Wednesday, May 4, 2011

Part 2: The Two-Legged Stool: Where Will Your Retirement Income Come From?

Part 2: Personal Savings

One of the first steps of retirement planning is to figure out how much we can expect to spend after we bid our working life adieu and the paychecks abruptly cease. Those pension checks from your employer and the gold watches are now mostly the stuff of black-and-white movies, so most of us will depend on Social Security benefits and personal savings.

In Part 1, I explained how to estimate your future Social Security benefits. The second common source of retirement income is personal savings, whether you saved them in a taxable account, like a bank savings account or stocks in a brokerage account, or you accumulated them in a tax-advantaged retirement account like a 401K or an IRA.

The amount of income we can generate from personal savings is trickier to predict than Social Security benefits for two primary reasons. First, we don’t know how long we will live. Social Security promises to pay us a monthly amount no matter how old we get, but our personal savings make no such guarantee. After we spend our savings, they’re gone.

The second difficulty is that there are a variety of ways to invest our personal savings and the better our investments perform, the more we can spend. Unfortunately, if they perform poorly we must spend less.

Here are some important differences between Social Security benefits and personal savings:

1.         You can outlive your personal savings, but you can’t outlive Social Security benefits.

If you spend or lose all of your personal savings, they are gone forever. If you live a very long life or you overspend, you can outlive your personal savings. Only in personal financial planning do we consider living a long time a problem.  We even have a name for it—longevity risk.

Social Security checks will keep coming for the rest of your life, no matter how long you live. (Remember this when politicians tell you that you would be better off keeping your FICA payments and investing them in the stock market to pay for your retirement.)

2.         Social Security payments will remain constant throughout retirement, but the amount you can spend from personal savings can shrink or grow over time.

Social Security benefits won’t shrink or grow as you age except for the inflation adjustment (not without an act of Congress, anyway). The amount of the check will grow to offset inflation, but your purchasing power will remain the same.

The amount of your personal savings that you can spend, however, depends on how well the money is invested and how long you live. You can invest your personal savings in stocks and bonds and if your investments perform well, you will be able to increase your spending over time. If the market performs poorly or you spend too much, you will have to reduce your future spending. 

Invest those savings in something safer than stocks, U.S. Treasury bonds, for example, and the amount you can spend won’t grow much, but it won’t shrink much, either.

3.         Unspent personal savings can be passed on to your heirs at your death, but there are no “unspent” Social Security benefits.

When you die, there are no “leftover” Social Security funds[1], even if you paid a gazillion dollars in FICA during your career but are only around long enough to collect a couple of monthly retirement checks. Your unspent personal savings, on the other hand, can be inherited by your heirs when you die.

So, if you retire with a million dollars in savings, how much of it can you spend each year of retirement? An estimate depends largely on how long you will live and how you will invest your savings.

The first question we have to ask is how long we will live. We discussed that in a previous chapter. The consequences of outliving our savings might be catastrophic, so we can’t take that risk. We have to assume for retirement planning purposes that we will live to be very old, just in case we do. Some planners recommend using age 95 and some 100. 

Your life expectancy won’t work for financial planning because that’s the average life expectancy for people like you. If we used the average, then half the people for whom we prepared retirement plans would outlive their savings.

How Will You Invest?

The second question we have to ask in order to estimate how much of our personal savings we can spend in retirement is how our savings will be invested.

If finance isn’t your strong suit, your first thought might be that for a thirty-year retirement, you could spend 1/30th (3.33%) of those savings every year. Just divide that pile of savings into thirty stacks, one for each year of retirement. Label each stack with the year it is to be spent, put rubber bands around them and stick 29 of them under the mattress.

Fortunately, the savings we don’t have to spend this year can be invested and can grow in certificates of deposit (CDs) or mutual funds until we need it, allowing us to increase annual spending. The stack labeled for spending next year can earn interest for one year, but the stack labeled for spending 29 years from now can earn interest for 29 years.  A stack of money can earn a lot of interest in all that time and we don’t have to wait 29 years to spend it.  We can spend more now, knowing that we will replace some of what we spend today with future interest earnings.

Even investing in the safest, lowest yielding investment portfolio available instead of sticking that money under the mattress, we can spend 33% more than that 1/30th of our savings each year.
Increasing a small percentage like 3.33% by a third may not sound like a big difference, but when you look at the annual spending amounts, you see that it is. If we were limited to 1/30th of our million dollars of personal savings each year, we could spend $33,333. An additional one-third increase of that 3.33% to 4.43% raises $33,333 to $44,333, or $10,000 more per year we can spend.

Once we retire, we might leave our personal savings in stocks and bonds, “save” it in a savings account or certificate of deposit, or even use it to purchase an insurance contract that provides a certain level of income for as long as we live (a “fixed annuity”). Each option has its own risks and provides its own level of income.

In keeping with the “start simple” theme from Part 1, though, let’s estimate how much income we might receive from the safest alternative and try to improve on it later in the planning process.

A Portfolio of Treasury Inflation-Protected Securities

Treasury Inflation-Protected Securities (TIPs) are U.S. Treasury bonds that pay interest that is adjusted for inflation. Real yields, the interest rate paid after inflation, are historically around 2% for TIPs bonds, but the U.S. Treasury compensates investors for inflation. If inflation runs 3%, for example, these TIPs bonds would actually pay 5%. If inflation is 4.5%, the bonds will pay 6.5%.

Said differently, the U.S. Treasury is promising to pay you 2% interest (the “real” interest rate) plus whatever rate of inflation you experience until the bond matures. 

TIPs are the safest investment available, since they are backed by the U.S. government and have no inflation risk. They’re also as easy to purchase as a CD. You can buy individual bonds from the U.S. Treasury online or you can buy them in mutual funds[2] or ETFs[3] from any broker.

The Safest Estimate is 4.46%

One very safe way to invest our retirement savings would be to invest them in a TIPs portfolio. Nobel Laureate and economist William Sharpe has shown[4] that retirees could spend 4.46% of the initial value of a TIPs portfolio every year with high certainty that the principal would last for almost exactly thirty years. A million dollar TIPs portfolio, therefore, would support $44,600 of annual spending after inflation and its balance wouldn’t reach zero for thirty years.

Investing our personal savings in TIPs when retirement age nears is a simple and safe way to ensure that our personal savings last as long as we do and to protect ourselves against inflation. Depending on each retiree’s unique financial situation, TIPs may or may not be the ideal way to invest, but they are a great starting point for planning purposes. Any other approach will involve more risk, so this approach provides a safe and conservative estimate that we may or may not be able to improve upon.

A Strategy for Estimating Spending Capacity

These assumptions of how long we will live and how we will invest our savings provide us with a basic strategy for estimating how much of our personal savings we can spend each year in retirement. First, we will plan to live to be 95 or 100 years old to make sure we won’t outlive our savings. Second, we will invest our savings as conservatively as possible so we earn a return that can keep up with inflation and increase our annual spending. 

Lastly, since we probably won’t actually live to be 95 or 100, but have to plan for it just in case, we will assume that some of our savings will be left over and pass to our heirs when we die. 

Add Personal Savings Spending to Social Security Benefits

Based on these assumptions, we have a reasonable estimate of how much income our personal savings can generate throughout a thirty-year retirement. Add annual Social Security estimates from Part 1 to 4.46% of expected personal savings at retirement.  If you’re lucky enough to have a company pension, add the annual benefit you expect it to pay and you have a pretty good estimate of your retirement income.

Here’s an example.  Assume my wife and I plan to retire at age 66 and the retirement calculator at the Social Security Administration’s website says I can receive benefits at that age of $1,200 per month.  The calculator tells me that my wife is also entitled to her own benefit at that age of $1,200 per month.  That’s $2,400 per month in social security benefits, or $28,800 per year.

Also assume my wife and I have saved a combined $100,000 in our 401K plans, 4.46% of which is an additional $4,460 per year that we can spend from our savings.

Social security benefits plus spending from savings will provide about $33,260 per year in retirement income.  There are trade-offs we can make to increase that income, but for now, an initial estimate of expected income is a good first step toward their financial plan.

For now, an initial estimate of expected income is a good first step toward their financial plan.

The Key Points

Here are the key points to remember from Part 2:

o      You can’t outlive Social Security benefits, but you can spend all your personal savings before you die.

o      You have to ration the spending of personal savings in case you live a very long time by planning to fund retirement to age 95 or even 100.

o      A safe portfolio of TIPS bonds should allow you to spend 4.46% of the amount of your personal savings the day you retire each year of retirement and have your savings last 30 years.

o      Add this 4.46% of your initial retirement savings to your expected annual Social Security benefits, plus any pension benefits you might have to provide an estimate of how much you will be able to spend each year in retirement.

o      You won’t have any leftover Social Security when you die, but you will probably have leftover personal savings unless you live to be very old.

If You’re Playing Along at Home

You can estimate your own expected income from personal savings now if you wish.

A simple estimate of how much you will be able to spend in retirement is the sum of your expected Social Security benefits from Part 1 and 4.46% of your expected personal savings account balance on your retirement date. If you are vested in a pension plan, you can add that, too.

Expand the table from Part 1 by entering your expected personal savings balance on the day you will retire in row (d). Calculate 4.46% of your expected personal savings and enter in row (e). 

If you are vested in a company’s pension plan, add the expected annual income in row (f). Add the amounts in the “You” column to those in the “Spouse” column and enter the sum in the “Combined” column.

We will develop a better estimate later, after we have decided when to retire and how best to invest our personal savings after retirement, but for now, we have provided an initial rough estimate of expected income.

(a) Monthly benefits at earliest retirement age ____

(b) Monthly benefits at full retirement age ____

(c) Monthly benefits at age 70

(d) Expected personal savings

(e) TIPs portfolio income. (Multiply row (d) x .0446 then divide by 12)

(f) Pension benefits

(g) Total expected retirement income at full retirement age. add rows b, e and f.

For reference, here is the table completed for John and Sara from Part 1:

(a) Monthly benefits at earliest retirement age 62
(b) Monthly benefits at full retirement age 66
(c) Monthly benefits at age 70
(d) Expected personal savings

(e) TIPs portfolio income. (Multiply row (d) x .0446 and divide by 12)

(f) Pension benefits

(g) Total expected retirement income at full retirement age. Add rows b, e and f.

[1] Some of your heirs may be entitled to Social Security survivor’s benefits based on your lifetime earnings, but these are independent of how much you collected in Social Security retirement benefits during your lifetime, so they aren’t really “leftover” money.
[2] Vanguard Inflation-Protected Securities Fund Investor Shares (VIPSX), for example.
[3] iShares Barclays TIPS Bond ETF (TIP), for example.
[4] “The 4% Rule - At What Price?”, p. 8, April 2008. Social Science Research Network

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