Posted February 8, 2010: Revised January 2015 – John Spitzer & Todd Houge
During our working years, most of us depend upon wages and salary income to meet our living expenses. Then, with retirement, we shift to other sources of income to meet our needs. There are three broad sources for our retirement income: Social Security, private pensions and annuities that pay as long as we live, and our personal investments. In this section, we review some important principles regarding these three components, outline the important features of each, and then provide our views regarding how best to use them.
Some Important Principles
Retirees generally have two major financial concerns – that they may outlive their money and that inflation will erode the value of their money to the point where their needs can no longer be met. The three different sources of retirement income differ in their ability to address these concerns:
Social Security addresses both concerns rather well. Once you begin drawing Social Security, you receive benefits as long as you live. Thus, you cannot outlive those resources. Social Security benefits are also indexed to inflation, which protects against our second concern. However, Social Security benefits are indexed to the Consumer Price Index (CPI), and the rate of inflation on goods and services purchased by seniors, especially the cost of health care, may deviate substantially.
Private pensions and annuities also address the “outliving my money” concern quite well – as with Social Security, payments continue as long as you live. Protection against inflation is more varied with these instruments, however. Most private pensions and many annuities are not indexed to inflation, but some annuities do offer inflation protection.
Our personal investment portfolios do not naturally guarantee protection against “outliving my money” nor do they provide natural protection against the ravages of inflation. On the other hand, investment portfolios do provide more flexibility (I can take a large withdrawal to meet a special need) and, in the event that I die in the early years of my retirement, the unused part of the portfolio passes to my heirs. We also have the ability to allocate a portion of these portfolios in investment securities that may afford some level of inflation protection, such as Treasury Inflation Protected Securities (TIPS).
Before we move on to the detailed features, let us recall some useful history with regard to Social Security. Contrary to some commonly-held views, Social Security was never intended to provide all of the income for an individual’s retirement. Rather, at the time Social Security was established, it was expected that Social Security would contribute about one-third of the total, with pensions contributing another third, and the remaining third coming from personal savings. In our view, those roughly equal shares still represent a reasonable approach.
If you pay Social Security taxes (FICA) for at least 40 quarters (10 years), you are eligible to start receiving retirement benefits at age 62. The payment amount is based on the highest 35 years of your earnings, with those earnings adjusted for inflation. The Social Security Administration website (http://www.ssa.gov) provides resources to estimate the level of benefits you will receive.
You may also choose to defer drawing benefits until you are older. The level of benefits increases substantially if you wait until “full retirement age,” and the starting income level increases further if you continue to defer taking the benefits beyond the full retirement age – up to age 70. Once you start taking the benefits, the payment amount is indexed to inflation.
Your full retirement age depends upon your birth year, as shown in the table below.
|Year of Birth||Full Retirement Age|
|1937 and prior||65 years|
|1938||65 years and 2 months|
|1939||65 years and 4 months|
|1940||65 years and 6 months|
|1941||65 years and 8 months|
|1942||65 years and 10 months|
|1955||66 years and 2 months|
|1956||66 years and 4 months|
|1957||66 years and 6 months|
|1958||66 years and 8 months|
|1959||66 years and 10 months|
|1960 and later||67 years|
There are no income limitations on your Social Security benefits once you have reached the full retirement age. But, if you begin taking Social Security benefits before reaching full retirement age and you continue to work, your Social Security benefits may be reduced significantly. In 2015, employees below the full retirement age who have earnings greater than $15,720 will have their Social Security benefits reduced by $1 for each $2 earned above the $15,720 limit (with some adjustments during the year that full retirement age is reached).
Fortunately, “non-work” sources of income do NOT count as earnings. “Non-work” sources of income include inheritance payments, pensions, income from investments, IRA distributions, and payments of interest.
Social Security retirement benefits receive favored treatment from the Federal income tax authorities. The taxation of the benefits is based on the sum of your Adjusted Gross Income + Tax Exempt Income + ½ of your Social Security Benefit. There is no Federal income tax on the Social Security benefits if this sum is less than $25,000 for single filers, or $32,000 for joint filers. If the sum exceeds those limits, a portion of the Social Security benefits is taxable – the portion increases to a maximum of 85%. (For more complete details, see http://www.socialsecurity.gov/planners/taxes.htm). Note, this does NOT say that the tax rate is 85% — put differently, in the worst case 15% of the benefits are tax-free, and the remainder is taxed at ordinary rates.
The State of Iowa eliminated its tax on Social Security benefits in 2015.
Private Plans That Pay As Long As You Live (Pensions & Immediate Annuities)
Prior to the advent of 401k plans, many private companies paid pensions to their retired employees – typically a fixed monthly payment for the life of the retiree. The payment amount was usually based upon a combination of the number of years the employee worked at the company, and the level of earnings.
These plans are called “defined benefit plans” because the level of benefits is guaranteed by the company (or the financial institution under contract with the company). In contrast, “defined contribution plans” such as 401k plans do not guarantee any specified payment amount in retirement. Although most companies have shifted to 401k plans, there are still some companies that have defined benefit plans.
Another way to address the concern of outliving your money is to purchase an immediate annuity. The general principle is straightforward: you pay a relatively large amount of money now, and you receive a regular payment for as long as you live. Thus, as with Social Security and with pensions, you cannot outlive the income stream coming from an immediate annuity. At the time when companies first started replacing defined pension plans with 401k plans, it was envisioned that retiring workers would “annuitize” much of their investment portfolios from their 401k accounts. As such, it was envisioned that the 401k would be a close substitute for the defined pension plan that it was replacing.
Immediate annuities are offered by life insurance companies, which is a good fit for them. The pricing of the annuity (the size of your regular payment relative to the amount you have to give them) is determined by your expected remaining life – just the kind of calculations life insurance companies do.
Immediate annuities typically offer several useful options. Many of us need to provide retirement income for our spouse and need to provide that income in the event that our spouse lives longer than we do. To address this need, the annuity can be structured to keep paying as long as either spouse is still living. Also, many of us have difficulty with the thought that we might purchase an annuity and then die before we have received anything close to the amount we paid. For this concern, annuities can be structured to pay at least as long as a specified guaranteed period.
Immediate annuities also offer some options to address inflation concerns. Vanguard offers an annuity that is indexed to inflation, with a 10% per year cap. You can purchase an annuity with automatic increases in the payment amount but, of course, the protection from this fixed increase may not match the actual rate of inflation very closely.
You can also purchase an annuity where the payment adjusts with stock market returns in an attempt to hedge inflation risk. True, historical stock returns have shown a remarkable resilience to inflation. That resilience, however is a long-run effect – in the short term, inflation has had a pronounced negative effect on real returns from stocks. For many retirees, the relevant time horizon is short term rather than long run. And, of course, you could ignore inflation and purchase an annuity with fixed payments, but that approach almost guarantees that the purchasing power of your annuity-based income will erode during your retirement.
How much do you have to pay for an annuity? The price depends upon your age and the options you select, such as how much you want the annuity to pay a surviving spouse and the length of a guaranteed period you desire. You can obtain prices online at sites such as Vanguard.com at this webpage.
To give you a rough idea for the costs of an annuity, we recently used this Vanguard website to price an immediate annuity for a married couple, both age 67. For this example, we priced an annuity that will pay $1,000 per month ($12,000 per year), for as long as either the husband or the wife is still living, with a 3% annual increase in the payment amount (to counter inflation). We also selected options that guarantee the couple or their heirs will receive at least as much back as they pay for the policy.
The price of the policy in this example was about $240,000. (The Vanguard annuity that increases the payments by the CPI – with a 10% cap – costs about the same amount.) Put differently, you would receive annual payments that are initially about 5% of the amount you pay to the annuity company, and the payments increase annually by 3%.
The tax treatment of the payments you receive from an annuity depend upon the extent to which taxes were paid on the funds you used to purchase the annuity. If you used funds upon which all taxes had been deferred (such as funds from a traditional 401k plan), the entire payment is taxable at ordinary rates. If you use funds from a Roth account, the entire payment is tax-free. If you use after-tax dollars to purchase the annuity, but the funds are not from a Roth account, the payments comprise a mix of principal (tax-free) and interest (taxable at ordinary rates). The mix is based upon mortality tables. If you receive enough payments that you have recovered your entire principal amount, the rest of the payments are 100% taxable at ordinary rates.
A word of caution: the annuities terminology is confusing – in particular, do not confuse immediate annuities with variable annuities, also called tax-deferred annuities (TDAs). As we have discussed, with an immediate annuity we pay a substantial amount now in return for receiving a stream of payments until we die. In contrast, a variable annuity looks very much like an IRA where I contribute after-tax dollars whenever I wish to do so, in amounts of my choosing, and I direct the funds into investments of my choice from a menu. For a more complete discussion of variable annuities, click on Tax-Deferred Annuities in the Tax Shields component.
Using Investments for Retirement Income
Suppose you project that you will have $240,000 in your portfolio at the time you and your spouse retire at age 67. As shown above, you can plan to convert the portfolio into an annuity, which will generate an initial annual payment of $12,000 that increases 3% each year, for as long as either of you are still living, and with a guarantee that you or your heirs will receive at least $240,000 in payments. But perhaps, like many others, you are reluctant to convert the portfolio into an annuity and would prefer to draw upon the portfolio directly for your income needs. How much can you safely withdraw from the portfolio each year without running out of funds?
Financial gurus generally recommend that you draw no more than 4.0-4.5% of your portfolio each year during the early years of your retirement. It is particularly important that you not deplete a portfolio significantly during the early years of retirement – a high withdrawal rate in combination with a sharp decline in the market will greatly increase the probability that you outlive your portfolio.
The gurus also generally recommend that you structure your portfolio as a conservative mix of stocks, REITs, bonds, and cash. The dividends and interest from such a portfolio will typically fall short of the target withdrawal rate (because much of the return from stocks comes from increased value rather than dividends). As a result, you will likely need to sell assets from your portfolio on a regular basis.
Many people find it difficult, psychologically, to sell securities during bear markets. An approach that we find attractive is to use a “liquidity buffer” – divide your portfolio into a “main portfolio” (holding your more volatile investments, such as stocks and real estate investments) and a “liquidity buffer” that holds cash and bonds or CDs. This “liquidity buffer” is a laddered portfolio of cash and bonds (or CDs) to cover the next 5 years of your income needs.
If you plan to withdraw 10,000 each year, you would start by creating a $50,000 liquidity buffer. The components of this liquidity buffer would be $10,000 in cash, $10,000 in bonds or CDs that mature in 1 year, $10,000 in bonds that mature in 2 years, $10,000 in bonds that mature in 3 years, and $10,000 in bonds that mature in 4 years. This structure is shown in the table below:
During the first year of retirement, you withdraw from the cash component for your income needs. At the end of the year, $10,000 of bonds mature and go into the cash account. Under normal circumstances, you would then liquidate $10,000 of your main portfolio, using the proceeds to buy a bond (or CD) with a 4-year maturity. So, in normal circumstances, you reestablish the initial liquidity buffer every year.
If the assets in your main portfolio are seriously depressed, however, then you do not immediately fill the 4-year slot of the bond ladder. Rather, you wait for the markets to rebound and then you fill all the empty slots in the ladder. With this approach, you can withstand a “down market” of 5 years duration. Thus, the ladder of bonds serves as a buffer to smooth the variation in returns from your more volatile investments. If you wish to be more conservative, you can create an initial ladder of longer duration.
With the buffer structure, the “main portfolio” must be large enough to generate an expected annual return equal to the annual income needs. You also need to allow for inflation. Using a 5% real (net of inflation) expected return on the main portfolio (in our view, 5% is a reasonable expectation for future real returns for stocks), you would need a $200,000 main portfolio to generate the $10,000 annual income in the example above. Thus, you would have a total portfolio of $250,000 and you would be drawing $10,000 per year – a 4% withdrawal rate.
As a general matter, we like Social Security’s characteristics a lot – you cannot outlive your money, the benefits are indexed for inflation, and at least some of the benefits are exempt from income taxes. We also like immediate annuities with adjustments for inflation, and we like the buffer structure for drawing upon a portfolio to generate income.
What mix do we recommend? Our first recommendation is to separate your retirement income into two components: “must have” (housing, health costs, food, and other basic living expenses) and “want to have” (travel, leisure, entertainment, etc.).
Income for “Must Have” Income
For the “must have” component, we like guaranteed payments – Social Security, pensions, and annuities. So, if your pension and Social Security do not meet your “must have” needs, we generally recommend annuitizing enough of your portfolio to cover the shortfall.
You may find it advantageous to shift your mix more towards Social Security. If you defer taking Social Security, the Social Security payment level increases significantly up to age 70. Rather than taking Social Security and purchasing an annuity at the time your retire, it may be cost effective to use cash to cover your income needs until you reach age 70, and then buy an annuity to meet your (reduced) shortfall. We recommend doing the calculations to see whether such a shift would be cost effective.
If you have a low tolerance for risk, you might annuitize more of your portfolio. Alternatively, if your portfolio is large enough to permit you to take a more aggressive approach, you could annuitize less than the shortfall amount and plan to cover it with portfolio withdrawals.
Income for “Want to Have” Income
For the “want to have” category of retirement income, we generally recommend drawing from your investment portfolio. Again, if you are risk-averse, you might purchase a large enough annuity to cover some (or all) of your “want to have” needs.
For drawing from your portfolio, we like the “buffer” structure approach. The gurus agree that a portfolio for generating income should contain some fixed-income assets, such as bonds and cash instruments. We think it is a good idea to use those fixed income instruments as your buffer. The buffer approach provides some reasonable guidance for how much to put into fixed income, and provides a psychological cushion during down markets that we find particularly comforting. The buffer approach also serves to automatically perform some portfolio rebalancing during down-markets (as you draw down the buffer, the relative share of the volatile assets increases), but without the angst of having to consciously buy more securities as the prices decline.
- Retirement Benefits – SSA Publication (Apr. 2013). Social Security Online, www.ssa.gov/pubs/10035.html
2. Retirement Planner – Retirement by Year of Birth. Social Security Online, www.ssa.gov/retire2/agereduction.htm
3. Exempt Amounts Under the Earnings Test. Social Security Online, www.ssa.gov/OACT/COLA/rtea.html
4. Vanguard Lifetime Income Program – Get an Instant Quote, https://investor.vanguard.com/what-we-offer/annuities/get-guaranteed-income?Link=facet