by Jonathan Goudy / Retirement Planning
The vast majority of those reading this submission find themselves, either currently or prospectively, saving for retirement using a defined contribution plan (such as a 401(k) plan), rather than the defined benefit pension plans that our parents or grandparents enjoyed. This is because few employers, other than governments, can afford to fund traditional pensions. Instead, we live with defined contribution plans, where our ultimate benefits will depend on our level of funding, our employer’s optional matches, and the performance of the securities markets throughout our lifetimes. Gone are the days when we would work for a corporation for 35 years and they would tend to our needs throughout our remaining lifetimes.
The new prototypical retirement involves our leaving our employer and:
- Rolling our 401(k) plan balance into an IRA that we manage ourselves or hire someone to manage for us.
- Collecting social security, depending on our ages when we start (waiting to age 70 maximizes our draw) and our work and social security payment history.
- Assembling our after-tax investments, such as securities accounts, investment properties, or our principal residence to determine what cash flow might be attainable.
We will discuss at another time the issue of proper investing of, and withdrawal rates from, retirement assets, assessing the likelihood of out-living our limited retirement assets, but let us discuss some sobering numbers:
- The federal General Accounting Office says around 29% of households age 55 and older have no retirement savings or accounts.
- The federal Census Bureau says the average net worth for an American age 55-64 (excluding home equity) is $45,447.
- Social security, with an average monthly benefit for retired workers of $1,354.04 as of October 2016, was intended to be a safety net or insurance policy, not a sole source of retirement income.
What can we do today to protect against outliving our retirement resources? Let us focus on a slightly more favorable example:
- Joe, age 70, has been making $150,000 per year but is retiring with an accumulated 401(k) balance of $1 million, that he is transferring to an IRA. Mary, Joe’s wife is also 70.
- Joe’s social security benefit, when he claims at age 70, will approximate $3,600 per month. Mary did not earn social security.
- Joe and Mary have non-retirement investments and savings of $500,000.
- Assuming 80% of prior salary in retirement, Joe and Mary would need $10,000 per month in cash flow.
- If they invested the IRA and withdrew 4% per annum, that $40,000, or $3,333.33 per month, would add to the $3,600 per month social security, leaving just over $3,000 per month shortfall to be paid out of after tax investment assets.
- What would happen if the markets had a 50% drop in value as happened in 2000 or 2008? The resulting $500,000 IRA balance results in $1,670 per month from the IRA at a 4% withdrawal rate, furthering the cash shortfall.
This is where we depart the accepted, conventional world of fee-only financial planning and stride boldly into the world of the commissioned brokerage industry. One solution to this risk and this cash shortfall is the use of a single payment immediate income annuity (SPIA). Let’s revisit our last scenario using the SPIA solution:
- Assume $500,000 of the IRA were used to purchase an annuity, payable for the joint life expectancy of Joe and Mary.
- $2,859.66 would be payable monthly during Joe’s life, decreasing by one-third upon his death, through Mary’s life.
- So long as Social security and the insurance company issuing the annuity survive, Joe and Mary will receive $3,600 + $2,859.66 = $6,459.66 per month until Joe passes and slightly less thereafter. Basically two-thirds of their cash flow nut has been covered by a pension that they created with social security and a SPIA.
- The projected $1,670 from the IRA (based on 4% of the $500,000 balance) and whatever can be generated from after tax investments should be able to make up the other third of needed cash flow. The IRA could be invested more robustly, because the annuity is supporting their cash flow needs.
Please note that interest rates are still near historic lows and the rates payable on SPIAs lock in at the time of purchase and will increase if and when market interest rates increase, making these numbers even better. If your retirement strategy can allow time for rates to rise, patience is encouraged.
In the past, annuities have been used to generate fees to brokers, to the potential detriment of the client. Placing expensive variable tax-deferred annuities into tax-deferred IRAs (“layering your tax deferral”) is tough to justify under a fiduciary standard. Nevertheless, there exist times and places for low-cost SPIAs in the crafting of your “do-it yourself” pension plan.
Remember, it’s not what you make that matters…it’s what you keep!
The general information herein is not intended to be, nor should it be treated as tax, legal, or accounting advice, nor can it be used for the purposes of avoiding tax penalties. Please seek advice from an independent tax advisor before acting on any information presented.