Basic Retirement Planning Questions

How much income will you need in retirement?

This is one of those good news, bad news subjects. The good news is that many of the expenses you had during your working years have disappeared. The bad news is that a few new ones (e.g., higher health care costs, increased travel and leisure expenses) may have taken their place. As a general rule, people tend to underestimate their post-retirement income needs. While every individual situation is different, assuming that you'll need eighty percent of your pre-retirement income is a good starting point. Let's say this amounts to $80,000.

The next step is to determine how much of your target income will have to be provided by your accumulated savings. In many cases, income from part-time work, your national social security system, and from defined benefit pension plans in which you have participated while working will provide a significant share of your target income. The key trade-off here (besides work versus leisure) is between employment income and pension income. Make sure to check whether your state and private pension plans place any limits on the amount of employment income you can receive without having your pension income reduced. Let's say these sources amount to $30,000. That leaves $50,000 in annual income (i.e., $80,000 less $30,000) that our investor's portfolio of financial assets must provide after he or she retires.

Another important point to keep in mind when making these calculations is what happens after a spouse dies. That usually, but not always affects the income received from these sources. For example, if a defined benefit pension plan provides a lifetime annuity only to one spouse, then his or her death may result in a substantial drop in income for the remaining spouse. On the other hand, if a couple decides instead to take a joint annuity, the annual payments received will be smaller, but will not terminate until the second spouse dies.

What are your savings goals?

After retirement, people save for two main reasons. The first is to protect their desired standard of living against unforeseen reductions in their income or increases in their expenses. For example, the first might be caused by cuts in your pension income. It is no secret that national pension plans in some countries are coming under pressure as the number of workers declines relative to the number of retirees. While both tax cuts and increases in the minimum retirement age are potential solutions to these problems, so too are cuts in the benefits paid to retirees. On the other hand, the main risk to a private pension comes when the company sponsoring it goes into bankruptcy, or out of business altogether. Under these circumstances, retiree benefits are often a prime candidate for cost cutting.

A closely related precautionary savings motive would be to provide income for a remaining spouse if the death of the first spouse would significantly reduce pension income.

Protecting themselves against increases in expenses is another reason retirees have precautionary savings. While the most common example of this is the cost of long term care later in life (either at home or in a nursing facility), unexpected house or car repairs also fall into this category.

The second major reason retirees save money is to provide for bequests to others after they die. As a practical matter, there are really two kinds of bequests: those you plan for, and those that result from you dying earlier than expected. So having a good estimate of your remaining life expectancy is very important for post-retirement investment management. One way to think about a bequest is in terms of a multiple of your annual portfolio income. Let's say, for example, that our investor wants to leave a bequest equal to ten times his or her annual portfolio income, or $500,000.

How long do you expect to live?

First, the good news. Studies have shown that retirees and near retirees are actually quite good at predicting their own expected remaining years of life (see, for example, "Perception of Mortality Risk: Implications for Annuities" by Drinkwater and Sondergeld). Further evidence of this is provided by the life insurance industry, which has found that people purchasing annuities (who derive maximum benefit only if they live for a long time) actually live longer than what standard mortality tables would predict.

The bad news, however, is that the chance you will outlive your savings, and suffer a sharp drop in your standard of living (known as "longevity" or "mortality" risk) usually gets less attention from retirees than concerns about their health and their investment returns.

One way to assess this risk is to look at standard remaining years of life tables, like the following one that comes from the US Social Security Administration, which shows estimated remaining years of life at different ages. Unfortunately, tables like this only show the "most likely" remaining life expectancy; in practice, there many outcomes on either side of this estimate (though there are some life expectancy calculators available that claim to provide more accurate estimates after you enter health and lifestyle data).

Given this, there is no way to escape the need to make a trade-off when dealing with what is technically called"longevity risk (or, more practically, "outliving your savings"). There are four ways to manage this risk, as we will discuss in the next section, "should you annuitize your savings?"

Stacks Image 102

Should you annuitize your savings?

There are four ways to manage longitivtiy risk.

The easiest is buying longevity risk insurance. Products which offer longevity insurance are known as "annuities." Annuities promise to make payments to you over some period of time. These payments can be either fixed (i.e., not increase with inflation to keep their real value constant) or variable (i.e., payments rise with inflation). By investing in a real annuity, you avoid the risk of having inflation erode the purchasing power of your income over time. Hence, in this article, we focus only on real return (inflation indexed) annuities.

The simplest inflation-indexed annuity promises to pay you a fixed real income for as long as you live. More complicated products will also make payments for a period of time after you die (e.g. until a spouse dies). However, annuities come with two potential costs: first, they require a large up front premium payment, which is not available for use as a bequest if you die earlier than you expect. While annuities that guarantee a payout for a minimum number of years to some extent limit this potential cost, the financial consequences of dying too soon have caused many people to decide against purchasing an annuity and instead look for other ways to manage longevity risk.

Another concern is that, as the 2008 crisis made clear, since annuities are issued by insurance companies, they also carry some amount of credit risk. If the issuing insurance company goes bust, there may be little or no payout under the annuity (though there has yet to be a major insurance company bankruptcy where we have seen how this scenario would actually play out).

The second way to hedge longevity risk is to use a long expected life in your calculations. However, this has two potentially adverse consequences: it leads to a higher accumulation goal (which implies reduced consumption before you retire), and, if you die sooner than expected, it results in a higher than desired bequest.

The third way to manage longevity risk is to use your bequest goal as a buffer, drawing it down if you live longer than expected. Of course, this means that, depending on the returns you earn on your investments after retirement, you may not achieve your bequest goal if you live longer than you expect.

The fourth way to manage longevity risk is to assume a relatively low real rate of return on your investments after you retire. The lower the assumed rate of return, the easier it is to achieve. We believe that the four percent real compound rate of return we have assumed in our example is prudent for someone with a normal risk preference. Expected real rates of return above this would, in our estimation, imply a higher than normal tolerance for investment risk, as well as a higher probability of not achieving one's portfolio income and bequest goals.

Let's look more closely at annuities.

Probably no other subject causes as much confusion as annuities. So let's start with the basics. Essentially, an annuity is the mirror image of a life insurance policy. The latter protects your family against the risk of you dying sooner than expected. In contrast, annuities protect you against the risk of you dying later than expected (and thereby outliving your savings).

Both of them work the same way: a group of people who want protection against the risk in question pay premiums into an insurance fund. In the case of life insurance, payouts are only made when an insured person dies. Some people pay premiums, but never receive a payout before they let the policy lapse. In the case of a life annuity, payouts are made at regular intervals to provide income to policyholders, and stop only when the policyholder dies. When this happens soon after the annuity is purchased, the "annuitant" receives less than the premium he or she originally paid. However, when the person dies many years after the annuity is purchased, he or she often receives payments well in excess of the premium paid.

Annuities come in many different forms (our most recent in-depth comparison "To Annuitize or Not to Annuitize? That is the Question" may be found in our May 2006 issue or signup). Two of the most important differences between them have to do with the length of time over which the payments are made, and whether they are fixed or variable.

With respect to the length of time, among the most important annuity types are "lifetime" annuities, which make payments only until the annuitant dies; "joint and last survivor" annuities, which make payments until the second of two people dies; "guaranteed term" annuities, which make payments for a guaranteed period, even if the original annuitant has died (with the remaining payments going to a designated beneficiary).

With respect to fixed and variable payments, some of the most important distinctions are between fixed payment annuities (where the amount remains fixed over time), variable annuities (where the size of the payment is tied to the performance of underlying investment accounts), and inflation indexed annuities (where the payment is increased with the consumer price index, to keep real purchasing power constant over time).

While annuities reduce the risk that you will outlive your savings (and suffer a drop in your standard of living), they do so at a cost.

First, they reduce the amount of money you have available for precautionary savings and bequests.

Second, they are not liquid -- once you have purchased one, it can be expensive or impossible to change your mind later. For this reason, studies have shown that using a portion of one's savings to purchase an annuity tends to be most attractive when (a) a person or couple expect to live for many more years; (b) they have relatively low income from other annuities (e.g., from national and private employer defined benefit pension plans); and (c) they are relatively more risk averse (see, for example, the paper "Private Pensions, Mortality Risk, and the Decision to Annuitize" by Jeffrey Brown).

Third, in today's low interest rate environment, life annuities have become much more expensive for any given target level of income.

In sum, annuitization remains perhaps the most difficult decision that retirees face. We strongly recommend discussing it with a financial advisor who has a fiduciary relationship with their clients (e.g., Registered Investment Advisers in the United States).

The portion of your target income not provided by annuity payments, as well as your precautionary and bequest goals must be generated from your accumulated savings. Asset allocation is the key to achieving these goals

Next: How to Determine Your Target Portfolio Return
Stacks Image 175
We hope our free content has helped you…
If it has, please click here to support our site.