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The income game

By Stephen Kelley - Main Street Money | May 16, 2020

You’re getting ready to retire and decide to seek out some advice on how to structure your income from your retirement accounts. You have $500,000 in your various retirement accounts and want to know how much you can safely spend each year and not outlive your money. Most planners are going to recommend not spending more than $20,000 a year, or even less, so as not to outlive your money (the number-one retirement fear among Boomers).

This 4% Rule, first conceived in 1995 by San Diego-based financial planner, William Bengin, is based on the premise that not outliving your money 90% of the time is the most important factor. In my opinion, the metric misses the point. While it’s certainly important to have enough that you don’t run out, that’s not the end of the story.

I just went online and opened up one of the free Monte Carlo simulators found on virtually every investment site. I like the one on the Vanguard site because it’s simple and runs 100,000 simulations in about three seconds. I entered a retirement savings balance of $500,000, a 60/30/10 mix of equities/bonds/cash, a 30-year retirement window, and four percent withdrawal rate. The simulator came back with a 90% probability of getting through the 30 years without running out of money. Okay, that’s what we’ve been told to expect. What we aren’t told to expect, however is the range of outcomes. In this case, results ranged from running out of money in about 20 years to having upwards of $7.2 million left over. Great for your kids, you not so much.

With such a broad disparity between failing with too little and failing with way too much, is it any wonder people don’t take us seriously? In my opinion it’s almost embarrassing. So, how to narrow the gap? Two choices. First, by being less aggressive in the market, or second, by adding more to my annual spend. My first choice was to increase my spending by 25% to 5% overall. That did narrow the range to out of money in six years at the low end to $5.6 million left over at the high end, but it also raised the probability I would run out of money to 25%. That was a non-starter, so I decided to change my allocations. That also narrowed the gap substantially, but it didn’t move the needle on whether I would run out of money. My thinking is, unless it increases my odds of success, why bother? So, I left it at 4%, figuring I would have to just suck it up, and if in my later years it looks like I’ll have a surplus, I can always spend more then. Poor consolation, in my opinion. And incredibly inefficient.

Why is that? In my opinion, it’s because the risk class of the investment strategy is unrelated to the risk we are trying to manage. There is no real definable risk class in the market that has anything to do with anything associated with your retirement plan. If there was, you’d be able to increase your income to maximum efficiency without substantially increasing your odds of running out. A retirement plan must solve the income requirement for up to 30 years, and sometimes more. The value of your market holdings is simply the amount you may be able to sell them for today, and even that isn’t a certainty; mutual funds don’t clear until the market closes, and any other type sale order must find a willing buyer.

How in the world do those two things line up? How do they line up over a 30-year horizon? Based on the Monte Carlo plan, it seems the answer is to spend so little you risk making your heirs filthy rich. How does that help you?

The answer really is a simple one, but it gets enormous pushback from Wall Street. The answer is you need to align the risk class you use to leverage your money with the risk you are attempting to manage. To determine the correct approach, let’s look at the pension industry. Pensions do have an investment component, often bonds and dividend-paying stocks, but they don’t rely on those to manage the life expectancy risk. To manage that, they turn to life expectancy itself.

This isn’t something you can do on your own because it’s impossible to predict how long you are going to live as an individual, or even a married couple. However, when you group yourself and your spouse together with several thousand others in similar circumstances, you can predict the average life span with pinpoint accuracy. After that it becomes easy. You simply pay into the fund a certain amount of money and the fund divides that by average lifespan. It then estimates the rate of return from its exceptionally reliable investments and nets out the costs. The result is your lifetime payout. For example, the $500,000 we began this exercise with would provide a 65-year-old about $30,000 per year, with a 100% chance of never running out of money.

But what do you do if you don’t have a pension? Simple, you purchase a personal pension, or an income annuity. We prefer Fixed Index Annuities for several reasons. First, growth is tied to market gains, but is not subject to market losses.

In good times that means you could receive significant returns, but you will never lose money during the bad times. Second, if you still have money in your account after you no longer need the income, the balance is returned to your beneficiaries. And third, they provide the most efficient level of income you can get, without having to risk a dime or ever running out of money. When it comes to retirement planning, you need a tool built from the ground up to provide income. Anything else will nearly always come up short.

Stephen Kelley is a recognized leader in retirement income planning. Located in Nashua, NH, he services Greater Boston and the New England areas. He is author of five books, including “Tell Me When You’re Going to Die,” which deals with the problem unknown lifespans create for retirement planning. It and his other books are available on Amazon.com. He can be heard every weekend on the “Free to Retire” radio show on WCAP and WFEA, and he conducts planning workshops at his New England Adult Learning Center, located in Nashua. Initial consultations are always free. You can reach Steve at 603-881-8811 or at www.FreeToRetireRadio.com.By Stephen Kelley, CSA

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