Planning Your Rest-of-Life: How Much Money Do You Need?

If you take care of your health, it's quite possible that you might live to 90, 95 or even 100. So if you retire in your sixties or seventies, you might be retired for 20 or 30 years--maybe longer. That should be a good thing--except if you run out of money in your seventies!

Unless you have significant benefits from a traditional pension plan, which provides a lifetime monthly income, you should be obsessed with managing your retirement savings so you don't outlive them. Most Americans approaching retirement need this obsession, given the decline of traditional pension plans. Your goal: to spend your last dollar as you gasp your last breath. Of course, that's much easier said than done.

Unfortunately, when it comes to drawing down their retirement savings, many people simply "wing it." They withdraw what they need for living expenses and hope their money will last. Well, hope is not a good strategy!

Instead of hope, let me show you a better strategy and three methods to draw down and invest any type of retirement savings you have, whether that's a 401(k) plan, 403(b) plan, 457 plan, traditional or Roth IRA, or just a savings account that has no special tax features.

The Overriding Strategy

The most important retirement strategy you can adopt is this: Don't consider your retirement assets to be money you can spend in retirement. I know this sounds weird, but stay with me for a bit.

Here's the concern: Let's say you have a few hundred thousand dollars or more, and because that seems like a lot, you spend money without considering how to make it last for your lifetime. Before you know it, your resources have dwindled significantly and you're faced with hard choices: return to work, drastically scale back your living expenses, or check into Club Dead.

What you should do is consider your retirement investments to be a monthly paycheck generator. Then, spend no more than this paycheck. Most of us live paycheck to paycheck while we're working; let's not stop when we retire.

To determine the size of your monthly retirement paycheck, use one of the three methods described below. These methods are designed to generate a lifetime retirement income, no matter how long you live. They can also provide protection against inflation--another important goal.

Drawdown Method 1: Spend Just Investment Income

Spending just your interest and dividends virtually guarantees you won't outlive your money. With a portfolio balanced between stocks and bonds, your annual income can range from 2-1/2% to 4% of your account balances; your actual rate will vary, depending on the specific asset allocation and the portfolio's emphasis on income-producing stocks.

This method works if the investment income your accounts generate is enough to cover your living expenses. It's also the best method if leaving money to your children or charities is important to you. Of the three methods discussed in this newsletter, this one has the highest chance of making your money last for your lifetime while protecting against inflation. However, it produces the lowest initial amount of retirement income, compared to the other two methods.

This method has two other advantages:

The volatility of the dollar amount of interest and dividend income from a diversified portfolio of stocks and bonds is much less than the volatility of the value of the underlying portfolio. This helps you ride out severe market downturns like the one we're experiencing now.

It holds in reserve your principal for your later years, when you might really need it to pay for long-term care expenses or an unforeseen emergency, or if high inflation returns.

Drawdown Method 2: Spend Principal Cautiously

This method requires that you withdraw income and principal in a way that minimizes the likelihood that you'll outlive the principal. One rule of thumb that can help make this happen is to calculate 4% of your retirement savings balance at the beginning of each year, then divide by 12 to determine your monthly paycheck. If you're in your late sixties or seventies, you might be able to increase your withdrawal percentage to 5%.

A variation of this method applies the withdrawal percentage to your account when you initially retire. Then you stick with the resulting dollar amount of withdrawal for as long as possible--at least a year, but longer is better. Give yourself an increase for inflation when you really need it.

With this method, there's still a chance you can outlive your resources, but the odds are low--about one in 10. There are online calculators that can help you determine the odds of running out of money with various withdrawal strategies. You can find one such calculator at www.troweprice.com.

This method is designed to withstand the worst scenario--a significant drop in the value of your investments early in your retirement. If this should happen, the goal of this method is to have sufficient assets invested when the market bounces back (as it typically has in the past). If you're withdrawing too much principal just before a market downturn, you might not have enough invested assets to recover.

This method works 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.

Since you're withdrawing principal, you'll need a smart cash management strategy. You should hold in liquid investments an amount equal to one or two years' worth of withdrawals, so you don't have to sell long-term investments such as stocks or bonds during a market downturn.

Drawdown Method 3: Buy an Immediate Annuity

Don't confuse immediate annuities with deferred annuities, which are investment vehicles that can have high expenses. Buying a straight-forward immediate annuity involves giving a lump sum of money to an insurance company; the company, in turn, pays you a monthly income for your lifetime. It's sort of a do-it-yourself pension.

When it comes to annuities, I prefer this straightforward type that simply pays you a fixed amount for the rest of your life. These annuities typically have the lowest transaction and commission costs. Acceptable variations include annuities that have specified increases built in for inflation and annuities that continue income to a spouse in case you die first. Both of these variations cost more, although the extra price can be worth it. Be careful with annuities that have bells and whistles with high costs and commissions, such as variable annuities that invest in the stock market but have a cap on market losses.

You can also now buy annuities online from brokers who shop among a handful of insurance companies to get the best deal; one example is www.immediateannuities.com. Pay attention to the safety rating of the insurance company; it's safest to use companies with one of the four highest ratings from S&P or Moody's.

An annuity typically has two disadvantages compared to the first two drawdown methods described above: You probably won't have enough left over to be able to leave money to children or charities, and you can't dip into your principal if an emergency arises. However, an annuity has one great feature that the other two methods don't have: You don't need to manage your own money. This might help if you get to the point where you're not as sharp as you used to be.

One Example, Three Ways

Suppose you've saved $100,000 for your retirement years. Let's compare how much annual lifetime income the three methods I've described above will generate.

Spend just the investment income: Assuming the dividend and interest rate of your assets is 3% per year, then 3% of $100,000 is $3,000 per year.

Spend principal cautiously: At a 4% drawdown rate, 4% of $100,000 is $4,000 per year. A 5% drawdown rate would produce an annual income of $5,000 per year.

Immediate annuity: In January, 2009, www.immediateannuities.com shows that $100,000 would buy a fixed annual income for a 65 year-old man of about $8,500. A 65 year-old woman would receive about $7,900; a married couple would receive about $6,900 until the last person dies.

With the annuity providing a much higher income than the first two methods, why wouldn't you put all your money in an annuity? Remember that an immediate annuity is typically fixed, while your annual income under the first two methods should increase with favorable investment returns. Plus, there are two advantages that the first two methods have over an annuity: You can tap into your principal in an case of an emergency, and there's a very good chance that money will be left over for your children or charities.

Income Diversification

Now that I've described three different methods of investing and drawing down your retirement funds, it's important to point out that you don't have to choose just one of these methods. In fact, you probably shouldn't. And here's why.

You're probably familiar with investment diversification, where you spread your investments across different types of assets and invest in more than just a few securities. For our purposes, an important refinement of this concept is income diversification, where you use two or more methods of generating retirement income. This way, you can balance the advantages and disadvantages of each method.

For instance, it's not recommended that you put all your money in an immediate annuity. Instead, apply just a portion of your retirement savings to an annuity--say one-third to one-half. Then invest the remainder of your retirement savings in stocks and other assets that have the potential to protect against inflation; use one of the first two withdrawal methods for this portion of your savings.

The appropriate withdrawal method can also change as you age. For instance, in your "early" retirement years (through your late sixties or early seventies), you might want to use the first method--living on investment income. If this doesn't provide enough income, then work part time while you still can. You'll also have a fallback source of income if there's a significant downturn in your portfolio.

Then wait until your mid seventies or later to begin drawing principal and/or buy an annuity. This might coincide with the time you stop working altogether. With an annuity, you'll also get a better rate for waiting.

One more thought: Consider your circumstances. You may not need an annuity if you have significant lifetime income from a traditional pension plan, or if your living expenses are low and living on just interest and dividends produces enough income.

Traps for the Unwary

Many people withdraw significant amounts in their "early" retirement years and rationalize it by thinking they'll spend less money on travel and recreation in their later years. This is risky business! Medical and long-term care expenses are likely to increase in your later years and can easily exceed money spent on travel and recreation. This is yet another reason why it's smart to be prudent with your money in your early retirement years and supplement your retirement income with wage income.

Here's one more potential snag. If your money is in a 401(k), 403(b) or 457 plan, or a traditional IRA, you'll want to pay careful attention to the minimum distribution rules (Roth IRAs aren't subject to these rules). Once you reach age 70-1/2, the IRS requires you to withdraw minimum amounts from these accounts, or they apply significant penalties. This doesn't require that you spend this money; you can always withdraw the money and put it in a taxable investment account. Many online resources have details on these rules.

As you can see, determining what to do with your retirement funds isn't a "one size fits all" exercise. It's part art, part science. It takes patience, skill and understanding of the issues. It also helps you decide when you can retire: If using these methods doesn't generate enough income, then maybe it's best to continue working for awhile. This might be easier said than done in today's environment, but it's nonetheless a necessary goal.

It's well worth your time to learn about all the possible methods and figure out which combination works best for you. The last thing you want to do is spend too much money in your sixties and seventies, and then be forced to go back to work in your eighties because you've run out of money. Instead, you want to feel confident that you can afford to see your 90s--maybe even 100!

P.S. Keep an eye out for my April newsletter, which helps you answer the question "How Long Might I LIve?"