One of the biggest fears in retirement is running out of money. Many people strive to save for most of their working lives, but turning that savings into actual income is a different story. Here’s a look at some of the most common retirement income strategies, as well as the pros and cons of each, according to a recent article from Forbes.
The 4% “Safe” Withdrawal Rate
This traditional approach involves withdrawing about 4% of the initial value of your retirement savings and increasing that amount each year to counter inflation. So, if you retire with $1 million, you would withdraw 4%, or $40,000 in the first year, increasing that amount with inflation each successive year.
Pro: Developed in the early 1990s by financial planner William Bengen, this strategy is very simple and based on real world scenarios. Bengen studied every 30-year period starting with 1926 and found that this was the highest safe withdrawal rate, assuming a simple portfolio of 50% large cap U.S. stocks and 50% intermediate term bonds. The method was later backed by three finance professors at Trinity University in what is referred to as the “Trinity Study.”
Con: Some industry experts claim the method is no longer safe, arguing that none of those historical periods had the current combination of low bond rates and high stock valuations. And when you add in the possibility of higher inflation and longer average life spans, this strategy might not be as “safe” as it once was.
The 7% “Optimal” Withdrawal Rate
One of the 4% critics, Wade Pfau, has argued that some retirees may be willing to take a larger risk of depleting their savings or reducing their income later in retirement in exchange for more income early on. Pfau proposes a 7% initial withdrawal rate as a more “optimal” balance between the competing demands of higher income and preserving retirement savings.
Pro: 7% would provide almost twice as much income as the traditional 4.
Con: Pfau admits that a 7% withdrawal rate is not technically “safe” as it had a 57% chance of failure over 30-year time frames. Those utilizing this strategy would need to be highly risk-tolerant with a higher stock allocation and have enough income from other sources like Social Security and pensions ot cover basic living expenses later in life.
When you purchase an income annuity, you trade a lump sum of cash for a guaranteed income from an insurance company as long as you live. Annuities can be purchased with inflation adjustments, the ability to access some of the principal and death benefits to a survivor. However, these features typically reduce the income payments you receive.
Pro: This strategy provides the highest income stream without the risks of high withdrawal rates. An example of this would be a 65-year-old man in California who purchases a guaranteed annual income of over $63,000 for life with a $1 million lump sum payment. That’s 50% more than he would get with a 4% withdrawal rate, without the market risk.
Con: You usually lose access to your principal and the ability to grow it and pass it on to your heirs. Also the guarantee is also only as good as the health of the insurance company who issued it.
Living Off Investment Income
Instead of withdrawing principal and risking depletion, you can simply live off of the the dividend and interest income.
Pro: You don’t have to worry about running out of money.
Con: With 10-year treasury notes paying less than 3% and the S&P 500 yielding less than 2%, this strategy provides the lowest total income. Your income would also fluctuate with interest rates and dividend yields, making it difficult to budget.
“Spend Safely in Retirement Plan”
The Stanford Center for Longevity and the Society of Actuaries studied 292 different retirement strategies before coming up with their “ideal plan.” This consists of delaying Social Security benefits to age 70, withdrawing 3.5% of your nest egg from age 65 to 70, and then using IRS required minimum distribution tables to determine withdrawals from all of your retirement accounts starting at age 70.
Pro: This strategy avoids the risk of running out of money without sacrificing principal involved with buying an income annuity or the sacrifice of income involved with living off just investment income.
Con: Your income will fluctuate with retirement account balances throughout retirement, making it difficult to budget.
The strategy that is best for you will largely depend on your own personal values. Discussing your options with a trusted financial advisor is always recommended before you retire.
Written by Rachel Summit