(This article is adapted from Recession-Proof Your Retirement Years: Simple Retirement Strategies That Work Through Thick or Thin by Steve Vernon, FSA.)
When withdrawing your retirement savings, your number-one goal is this: Don’t outlive your savings. Unfortunately, many retirees “wing it” and withdraw funds much too quickly, with the inevitable result that they'll run out of money before they die.
When it comes to your retirement savings, don’t consider your retirement assets as money you can spend in retirement. Instead, consider the money to be a monthly paycheck generator. Then, spend no more than this paycheck.
Here are three retirement income generating strategies described to survive economic downturns while generating a lifetime retirement income, no matter how long you live:
Retirement income strategy No. 1: Spend just your interest and dividends — your investment income. Of the three methods I’ll discuss, this one has the highest chance of making your money last for your lifetime while giving you flexibility and access to your savings. But it provides the lowest amount of current income.
Spending just your investment income virtually guarantees that you won’t outlive your money. With a portfolio balanced between stocks and bonds, your annual income can range from 2 percent to 3 percent of your account balances.
This method works if your investment income is enough to cover your living expenses and it’s the best method if leaving money to your children or charities is important to you.
It has two other advantages: For one, fluctuations in the dollar amount of the investment income from a diversified portfolio can be much less than the volatility of the underlying investments. So this method can provide peace of mind during market volatility. For another, in an emergency, you can tap into your principal.
(MORE: Test Your Retirement IQ)
Retirement income strategy No. 2: Spend your principal cautiously. This method requires you withdraw income and principal in a way that minimizes the likelihood you'll outlive the principal.
It works best if you need more income than just interest and dividends and if leaving money to children or charities isn’t as important as maximizing your retirement income. You also have the flexibility to tap into your principal, if an emergency arises.
One rule of thumb for this method is to calculate 4 percent of your retirement savings remaining at the beginning of each year, then divide by 12 to determine your monthly paycheck. Of course, there’s still a chance you'll outlive your resources, but the odds are low — roughly one out of 10. Free online retirement calculators, like the one at the T.Rowe Price site, can help you determine the percentage that will give you 90 percent odds of success.
This method is designed to help you withstand the worst scenario: a significant drop in the value of your investments early in your retirement. Using this method means you’ll have sufficient assets invested when the market bounces back (as it typically has in the past). If you withdraw too much principal during a market downturn, you might not have enough invested assets to recover.
Retirement income strategy No. 3: Buy an immediate annuity. With an immediate annuity, you give a lump sum to an insurer, which promises to pay you a monthly income for life. It’s really a do-it-yourself pension.
You could buy an immediate annuity with built-in inflation increases or one that pays income to a spouse or beneficiary if you die first. Both of these variations cost more money, although the extra price can be worth it.
An immediate annuity typically has one great feature that the other two methods don’t as well as two disadvantages. The extra advantage is that you won’t have to manage your money. The two drawbacks are that you won’t be able to leave money from the annuity to children or charities and you can’t dip into your principal if an emergency arises.
How much money you’ll get from an immediate annuity depends on:
- Your age and sex when you buy it
- Whether you cover a beneficiary
- The safety of the insurer
- Interest rates when you buy the annuity
It's important to choose a highly rated insurer, since there’s no federal protection for annuities as there is for bank savings accounts. The safest approach is to buy an annuity from an insurer with one of the four highest ratings from Moody's Investors Service and Standard & Poor's. For Moody’s, this would be Aaa, Aa1, Aa2 or Aa3; for S&P, you'd want AAA, AA+, AA or AA-.
There are three ways you can buy an immediate annuity. You can use an online service such as Immediateannuities.com or Incomesolutions.com. You can contact an insurance broker who’ll shop around for the best deal. Or you could work with a financial planner or investment adviser. If you’ll use either of the last two options, be sure to ask how much the pro’s commission is.
Buying an immediate annuity provides a higher income than the first two methods, so why wouldn’t you put all your money in one?
For one thing, the annual income from an annuity is usually fixed, while income under the first two methods should increase with favorable investment returns. For another, it’s a good idea to diversify your retirement income by using two or more of the methods mentioned. Also, an immediate fixed annuity won’t provide cash in an emergency or inflation protection.
The best choice is to deploy just a portion of your portfolio to an annuity — say one-third to one-half — and use one of the other two withdrawal methods for the rest of your portfolio.
You may also want to alter your withdrawal method as you age. When you're in your early retirement years (late 60s and early 70s), I recommend using the first method and living on your investment income. If you need more income, work part-time while you still can. Once you’re in your mid-70s or later, you could begin drawing principal and/or buy an annuity.
One more tip: If your money is in a 401(k), 403(b) or 457 plan or a traditional IRA, pay attention to the minimum distribution rules that kick in at age 70 1/2. (Roth IRAs aren’t subject to them.) At 70 1/2, the Internal Revenue Service requires you to withdraw minimum amounts from these accounts and applies significant penalties if you don’t. You don’t have to spend the money; instead, you can withdraw the cash and put it in a taxable investment account.
It’s well worth your time to learn about all the methods and figure out which combination works best for you. The last thing you want to do is spend too much money in your 60s and 70s and then need to go back to work in your 80s because you’ve run out of money.
Instead, you want to feel confident that you can afford to live to see your 90s — and maybe even 100!