Finding retirement financial safety in most troubled times

Almost all investors have seen their stock portfolios tumble sharply over the past 18 months, and many fear more troubled times ahead. Unemployment is high, the dollar is weak, and the national debt is huge and growing. Americans are losing faith in their retirement plans.

For many, if not most of us, developing a plan to provide a guaranteed income stream for our retirement years, as outlined below, is our best option.

The facts for retirees are clear. We are living much longer—into our 90s is common—so we need our retirement money to stretch further than ever before. Inflation remains a constant threat to erode our purchasing power over time. With the volatile markets of the early 2000s and the last year and a half, many retiree investors might simply run out of money if they follow the conventional financial planning industry advice on income planning.

Industry experts have taught we can count on a 4 percent withdrawal rate from our retirement nest egg if we need income. For example, with savings of $200,000 we could safely withdraw $8,000 per year for our income needs. The thinking is, over time, retirees can achieve a 6 percent to 8 percent return on their investments and not run out of money; in fact, their portfolios should grow.

This type of income planning might work and actually exceed expectations if a person is lucky enough to retire in a market with a preponderance of good years in the beginning. This planning falls apart if one happens to retire during a market with a majority of bad years in the beginning, such as this decade with the technology bubble in 2001 and 2002 and the more recent economic meltdown of 2008.

With big market losses in the beginning of retirement, many retirees start to eat into their principal and easily can reach a point where their savings no longer support their current lifestyle. In other words, they will need to lower their lifestyle, or they will run out of money before they die.

The best income plan for many, if not most, retirees is to develop a plan that provides a guaranteed income stream to minimize the risk of stock market fluctuations. I base part of this belief on my own analysis and experience and part on recent and comprehensive academic research on this subject.The following excerpt from a white paper entitled “Investing Your Lump Sum at Retirement,” by David F. Babbel and Craig B. Merrill, fellows of the Wharton Financial Institution and Business School, sums up the matter.

“If you laid all the economists end to end, they still wouldn’t reach a conclusion. Well, that has changed, at least in one area, because economists have come to agreement from Germany to New Zealand, and from Israel to Canada, that guaranteeing a substantial portion of retirement wealth is the best way to go … the economists who have discovered this include Nobel Prize winners … and come from universities such as MIT, Wharton, Berkeley, Chicago, Yale, Harvard, London Business School, Illinois, Hebrew University, and Carnegie Mellon, just to name a few.”

There are two basic ways to develop a guaranteed income plan with retirement funds. In either case, first determine how much income you will need to cover your basics in retirement—food, utilities, and so on. Subtract this amount from your Social Security benefit and other incomes. The difference gives you the amount of income you will need from investments.

To cover this income need, many experts suggest the purchase of a guaranteed lifetime income plan from an insurance company. In exchange for a lump-sum deposit on your part, an insurance company will provide you a guaranteed income stream for the remainder of your life. The amount of the payment is based on many factors, but primarily on the amount you invest and your age. If this sounds familiar, it should. In the past, these were called pensions and were funded by your employer. The difference now is that you are providing your own pension.

An alternative to the above is to set up a series of so-called “buckets of money” to cover five-year periods of retirement, although there are no hard and fast rules here. This alternative gives a retiree much more flexibility, which is an obvious benefit. A four-bucket strategy could work something like this: The first three buckets would be created to provide safe, yet inflation-adjusted income to cover the first 15 years of retirement. The remaining assets would be placed in a fourth bucket and typically invested in a sound long-term equity portfolio for growth, which I will discuss below.

In the first bucket, designed to cover your first five years of retirement, typical investments could include money market funds, bank certificates of deposit (CDs), or the above mentioned guaranteed immediate annuities provided by an insurance company, but only to cover a five-year period.

In the second bucket, designed for retirement years six though 10, the idea is to seek safe, but slightly higher rates of return. Investments could include long-term CDs, deferred five-year guaranteed insurance products, or possibly short-term government-backed bonds.In bucket three, for retirement years 11-15, you’d still want to seek safety. Your time horizon, however, would be much longer—10 years before any proceeds would be needed for income. Accordingly, appropriate investments could include guaranteed indexed insurance products, government-backed bonds, and real estate investment trusts.

So let’s review. If you retire at age 66—the normal retirement age for full Social Security benefits—and you use the four-bucket strategy, you would have provided your income needs until age 81 without relying on stock market returns. This is a very appealing and prudent approach for the majority of Americans living today considering the volatility and uncertainly of short-term market returns.

Because stock market investing is still your best option for superior returns over the long term, you’d use bucket four for that purpose. According to Chicago-based Ibbotson Research, there never has been a 15-year period when the broad stock market, as measured by the S&P 500 index, produced a negative return. Further, there never has been a 20-year period when the broad stock market didn’t exceed the rate of inflation. To minimize risk, investors should diversify and plan on investing for a minimum of 15 to 25 years.

The goal for bucket four is to invest enough money long term at a realistic rate of return so that when buckets one, two, and three are exhausted, bucket four has grown to the point it would have as much or more money in it as when you first retired some 15 years earlier. This means you would have provided 15 years of dependable income while maintaining or growing your retirement nest egg. You could then develop an income plan for the next 10 to 15 years, or whatever period you deemed appropriate.

The advantages of guaranteed income planning in retirement are numerous, with safety and predictability being its hallmarks. In these days of uncertainty, as Martha Stewart would say, that’s a good thing.Kelly C. Ruggles, a fee-based financial planner, owns American Reliance Group Inc., a Spokane-based registered investment adviser, and is the author of “Financial Concerns For Retirement.”

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