You want to retire, but you also want to make sure your savings will last. The primary risks to running out of money in retirement include a long life, poor returns and unexpected expenses.
A big part of protecting yourself from these risks includes generating a reliable, stable stream of income that will provide for your needs. How you do this depends on several factors, but one of the most effective is creating lifetime income.
Lifetime income is a payment that you can count on for the rest of your life, no matter how long you live. It provides an income baseline—regardless of whether you exhaust your other assets—and it helps protect against questionable decisions associated with mental incapacity, cognitive decline and fraud.
Research by TIAA and others suggests that covering about 2/3rds of your expenses with lifetime income sources decreases the risk of running out of money1. Look to cover these expenses with a combination of Social Security, benefits from a defined benefit plan or other fixed income and lifetime income annuities.
Types of lifetime annuities
Lifetime income annuities can be either fixed or variable. With a fixed income annuity, you are guaranteed a consistent income stream, although the guarantee is based on the claims paying ability of the issuer.
Payments from variable annuity accounts are not guaranteed and will fluctuate based on the performance of the underlying investments. The payments are guaranteed to last for your lifetime, but the amount may go up and down.
Consider choosing a combination of fixed and variable annuities. This balances the need for growing income to offset inflation with the need to avoid very large income reductions and the potential of running out. You can determine the ratio of fixed to variable by measuring your risk tolerance; the less risk you are willing to assume the higher the fixed income proportion.
Comparing withdrawal strategies
Let’s consider Pat. Pat has determined that he needs $80,000 per year to cover his basic expenses in retirement. He has Social Security and pension benefits that amount to $40,000 per year and he has $1 million in investment assets.
Pat is considering two strategies: a systematic withdrawal of 4% of his investments or purchasing an annuity.
Systematic withdrawal option
Pat could use a systematic withdrawal process of 4% of his savings per year. He has $1 million, which will provide him $40,000 per year. Over the long term this seems reasonable; however, there are a number of risks to this strategy:
A period of low interest rates could make his income-producing investments less likely to generate the expected return. Additionally, if inflation is high, he’ll need to withdraw larger amounts of money and the principal value of the assets could decline.
Both could result in erosion of his principal, and he effectively has no cushion against these risks.
Alternatively, if Pat had a lifetime income source of $20,000 and stuck with his plan to systematically withdraw 4% of his assets, he would need $500,000 to produce the difference between the lifetime income and the desired $40,000; any additional funds that he has would be a cushion.
It’s important to create an effective withdrawal strategy for your retirement savings assets, but the only investment you can purchase that provides income you can’t outlive is a lifetime annuity. Your financial advisor can help you review your lifetime income options within the context of your overall financial plan and develop a strategy that works best for you.