Running out of money before you run out of life.
It’s the biggest fear many retirees face. And, for baby boomers and
succeeding generations without guaranteed pensions, it’s not just a
night terror — it’s a realistic concern. Without adequate savings, a
prudent lifestyle, and regular financial checkups, running low in
retirement is a very real possibility.
In my last article I reviewed the two fundamental
solutions when you find yourself running low in retirement — reducing
expenses, and increasing income.
In that article, I went deeper into the two most powerful
expense strategies
: cutting discretionary spending, and downsizing your home. These are
major levers you can throw on the expense side to modify your lifestyle,
and salvage a financially independent retirement.
But they might
not be enough. Or you might want to go further to ensure your comfort or
security. So in this article I’ll explore the
income-based solutions to running low in retirement.
As I’ve written, to be realistic, a retirement backup plan needs to be entirely
under your control. It can’t rely on good fortune, the benevolence of others, or external economic conditions.
So,
we won’t be discussing either working or inheritances here. Maybe you
could return to some work in retirement. But that generally requires a
cooperative economy or employer. And it may not be physically possible
for older retirees. Or, maybe you can count on inheriting some family
wealth, eventually. But inheritances are dictated by the life span and
spending habits of others. You shouldn’t pin your baseline retirement
comfort on factors you can’t control.
If you have investments, you
may be tempted to try picking “better” ones that would outperform the
market. But decades of research prove that it is impossible to
consistently beat the broad market indexes. Not only do the majority of
active stock pickers fail, but they also usually generate higher
expenses along the way — a major headwind to success.
If your investment portfolio is very conservative — largely in cash, CDs, or bonds — you
could
allocate more to stocks to increase returns. But holding more stocks
than is suitable for your risk tolerance is a dangerous game. You might
bail out at a loss when the going gets tough. And it will get tough.
Because, to potentially increase returns, you must add volatility to
your portfolio and take on more risk of
reducing returns. Selling at a loss would damage your perilous retirement finances even further.
Fortunately,
you can still access a couple of powerful income-based strategies. You
needn’t go back to work, hope for an inheritance, pick stocks, or change
your asset allocation. There are other legitimate and safe approaches
to increasing retirement income. But, they carry a critical
prerequisite: You
must have some assets — either investments or a home — to begin….
Annuitizing
The
first strategy for safely increasing retirement income is to purchase a
fixed annuity. I prefer the plain vanilla single premium immediate
annuity . With this type of annuity contract, you pay the insurance
company a lump sum, and they then pay you a monthly income for life.
There is no variability — no “upside,” or “downside” — in the income
stream, other than perhaps inflation adjustments, if you pay for those.
And fees are easy to assess, because you know precisely what you’ll pay,
and precisely what you’ll get back, and when.
Fixed annuities are
generally invested in bonds, yet they can pay more than the going rate
on a typical bond fund. That is, they can substantially increase your
investment income over what you could accomplish with your own
investments, given a similar level of risk. How do they do that?
The
first reason is simple: An annuity returns some of your principal to
you, along with interest payments. That means you are consuming
principal. When you purchase an annuity, you give up control over your
principal and, in return, the insurance company returns portions of it
to you over time to increase returns. But, you probably won’t get it all
back unless you live longer than expected.
The second reason that
an annuity can enhance returns is more complex. It’s called mortality
credits — the technical term for the benefit you get by pooling your
money with a large group of other people.
Individuals don’t know
their lifetime in advance. If you’re managing money on your own, you
must live conservatively to ensure you don’t run out. By contrast, an
insurance company can know the statistical lifetimes of a large group
quite accurately. That means the company can pay everybody a better
income than they could afford on their own, confident that some
individuals will die earlier than average, leaving assets to pay the
incomes of those who live longer.
Add up both of these factors and
you get a powerful result: When you purchase an annuity, you can
usually increase your effective investment income yield by
several percentage points,
depending on your age. As a rough example, consider that as I write
this, the SEC Yield on Vanguard’s Intermediate-Term Bond Index Fund
(VBIIX) is about 2.5%. Yet ImmediateAnnuities.com reports that an
equally safe fixed immediate annuity can pay a 65-year-old couple about
5.7% — more than 3 percentage points higher.
So, your liquid
assets, whatever they may be, can go much further in providing
retirement income as an annuity. Just understand that an annuity is not
like your other investments. You don’t have access to your principal. So
the downside, if you must put most of your assets into an annuity, is
that it reduces or eliminates your cash reserve for dealing with
unexpected expenses or leaving a legacy. But your heirs would probably
prefer that you be self-supporting, even if it means they lose out on an
inheritance. And an annuity can be instrumental in achieving that
primary objective — baseline retirement security.
Reverse Mortgages
What
if your investment assets are minimal or you’ve already maximized your
income from annuities? Is there somewhere else you can turn to produce
more retirement income? Yes, if you own or have substantial equity in
your house, there is. It’s a somewhat complex and checkered financial
product that has recently become more palatable. As noted retirement
researcher Wade Pfau writes, “…recent research has demonstrated how
financially responsible individuals can improve their retirement
sustainability with a
reverse mortgage.”
A reverse mortgage lets you generate income from your home
equity, guaranteed for life as long as you stay in your home. You, or
your heirs, may not own your home in the end, but you’ll never owe more
on the loan than the value of your home. Government insurance protects
you if the bank has problems producing income, and it protects the bank
if you should consume all your equity before dying. From your
perspective, the advantage is clear: using only your home, without
requiring any additional assets, you now have access to an income stream
that will last as long as you do.
Though recent reforms have
reduced the costs and risks, reverse mortgages are far from a perfect
solution. In my opinion, they should be considered a last resort. They
remain complex, and expensive. They are sometimes sold aggressively in
inappropriate situations. Used recklessly, they could result in losing
your home. Why? Because you still must have cash flow to pay for taxes,
insurance, and maintenance, or risk default. Given the expense and
downside, the government requires financial counseling for reverse
mortgages in most cases. But they are a legitimate choice in the right
circumstances.
The biggest downside to a reverse mortgage in my mind is the
expense.
The transaction costs are similar to buying a home. At settlement there
will be an origination fee (shop around for the best deal: only the
maximum
is set by the government), an upfront mortgage insurance premium
(generally 0.5% of the appraised value), and other typical real estate
closing costs. Then, for the life of the loan, the lender will draw down
your home equity to pay its interest charge based on the market rate,
an FHA insurance premium of 1.25%, and possibly a servicing charge.
Those long-term charges will substantially erode your wealth, even
though the effects may be hidden and muted by the regular income.
In
my example calculations, about 5-7% of the available home equity
disappears into fees at the start of a reverse mortgage. Then there are
the monthly charges compounding for the life of the loan after that. If
there is a cheaper way you can generate retirement income than a reverse
mortgage, you should choose it instead. My figures show a reverse
mortgage generating about a 3% draw against your total home equity for
life, not adjusted for inflation. Compared to getting
zero, that’s pretty good. But compared to annuitizing, or probable stock market returns, it’s nothing special.
The second biggest downside to a reverse mortgage is the
complexity.
The more complicated a financial instrument, the harder it is to
determine the risks and value. You may have to rely heavily on mortgage
professionals to understand and compare offerings. Two online
calculators that I found useful in this process were from the Mortgage
Professor and the National Reverse Mortgage Lenders Association (NRMLA).
Despite
the drawbacks, reverse mortgages will likely be the best retirement
income solution for many people who are “house poor” — stuck in large
homes with inadequate cash flow. Downsizing would be preferable, but
reverse mortgages are another option. Scott Burns writes, “Used for long
term planning rather than emergencies, reverse mortgages are likely to
become a major tool for the millions of Americans who have a lot more
equity in their homes than in their retirement savings.”
Example
How
do these income-based strategies work in practice? For a typical
retired couple, what is the potential financial benefit of annuitizing
and taking out a reverse mortgage? To answer these questions, let’s
analyze a simple scenario….
Assume a couple, both age 65, that is
concerned about their ability to meet retirement expenses going forward.
They have $500K in total saved investment assets, and they own their
$250K home, free and clear.
For an initial retirement income
strategy, they could try systematic withdrawals from their investments
using a “safe withdrawal rate” (SWR), expected to preserve their assets
over a 30-year retirement. What is that SWR these days? Well, it’s
probably less than the historical 4%. In fact, Wade Pfau recently argued
that it’s more like 2% . But, for our example, let’s give systematic
withdrawals the benefit of the doubt, using a slightly more optimistic
3% SWR.
At a 3% SWR, this couple’s $500K in investments can safely
generate about $1,250/month in inflation-adjusted retirement income.
Coupled with Social Security, that might be enough, but it could be very
tight, depending on their lifestyle. What if they want to live less
frugally, and are willing to give up some control of their principal?
Well,
as I write this, ImmediateAnnuities.com will let them buy an annuity
with those investment assets that generates about $2,400/month. And the
NRMLA reverse mortgage calculator shows they can take out a reverse
mortgage on their home to generate about another $700/month for life.
That’s a total of about $3,100/month in guaranteed retirement income.
So, by annuitizing plus using a reverse mortgage, this couple is able to
nearly triple
their available monthly retirement income versus what could be achieved
using a safe withdrawal rate for their investments alone! By virtue of
having some assets — investments and a home — and choosing to give up
some control over their principal, they can significantly boost their
retirement income. Though the final amount is not inflation-adjusted,
it’s likely to exceed what they could safely draw from investments, for
decades to come.
Conclusion
So that’s it. This article and the last have provided the ingredients for a backup plan on both the
expense and
income
sides of retirement. The strategies I’ve described give you leverage to
preserve a comfortable retirement, without charity from the outside,
even in some of the worst-case financial scenarios.
The essential strategy for increasing retirement income is this: You give away some or all of your
principal
in exchange for more income. That also means that you lose some
flexibility — for handling emergency expenses, gifting, or inheritance.
But, in return, you get the peace of mind of guaranteed income for life.
Running
low in retirement would be a nightmare. But there are solutions to keep
you safe. If you are in this particular boat, you may have to give up
pride of ownership in the vessel, but at least you can keep it afloat
for the duration of the voyage!
Culled from money in yahoo fiannce
