over your lifetime, check out the Financial Engines Social Security calculator.
9. b. There’s no doubt that if interest rates continue to rise as they already have since the beginning of the year, that bonds and bond funds could post losses. But as long as you stick to a diversified portfolio of investment-grade bonds with short- to intermediate-term maturities, those losses aren’t likely to come anywhere close to the 50% or more declines stocks have suffered in past meltdowns. Which means that while bonds at current yields may not provide as much of a cushion as they have in past years, a portfolio that includes bonds will be much more stable than an all-stocks portfolio. In short, for diversification reasons alone, it still makes sense to include short- to intermediate-term bonds or bond funds in your retirement portfolio.
10. b. or c. The main reason to consider a QLAC is to hedge against the possibility of running through your savings and finding yourself short of the income you need late in retirement. But the fact that you can postpone RMDs and the tax that would be due on them is an added bonus. To qualify for this bonus, however, you must be sure that the longevity annuity you buy with your 401(k) or IRA funds meets the Treasury Department’s criteria to be designated as a QLAC and that the amount you put into the QLAC doesn’t exceed the lesser of $125,000 or 25% of your account balance.
Give yourself 10 points for each question you answered correctly and then see how you did on my highly scientific grading system below.
0-40: You really need to brush up on retirement income basics, preferably before you start collecting Social Security and drawing down your nest egg.
50-70: You understand the basics, but you’ll improve your retirement prospects immensely if you take a deeper dive into how to create a retirement income plan.
80-90: You clearly know your way around most retirement-income concepts. That doesn’t mean you couldn’t profit, however, from learning more about such topics as Social Security, different ways to get guaranteed income and how to set up a retirement income plan.
100: If the answers in this quiz weren’t so obvious, I’d say you’re a retirement income expert. Still, congratulations are in order if for no other reason than you actually read this story from top to bottom and got every answer right. (7/28/15)
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.