How to get an income stream of over $ 40,000 from a $ 1 million IRA.
Dilemma for retirees: are you making an annuity i.e. converting your IRA into a life annuity?
Go inside and you are exposed to inflation. You are also locked in, unable to access the main in an emergency.
If you don’t create an annuity, you run the risk of your savings running out.
Attached is a compromise plan. It combines a limited dose of fixed annuities that you can’t survive with a larger element of investing in mutual funds.
The big uncertainty in retirement investing is your lifespan. If you knew ahead of time that you would last exactly ten years, you could live well, spending 10% of your initial nest egg each year. But you don’t know. What if you retire at 67 and are destined to live to age 100?
The solution to the lifetime problem is the annuity, a mechanism for turning an IRA balance into what was the norm in retirement, a fixed monthly pension. An annuity is the only way to get both a high payout from a retirement account and full assurance that the money will keep coming as long as you live.
Despite all the pressure from experts, retirees are very reluctant to buy annuities. The lack of liquidity and the lack of inflation protection are the things that bother them.
My compromise plan addresses these issues. This locks up some of your capital but still leaves you with a lot of cash. This gives you an income stream that ends up decreasing, but in its first 16 years the purchasing power is pretty stable.
Did you want more certainty than that? You can’t have it, unless you just live like a poor man. To completely eliminate both the risk of running out of money and the risk of unexpected inflation, you need to buy a collection of inflation-protected Treasury securities and buy them back very slowly.
Check the calculations on these TIPS, which have negative returns. A 100-year TIPS portfolio causes you to spend less than 3% of your IRA each year. You probably can’t make a living from it.
Part of the solution is to use annuities in small doses. Along with Social Security, annuities help cover mandatory expenses like rent and food, allowing you to be a little more adventurous with the rest of your money. The other part of the solution is to remove percentages an investment account, not predetermined dollar amounts.
Our hypothetical IRA owner is Jane Doe, who retires at age 67 with $ 1 million in her IRA. In decades past, when stocks and bonds were cheaper, she could have left the entire amount in a mutual fund and used the 4% rule. This formula, which we’ll call the old rule, allows him to start with a withdrawal of $ 40,000 and then increase that amount each year to keep up with inflation. At 3% inflation, that would mean spending $ 40,000 this year, $ 41,200 in 2022 and $ 42,400 in 2023.
This kind of draw would be risky today. With stocks and bonds priced high i.e. future returns on corporate earnings and interest coupons depressed, Jane would run a high risk of running out of money.
The problem stems not only from the diminished prospects for future average returns (compared to those of the past 39 exuberant years on Wall Street), but also the volatility of those returns. This is known as “sequence risk of returns”. If there is a market downturn at the start of Jane’s retirement, those fixed dollar withdrawals will severely deplete her savings and leave her unable to participate in a market rebound.
Here is the compromise.
1. Jane invests $ 200,000 in an annuity by paying a fixed monthly sum for life, starting now. She can expect to earn something like $ 10,400 a year. (Men get slightly better payouts.)
2. She buys a deferred annuity for $ 50,000 that offers a fixed income starting at ten years. This will bring in an additional $ 4,800 per year.
3. It invests the remaining $ 750,000 in the Vanguard Balanced Index Fund and withdraws a percentage each year. The fraction starts at 4% and then increases by 0.25 percentage points per year. In 2031, when she turns 77, she will cash 6.5% of what she has left. At 87, she will collect 9% of the fund. Withdrawals are well above the RMD, or minimum required distributions, set by the IRS.
This withdrawal plan has flexibility. When the market is down, Jane tightens her belt. If she recovers, she can return to her usual level of discretionary spending. If it surprises on the upside, she can vacation in Europe.
Annuity payments last until the age of 100 and beyond. The mutual fund account is never completely exhausted.
How well does this retirement income resist inflation? Pretty good. I tried it on the assumption that the fund has an average annual return of 5% while inflation is on average 3%, which means the real portfolio return is a little less than 2%.
Then, Jane’s combined annual income (fund withdrawals plus annuity payments) would soar over the first ten years, from $ 40,400 to $ 62,100 in nominal terms. The $ 62,100 is equivalent to $ 46,200 in today’s currency. Sixteen years later, the payout would be $ 64,900, which is equivalent in purchasing power to the $ 40,400 where it started.
How does the compromise plan compare to the old 4% rule? With the latter, Jane would have invested the same $ 750,000 in the balanced fund and would have placed an additional $ 250,000 in low yield bonds. Keep in mind that an annuity is the same as a collection of low yielding zero coupon bonds.
If the Vanguard Balanced Fund can be counted on to generate a constant 5% annual return, the old rule would be somewhat preferable. This would ensure that our retiree would spend more after her 84th birthday than with the compromise retirement, and leave less to the heirs. In my diagram, Jane, at 99, would still have in the fund account an amount equivalent to $ 99,600 in today’s money.
But it is unwise to think that the prices of stocks and bonds will remain stable. They crash periodically.
Let’s try a different feedback model. This time, let’s assume Jane’s retirement starts off badly, with three consecutive years of -10% returns on the balanced fund, followed by three bullish years that put the fund back on its 5% trendline.
During the decline, Compromise Jane retreats, with a payment floor (in today’s dollars) of $ 30,400 before recovering and then peaking in 2031 at $ 46,200. Old Rule Jane is moving forward with draws at the $ 40,000 (in today’s dollars) level. But if Mrs. Old Rule lives too long, she will be in trouble; she is devastated at the age of 95.
It’s hard to get away from this streak risk, except by resigning yourself to a meager draw or being flexible in your spending rate. Flexibility is the lesser of these two evils.
It’s time to start thinking about annuity strategies before you retire. In some cases, it makes sense to make the purchase long before you start collecting. Payments are better on deferred annuities because a certain fraction of the buyers die before receiving any money.
The illustration above is for a single person, but of course many pension plans involve couples. They need more savings to reach the same level of spending because two people live longer than one.
Rules to follow:
– Annuities are established for people in very good health. If you expect just average lifespan, don’t buy one.
– The first annuity to buy, before considering any commercial policy, is that offered by the Social Security Administration. You buy it while you wait 70 years to start collecting. You thus benefit from an increase in your inflation-protected benefit from 70 to 110 years.
– Do not overdo it. Putting 25% of your assets in annuities makes sense for someone with $ 1 million in savings; beyond this level of wealth, the percentage should decrease. Highly successful retirees who expect to leave money for their children or charities may ignore the annuity altogether.
—Distribute your assets using at least two insurance companies. The most financially sound providers are New York Life and Northwestern Mutual. Guardian and MassMutual follow closely behind.
—Skip out upgrades that allow your heirs to recover a certain amount if you die young. These riders lower your monthly payment and defeat the purpose of the annuity, which is to make sure you don’t outlive your income. If the survivor in question is a spouse, then take a totally different approach: get a joint life annuity.
—Before talking to an agent, get an idea of the prices online at Master plan income, formerly known as Abaris. The rates quoted above for Jane Doe are averages of quotes from New York Life and Guardian.