FREE NEWSLETTER

Getting to the Number

Kevin Thompson

WHAT WILL RETIREMENT cost? One solution to this riddle is to save as much as we can and hope it’ll cover our expected expenses. Finding the right answer—the exact amount of savings required—can involve hours of calculation, and even then there’s a fair amount of uncertainty.

At my financial planning firm, we help clients with this calculation. Our starting point: We believe the foundation of most retirement plans should be Social Security. Many Americans choose to take Social Security earlier than their full retirement age (FRA). There are downsides to taking Social Security early, of course, the greatest of which is a permanently reduced benefit.

Waiting to file until age 70 is in most people’s best interest, I believe. Their eventual benefit will grow 8% for each year they defer filing beyond their FRA, yet many people feel they can’t afford to wait. At our firm, we help build an income bridge so clients can more easily defer Social Security until 70.

We use a portion of their portfolio to make up for the missing Social Security benefit. Our clients get the same income they would have received had they filed early. The bridge tends to take away feelings of loss and provides them with needed income.

By effectively swapping risk assets like stocks for a larger guaranteed Social Security benefit, we hedge the risk that folks will outlive their other savings—and, for many, move retirement from a possibility to a reality. Now I hear what you’re saying—that I’m removing a piece of their portfolio to annuitize it. Yes and no. Unless they die early in retirement, they’ll get back the money in the form of a larger stream of guaranteed income, and that income will be delivered when it’s truly needed.

Many of my clients worry that Social Security won’t go the distance. Yes, the Social Security trust fund will be depleted by 2034, according to the latest estimate from the system’s trustees. Benefits may eventually be means tested, meaning they’re trimmed for those with higher incomes. But for those already collecting Social Security, I believe the likelihood of a benefits reduction is low.

For married couples, the longer the higher-earning spouse defers, the greater the survivor benefit that the lower-earning spouse will potentially receive. One objection I hear: Lower-earning spouses lose their entire benefit when they inherit the higher benefit of their spouse. This is true. But the surviving spouse’s cost of living should be lower for items such as food, health care and certain utilities. A financial planner can put a pencil to these expenses to calculate how your budget might change.

It can feel strange to no longer have a paycheck once you retire. To replace it, you’ll need to liquidate savings to sustain your lifestyle. The traditional approach is to withdraw 4% annually—in addition to guaranteed income from pensions and Social Security.

Our Free Newsletter

For instance, if you need $100,000 a year in retirement, you and your spouse might receive $50,000 from Social Security and $20,000 from pension income. That means you need to draw another $30,000 from savings. A quick calculation suggests you’d need savings of $750,000, assuming a 4% withdrawal rate.

Many clients say that once they have $1 million saved, they should be fine. Is this true? That depends on living costs and goals. Do you have legacy aspirations, including leaving money to charity or to family? Do you want to see the world, play golf five times a week or join a country club? You need to think about more than just a big round number.

Digging deep into what your life might look like tells us how much money you could need. Of course, it’s not just about the amount of assets. It’s also about how they’re invested. For individuals with a large nest egg but little guaranteed income, sequence-of-return risk comes into play. This is the risk of encountering down years at the start of retirement.

It’s human nature not to want to take money out of a depreciated asset. When the market is down, however, you may be forced to sell investments to cover living expenses. Once you’re forced to sell that asset, you may never recover your portfolio’s value when the market goes back up. How do you offset this risk?

Adding in guaranteed income sources, such as single premium immediate annuities and deferred income annuities, including qualified longevity annuity contracts, is one way to do it. Some of these can be purchased with a cost-of-living adjustment rider, where annual payments increase by, say, 2% or 3% each year. Having 60% to 70% of your expenses covered by guaranteed income—whether Social Security, pension or annuities—greatly reduces longevity risk.

Some people aren’t comfortable annuitizing, which is fine. We can help them ladder Treasurys or other bonds to produce the income they need. There’s limited risk of principal loss—provided they hold the bonds to maturity.

Finally, we’ll stress test a retirement plan, factoring in such things as higher inflation rates and tax rates to see how the plan stands up to such challenges. We can even factor in a 25% cut to Social Security benefits.

People often get “to” retirement haphazardly. They gather assets through their career, hoping to have enough wealth to get them over the finish line. I help them start planning “for” retirement, which involves discussing what your day-to-day will look like and stress-testing the possibilities that may derail your new life.

Kevin Thompson is a former Major League Baseball player and now CEO of 9Innings Capital Group LLC. He is a Certified Financial Planner® and Retirement Income Certified Professional®. Kevin graduated from the University of Texas at Arlington in 2011 with a degree in finance. His previous articles were Home Sweet Whatever and Big League Lessons.

Do you enjoy HumbleDollar? Please support our work with a donation. Want to receive daily email alerts about new articles? Click here. How about getting our newsletter? Sign up now.

Browse Articles

Subscribe
Notify of
20 Comments
Inline Feedbacks
View all comments
David Lamb
David Lamb
1 month ago

Perhaps this a nitpick but I feel compelled to point out that, contrary to the statement:

“By effectively swapping risk assets like stocks for a larger guaranteed Social Security benefit,”

Social Security benefits are not “guaranteed”. Although nearly everyone on earth pooh-poohs the notion that Congress might not step in to shore up the SS Retirement Trust Fund when it reaches insolvency (now projected to occur around 2034/35), I believe that assumption carries a potentially high risk because the projected benefit deficit is about 20%, far too large for many (I think most) retirees to ignore. While we agree that “the foundation of most retirement plans should be Social Security” (in fact, it MUST be Social Security for many if not most), in my opinion a retirement plan that does not at least consider “what happens to my plan, my lifestyle, etc” in the event that SS benefits are cut is potentially unsound, at least for those of us with modest retirement assets and thus dependent upon SS for a significant majority of our retirement income.

Kevin Thompson
Kevin Thompson
1 month ago
Reply to  David Lamb

Not nit picky whatsoever. It our planning, and I believe in the article at one point, we mentioned we solve using cuts to SS benefits and other outside forces such as higher than expected inflation, taxes, etc. We stress test for multiple events.

David Lamb
David Lamb
1 month ago
Reply to  Kevin Thompson

Yes, you did. I just didn’t want others to start thinking wrongly. I still think I nit-picked. 😉

John C
John C
1 month ago

Good article. I am one who has decided a small percentage (15-20%) of our portfolio will include annuities. During the pandemic I purchased a book called Safety First by Wade Pfau and listened to numerous podcasts with him discussing the concept. He stated that purchasing annuities should be considered a replacement for a portion of one’s bonds but they have longevity that bonds cannot offer. Additionally, Mr. Pfau states having some guaranteed income allows one to be more aggressive with your allocation to equities. I found some of the large participating insurance carriers have fixed annuities with the potential of dividend income on top of a guarantee. That is the route we are taking and I have already started the process of slowly purchasing some annuities toward my target retirement date.

Nick M
Nick M
1 month ago
Reply to  John C

Oh my. “Fixed annuities with the potential of dividend income on top of a guarantee” sounds like a “fixed indexed annuity”. These have multiple layers of imbedded fees, which result in horrible returns. There are many websites critical of these products, and this criticisms are often valid so I recommend reading those also, but here is what FINRA has to say about this type of product. https://www.finra.org/investors/insights/complicated-risks-and-rewards-indexed-annuities

Strongly consider instead using a simple SPIA for annuitization needs, and investing the rest in broad market index funds through an actual brokerage firm.

Last edited 1 month ago by Nick M
mytimetotravel
mytimetotravel
1 month ago

Please, please, tell me where I can buy an annuity “with a cost-of-living adjustment rider, where annual payments increase by, say, 2% or 3% each year.” I would love to do so, although i would prefer an increase tied to the actual cost of living rather than a fixed percentage.

Jonathan Clements
Admin
Jonathan Clements
1 month ago
Reply to  mytimetotravel

Fidelity’s Guaranteed Income Estimator includes the option of a 2% annual increase. To see the link to the Estimator, scroll down the page:

https://www.fidelity.com/annuities/immediate-fixed-income-annuities/overview

I’ve also seen other annuities offered with a 3% annual increase, and I suspect other percentage increases are also available (though nobody, as far as I know, offers a true inflation-linked annuity). This may be an occasion when it’s worth picking up the phone and calling a major life insurer, such as New York Life, which I believe is the biggest seller of immediate fixed annuities.

Mike Roberts
Mike Roberts
1 month ago

I’ve written a few articles on this site about reverse mortgages, which can be a tool to bridge the gap until Medicare kicks in or to postpone applying for Social Security. A reverse mortgage can get rid of an existing mortgage payment or give retirees the ability to tap home equity and use it as an income source without adding a mortgage payment to the picture.

wtfwjtd
wtfwjtd
1 month ago

IMO, delaying Social Security as long as possible should be done before even considering any type of annuity. I was talking to a planner the other day, who barely mentioned SS before jumping right to preaching about the latest and greatest whiz-bang product of the insurance industry, the so-called “structured” annuity. I admit, I had to do a little research on this one…but it’s an insurance product, so it has to be great, right? (hint: don’t get too excited).
Sorry about the digression Kevin. It is good to see that you have this one figured out, and are advising your clients with these things in mind.I’m sure there are cases where certain types of annuities are useful to some people. But I’m equally sure that those scenarios are probably far less common than the insurance industry would care to admit.

Kevin Thompson
Kevin Thompson
1 month ago
Reply to  wtfwjtd

By the way, I often wonder how those structured products are priced so I asked an insurance carrier to send me the breakdown. Well, I looked over their black scholes model of options pricing and actually saw that most of the money invested from the premium is not invested in the options strategies at all. They are actually offset 80% inside of bonds, which is why insurance carriers want rates to rise.

my main query is, if most of that money is invested in bonds then what do these massive portfolios look like in this bond market rout? Furthermore, I asked them how can they structure these annuities by so call covering the calls/puts and receiving the premium? There isn’t legitimately enough liquidity on options exchanges to cover the sheer size of all of these insurers selling virtually the same kind of product. Maybe I’m wrong.

Last edited 1 month ago by Kevin Thompson
wtfwjtd
wtfwjtd
1 month ago
Reply to  Kevin Thompson

Another thing that gives me pause, besides all the issues you mention, is that there’s no way to compare the performance of a company’s particular offering to…well, most anything, actually. I started reading some of the fine print on one, discovering that upside interest only accrues on capital, not earnings; start/stop periods of what your capital is indexed to don’t necessarily coincide with when you actually invest, and on and on. If these are the things I’ve caught, just with a brief perusal, what else is hiding in there that I don’t know about?
At times, these sorts of products almost seem like an attempt at deliberate obfuscation, designed to trick me out of parting with my hard-earned cash. Maybe like you, I’m overlooking something obvious. But then again, maybe not.

Kevin Thompson
Kevin Thompson
1 month ago
Reply to  wtfwjtd

Yes, very common. Most of the annuity products you mentioned are simple interest which basically take into account initial premium and not gains. Have to find an advisor that understands the product they sell. Or be left holding the proverbial “bag”.

Kevin Thompson
Kevin Thompson
1 month ago
Reply to  wtfwjtd

you hit the nail on the head. We were talking about immediate and deferred annuities, not the variable versions.

parkslope
parkslope
1 month ago
Reply to  wtfwjtd

I think any mention of annuities should include the caveat to only consider fixed annuities (immediate and/or deferred).

Nick M
Nick M
1 month ago
Reply to  parkslope

The insurance industry is on to that word, so they now sell “fixed indexed” annuities, which are not much different than standard, horrible, variable annuities. I think you are actually referring to a SPIA, which is the only annuity I would consider.

Ormode
Ormode
1 month ago

“For individuals with a large nest egg but little guaranteed income, sequence-of-return risk comes into play. This is the risk of encountering down years at the start of retirement.”

Really? If you have $5 million, $10 million, $20 million, etc, you can live very nicely on your dividends and interest, without selling a thing. That’s the advantage of having real money. If you can’t get enough income without selling something, then your nest egg isn’t large and you have to watch your spending.

Kevin Thompson
Kevin Thompson
1 month ago
Reply to  Ormode

There’s a reason less than 1% of our population has that amount of money, a majority of people have $1 million or less. You could live very nicely at 5, 10 $50 million, but the likelihood of achieving that is very low. So the objective is to increase the likelihood of never running out of money with a lower amount of assets, which, in theory yields more from a lesser harvest.

Brent Wilson
Brent Wilson
1 month ago

I appreciate the willingness to not push annuities for clients that aren’t comfortable with them.

My wife and I are 20 years or so from retirement and sometimes we do get that “haphazard” feeling around our accumulated assets and whether they will be enough to fund our retirements. It’s so hard to predict what our future expenses may be but it still helps to take this time and consider what’s important in our lives today, and what our goals are for our future.

Kevin Thompson
Kevin Thompson
1 month ago
Reply to  Brent Wilson

The most important thing is the client and figuring out how to get the most out of their assets successfully. Our entire goal is to maximize the efficiency of the assets on their balance sheet, and give them the highest level of income, no matter what the market environment tells us. I am not the biggest annuity guy myself, however, people do not realize that pensions, and Social Security are nothing more than an annuity.

Last edited 1 month ago by Kevin Thompson
Kevin Thompson
Kevin Thompson
1 month ago

Thank you Mr Clements in allowing us the opportunity to write for your blog once again. Truly and honor and a privilege.

Last edited 1 month ago by Kevin Thompson

Free Newsletter

SHARE