CHAPTER
15

Investing for Retirement

In This Chapter

• How much will you need to retire?
• When can you retire?
• Maximizing guaranteed income
• Protecting your funds
• Withdrawal strategies

The old reality was that Social Security provided a base to guarantee minimum living expenses. The new reality is that even if you collect the maximum monthly payment at full retirement age (currently $2,639/month), you’ll have a tough time living on it. Of course, most people don’t collect the maximum—$1,335/month is the average collected benefit. You’re probably going to want, or need, more than Social Security will provide.

It’s likely that investing for retirement is the most long-range, expensive goal most of us will ever face. Yet we put it off, push it out of our minds, and begin investing later than we should or maybe not at all. That’s really unfortunate, because nowadays it’s all on you.

Many of our parents and maybe grandparents could count on a pension from their jobs, coupled with Social Security payments that went a lot farther. If they saved above and beyond that, they had guaranteed income plus a little extra. But retirement looks very different nowadays. Let’s dial back a little and think about the good old days and how the new reality immediately suggests steps you should take.

Estimating How Much You Need

Retirement income can best be balanced if it’s designed like a three-legged stool (which one way or another always balances):

• First leg Guaranteed income through Social Security, pensions, and certain types of annuities
• Second leg Taxable income from retirement accounts and other investment accounts
• Third leg Tax-free income from Roth IRAs (and possibly some annuities)

The closer you are to retirement, the easier it is to estimate your living expenses, and the harder it becomes to save enough. So the best advice is to start early and keep it up.

I discussed how to get a rough estimate for your retirement savings goal back in Chapter 2. You’re not going to be able to pinpoint exactly how much you can withdraw until you’re very close to retirement, because at that point it’s going to depend on inflation, how well your investments have done, and what your spending needs have become.

Many retirement income calculators assume you’ll need 70 percent of your then-current income as retirement income. I’ve yet to discover why that figure is near universal. It seems to assume that you’re saving 10 to 20 percent of your current earnings, that your taxes will be lower, and that you won’t be spending as much on transportation, clothing, or other work-related expenses. Of course, if you’re not saving much now, you’ll need close to what you’re earning. If your taxes won’t go down in retirement, there’ll be no reduction in need. And if you’ve been dreaming about travel, or pursuing hobbies you didn’t have time for, or upgrading or repairing your home, your expenses could actually go up.

The better web calculators will estimate the effects of inflation (use at least 2.5 percent to 3 percent per year if you can choose) and estimate your return on portfolio low—say, 6 percent to 8 percent. Check out Kiplingers.com, aarp.org, Quicken software, and any brokerage house where you have an account—they’ll all have calculators. Admittedly these enterprises have an interest in getting you to save more, but I can almost guarantee you’ll be stunned by the figure.

Employer Plans

The moment you get your first job you should begin contributing to your workplace’s retirement program. (See Chapter 6 for information on workplace retirement plans.) At a bare minimum, you should contribute enough to get the employer match to your contributions. Some employers will match 3 percent or 5 percent or whatever percentage of your salary as long as you’re contributing an equal or greater amount; some will match half of your contributions up to a certain maximum. Contribute that amount—it’s the best guaranteed return on investment you are ever likely to get. What other investment guarantees you a 50 percent return on your money the moment you invest it?

Besides the employer match, your workplace retirement plan offers a direct reduction to income, which will lower the income tax you need to pay. Depending on your tax bracket, that makes the savings hurt a lot less. For example, if you’re currently in the 25 percent tax bracket (about $75,000 to $151,000 for a couple), every dollar you save is only going to cost you 75 cents in lost spending power. It’s really an investment return that’s impossible to pass up.

It’s not easy to avoid the tax man, but some jobs (especially government) offer other income deferral programs. Be careful to read the fine print and consider whether it will work. If they require a lump sum distribution at retirement, you could be hit with a gigantic tax bill in your first year.

One other strategy that people use to save with tax-deferred benefits is a variable annuity. You make contributions to the annuity, and the earnings on your contributions grow tax-free until you begin withdrawal at retirement. At that point, your payout consists partly of your own contribution (not taxed) and partly earnings (taxed). You don’t get any deduction for your contribution, but it theoretically improves your earnings potential.

I’m not a big fan of variable annuities for several reasons:

• They often come with huge commissions or fees that eat into the money you have to invest.
• They’re hard to get out of if you change your mind, and may have surrender charges and tax consequences.
• Your investment choices are limited by what the annuity provider offers—often their own high-cost, low-performing funds.

Usually, people would be better off simply investing the money in a brokerage account of mutual funds, chosen with an eye to tax efficiency. But if you’re absolutely rabid about avoiding taxes, and have maximized your workplace retirement and IRA contributions, you might seek the advice of a fiduciary investment adviser or financial planner to evaluate any variable annuities you’re considering.

Guaranteed Income

Investment returns in retirement accounts are always subject to risk and variability. But there are sources of guaranteed income to keep in mind: Social Security, pensions, and single premium fixed income annuities (SPIAs).

Social Security

Social Security is valuable for two reasons: it’s money you can never outlive and it has a guaranteed cost of living increase so it has some chance of keeping pace with inflation. While I’ll agree that it’s not enough for most people to live on, without it most of us would really be in a fix. And what is it really worth? If you get the average $1,335/month payment, you’d need an extra $400,500 in investments in order to withdraw that same amount. Eligible for the current maximum? You’d need $807,900 to withdraw that amount of income. That’s in today’s dollars, without cost of living increases. It’s not chump change.

Sadly, most people begin collecting Social Security at 62, which reduces their benefits by about one third. Your best strategy is to wait as long as possible, ideally until age 70, to collect maximum benefits.

There are a few good reasons to collect benefits at 62:

• You’re unemployed with no prospect of getting another job. If you do start earning money before your full retirement age, you lose $1 of benefits for every $2 you earn.
• You have a terminal illness—but it will reduce your survivor’s benefits.
• You have very young children and collect Social Security for them as dependents.

On the other hand, waiting until 70 will give you benefits almost twice as high as what you would have collected at 62. Also …

• You’ll receive the highest benefit possible—about one third more than you would have received at full retirement age.
• Your cost of living increases are based on the higher dollar amount.
• Your surviving spouse can have higher benefits.
• As long as you continue working, you may increase the basis of your benefits.

Sometimes I’m asked whether it would be a good idea to take the benefits and invest them instead. Bottom line, no. Let’s look at an example.

Let’s say you’d get $1,000 a month at full retirement age, but decide to collect reduced benefits at 62 and invest the money.

• “Safe” portfolio withdrawal rate is about 4 percent.
• At 5 percent return = $39,761 ($132/month extra from portfolio).
• At 8 percent return = $42,262 ($140/month extra from portfolio).

But wait!

• Waiting guarantees about a 6.25 percent return from 62 to 66 (and about 8 percent yearly for the years between 66 and 70).
• Social Security is indexed to inflation.
• You would have received an extra $250/month.

So as you can see, it doesn’t make any financial sense.

Would you be better off taking Social Security and withdrawing less in the early years from your portfolio? Only if you’re certain your portfolio will grow more than 8 percent a year plus a cost of living increase.

In waiting, you’re betting against the house. Social Security was calculated on an average life span, and benefits are paid based on those calculations. Trouble is, they’ve turned out to be wrong—people are living much longer than expected.

If you don’t expect to live very long, take benefits at 62. If you think you might live to be older than about 77, you’d be better off waiting until full retirement age (66 or 67, depending on when you were born). If you wait until 70, you win if you live past 83. Average life span in the United States is 76 for a male and 81 for a female. However, that average includes infant deaths and people who die young. If you manage to make it to 65, you have 15 to 18 years more expectancy (male) and at least 19 (female). It’s your call, but waiting at least until full retirement age is a pretty good investment.

Pensions

When people who have a pension retire from their jobs, the company will almost always offer them a lump-sum payout in order to forego monthly payments. Should you take the lump sum and invest it, or should you stick with the pension? Not an easy answer, but here are some points to consider:

• Does the pension payout go up with inflation? If not, it’s going to be worth less each year. However, if it allows you to delay withdrawing from your own investments, your investments may grow enough to make up the difference in the future.
• Do you have high interest debt with no way to pay it off? If you can relieve some high-cost payments and this will allow you to live on much less, it might be worth running some numbers.
• Could you use the money to buy a single premium annuity that would pay more than the pension (probably not, but you could check)?
• Is it important to leave money to heirs, and this is all you have? When you’re gone, the money’s gone (but you can elect for lower payments to be made to your surviving spouse for their lifetime).

For most people, projections will indicate that they are better off with the monthly payments than the lump-sum payout, but there are exceptions. This is an issue where you need to consult a fiduciary financial planner. Scrutinize the numbers to determine what rate of return they’re using to make the projections. (It should be conservative.) If they recommend you take the lump sum, be very sure that they’re not just trying to get you to invest it with them, and that they are acting in your best interest.

SPIAs

If you’re not lucky enough to have a pension, you can buy your own. It’s called a single premium fixed income annuity (SPIA). It’s a pretty simple operation: you give the annuity provider (usually an insurance company) a lump sum and they agree to pay you a monthly (or quarterly or yearly) sum for as long as you live.

Tip

SPIAs have many options. Any except single life (payments made on one life only) will reduce your monthly payment. Joint and survivor means full payment for your lifetime and reduced payments for a spouse for life if you pass away. Period certain: if you die before 10, 15, or 20 years your beneficiary gets payments for the remainder of the term. Cash balance: if the annuity hasn’t paid out your initial investment by your death, a beneficiary gets the remainder in a lump sum.

As with all investments, SPIAs have advantages and disadvantages. If you understand that providers are assuming some people will die young, you’ll understand better how these work.

Advantages of SPIAs:

• You can never outlive the money if you choose a lifetime annuity. Even if they’ve paid you everything you originally invested, the payments will keep coming.
• A SPIA will give you more income for your investment than you could withdraw from a portfolio of the same size. If you could withdraw 4 percent per year from a portfolio, a SPIA might pay out anywhere from 5 percent on up, depending on what options you select and your age when you purchase it.
• As long as you choose to purchase from a high-quality insurance company, even if the company’s investments lose money, you will still get payments. It’s much less risky than depending on your own portfolio.
• It can give you more spendable income in the early years of retirement, when you may want it for travel or other goals. As you get older, you may not have as much need for income (especially if you’re protected for long-term care or other health needs).

Disadvantages of SPIAs:

• Once you give the annuity company the money, you can never get it back. There will be no inheritance for your heirs from this money (unless you choose a specific provision that continues the term or pays out a balance).
• If you die young, the money’s gone. Once you’re gone, it’s gone.
• If you need money for an emergency, you can’t get it from the SPIA.
• If markets are good, you won’t get any more money—the insurance company takes the profit.
• Usually your payments won’t increase over time. Inflation will erode the value of your payment.
• Even if they refund the remainder of your principle to heirs, you won’t get the earnings that money generated.
• Generally SPIAs should be purchased with money from taxable accounts. If the only money you have is already in retirement accounts, you should be sure that the SPIA payment will meet the RMD.

SPIAs make higher payments the older you are when you begin them, so it can make sense to wait until you’re in your late 60s to evaluate your health. If it’s good, 70 years old may be a good age to begin a SPIA. If your health is poor, you may not want to invest a large lump sum.

Tip

Deferred annuities are similar to a SPIA in that you invest a lump sum (or a series of payments) with the promise that at some future date you receive an annuity payout. All the same advantages and disadvantages apply, with one more caveat: check out the actual compound rate of return you’re getting from time of investment to payout. These are generally lower than you might get in a diversified portfolio. You’ll need to weigh guarantees versus growth. These are complex products worth having evaluated by a fiduciary financial adviser (not the same person who’s selling the product).

It’s a quirk of our natures that people love to have pensions but hate to purchase annuities, when in reality they’re about the same thing. We all hate losing control of our money, but if we never had it, it seems like a benefit to receive guaranteed payments.

If having an income annuity would make the difference between not enough income or just right, you should consider a SPIA. If you’re concerned about investment risk, or outliving your investments, an annuity might give you peace of mind. No one should put every penny into a SPIA, but if you can purchase one that, with Social Security, will guarantee your minimum necessary living expenses, it’s a worthy investment for a portion of your retirement savings.

Realigning Your Portfolio to Produce Retirement Income

When we’re accumulating investments to build retirement income, we focus on growth of the worth of those investments, saving to the best of our capabilities, and reinvesting dividends (and mutual fund capital gains payouts) to build shares. In retirement we still need to be concerned about growth, because our investments need to give us enough to withdraw but still keep pace with or exceed inflation. However, we are also in a withdrawal or distribution phase, so we need income. A portfolio can provide income in several ways, so let’s look at the options for withdrawing money from the portfolio.

Continue to reinvest income, rebalance yearly, and take money out of investments for the next year’s withdrawals. From a purely financial standpoint, this method has the potential to generate the best increases. You’re still reinvesting income, and future dividends are based on building that pyramid. However, you have to have the fortitude to rebalance and sell investments, taking out a lump sum and putting it in a cash account you can withdraw from. Also, in a market where your investments are tanking, the reinvested dividends go downhill with the rest of your shares.

A variation of this rebalancing method is the bucket approach, where you designate at least three buckets:

• One for current (2- to 5-year) expenses you keep in cash
• One for safe investments (like bond mutual funds, and stable and dividend stocks) for 5- to 10-year needs
• One for high-potential but more volatile investments (stocks and stock mutual funds) you can leave alone for 10 years, especially if they’re not performing well

Each year you rebalance and fill up the cash bucket from the safe investments, and possibly the safe investments from well-performing risky investments. If it’s a bad year, you can wait to replenish and not be forced to sell poorly performing investments.

Also, realign your portfolio to emphasize dividend and interest paying investments. Instead of reinvesting earnings and rebalancing to withdraw earnings, the income dividend approach means you refocus your stock and mutual fund purchases to favor ones that generate dividends or interest. (See Chapters 10, 11, and 12 for more specifics.) Rather than reinvesting dividends and interest, you have them deposited in your cash account or sent as checks and use that as your spending money. If you emphasize this, you may be able to collect about half (2 or 3 percent) of your safe portfolio withdrawal (remember, around 4 percent total). You then depend on capital gains in your investments to provide enough overall gain to beat inflation and tide you over in bad markets. You’ll still need to rebalance and take the rest of your needs out of the portfolio (unless you have a SPIA or enough income between Social Security and dividends).

Warning

As discussed in Chapter 11, don’t go overboard and choose all your stocks only based on dividends. Unusually high dividends don’t do you any good if the investment itself loses money. You still need to be aware of total return, and at least some of your portfolio needs to produce enough growth to beat inflation.

The traditional solution for retired people was to purchase quality, well-paying bonds. It’s not so viable at the moment because we’re in a low-rate environment. See Chapters 10 and 12 to parse out whether some portion of your investments should be in bonds or bond mutual funds. It’s more of a safety move than an income move at the moment.

Well, both. You need some growth and some safety in a portfolio. People with a good pension or annuity and high Social Security payments can probably afford to emphasize stocks (and stock mutual funds) in order to get that growth, either for themselves or for their heirs.

People who have moved into the stage of life where they may be becoming more frail, and for whom health issues and long-term care are bigger concerns than travel or a new car, may be inclined to tilt their portfolios to safety with bonds (and bond mutual funds) and cash. Because you would have a shorter time horizon (perhaps 10 or 15 years rather than 30), inflation erosion of spending power is a less predominant concern.

However, in old age, especially if you have adequate income and provision for long-term-care needs, should they arise, you might decide that you are investing not so much for yourself as for your heirs. If your heirs are relatively young, you may feel comfortable orienting at least some of your portfolio to produce maximum possible gains for them. We’re back to stocks, again!

What If It’s Just Not Enough?

Maybe you’ve done everything right, but some disaster has struck and you can see that Social Security, any pension, and your investment portfolio will just not produce enough income for your retirement. It’s not an easy situation to solve, but there are some steps you can take:

Work longer This doesn’t necessarily mean in your current high-pressure job. Even a part-time job can provide you with supplementary income and delay depletion of your investments.

Consider moving Many, many people have too much investment in their home. It’s possible to have great net worth and be unable to pay your bills. A smaller place, a cheaper neighborhood, or a cheaper city may give you a better housing situation and lower property taxes. It costs more even to make repairs in Manhattan than it does in Indiana.

Consider renting Can you rent out your current home and de-camp to another country for a few years? You’ve always wanted to travel, right? Sometimes the rental on your current place would support you in style in another country.

Live with the kids It all depends on your family, but in some cases this can be a mutually supportive relationship—which works for most of the rest of the world.

The golden key to retirement is savvy saving. Maximizing your savings, taking advantage of tax-favored accounts and employer matching contributions, and putting together a sensible portfolio that grows over time are necessities for a stable and secure retirement.

The Least You Need to Know

• Determine how much guaranteed income you will have from Social Security, a pension, or an investment in a single premium income annuity.
• Your investment portfolio must grow in order to keep pace with inflation, especially if some of your guaranteed income does not.
• You’ll withdraw from your investment portfolio to make up the difference between your guaranteed income sources and the remainder you need to support your retirement income.
• In retirement, structure your portfolio so that you will not be forced to sell investments in a bad market to cover spending needs.
• Your risk tolerance may change depending on the size of your portfolio, changes in needs and spending priorities, and your desire to leave an inheritance.