How to Maintain Your Retirement Income
Saving enough by age 65 to ensure that you can maintain your standard of living through a long retirement has become increasingly difficult. Consider just this one fact. Current retirees receive close to 70% of their retirement income from Social Security and defined-benefit pension plans, while today's workers will probably only receive one-third of their retirement income from those sources (Source: Ibbotson Associates, 2007).
While that means you will be responsible for a significant portion of your retirement income, Social Security and defined-benefit plans are a valuable component of that income. For years, we have heard that Social Security benefits are modest at best and should not be counted on as our only source of retirement income. Sometimes, it's even suggested to completely forget about Social Security benefits when planning for retirement, because changes in the system will probably be necessary when the huge number of baby boomers start retiring. But the fact is that Social Security benefits are a very valuable benefit, especially since benefits are adjusted for inflation annually.
For instance, the maximum Social Security benefit in 2008 for workers retiring at full retirement age is $2,185 monthly. While that might not seem like that much money, consider how much you would need to accumulate to generate that monthly income. A 66-year-old male would have to pay approximately $377,000 for an annuity that would pay $2,165 monthly for life with annual inflation adjustments, while a 66-year-old woman would pay approximately $421,000 (Source: Vanguard, 2008).
While only 21% of the work force is currently covered by a defined-benefit plan, it is a valuable benefit if you are covered by one. Defined-benefit plans typically don't adjust your benefits for inflation, but they will pay a benefit for your life or the joint lives of you and your spouse, depending on the option you choose.
But despite the value of Social Security and defined-benefit plans, you will probably be responsible for the majority of your retirement income, whether you obtain that income from 401(k) plans, individual retirement accounts (IRAs), or taxable investments. Before retiring, you will want to ensure that you have sufficient savings to support yourself for 20, 30, or even 40 years, depending on your age when you retire.
Deciding how much you need to accumulate by retirement age is difficult, since so many of the variables that go into that calculation are uncertain. To come up with an estimate, you need to make assumptions about your life expectancy, how much income you will need during retirement, how much you will receive from other retirement sources, when you will retire, your long-term rate of return on investments, future inflation, and future income tax rates. If your estimates are inaccurate, you could end up with little in the way of income in the later years of your life.
Because of all the uncertainty, it is typically recommended that you only withdraw modest amounts from your retirement savings, especially in the early years of your retirement. A common rule of thumb is to withdraw no more than 4% annually from your retirement funds. So if you want to withdraw $75,000 annually from your retirement assets, you'll need to accumulate $1,875,000 by retirement age.
But that 4% figure is based on the value of your investments when you are ready to make the withdrawal and is not a static number based on your savings when you retire. During periods of market volatility, your asset balances can fluctuate significantly, causing major changes in the recommended withdrawal amounts. Market fluctuations are especially dangerous during the early years of your retirement, when it can be difficult to make up for market declines while you are withdrawing money from those reduced balances. If you are not able to overcome market declines, you could be forced to drastically change your retirement plans.
How can you ensure that your retirement savings will last a lifetime? Consider these points:
• Annuitize a portion of your retirement assets. This will provide you with a definite monthly income for the rest of your life. Annuities can be purchased with or without inflation protection. Since an annuity is paid for the rest of your life, it protects you from outliving your savings and from the risk that lower-than-expected investment returns will reduce your portfolio. Typically, the benefits will end once you (and your spouse if you elect joint benefits) die, although some annuities will pay a lump sum or periodic benefit to beneficiaries. Thus, it is important to understand that if you (and your spouse if you elect joint benefits) die at a relatively young age, your benefits may not equal the purchase price of the annuity. While you probably do not want to use all of your retirement assets to purchase an annuity, you may want to use enough to purchase an annuity that will cover your regular monthly expenses.
• Withdraw conservative amounts from your retirement assets. If you limit your withdrawals to 3% or 4% of your balance, the assets should last for decades. At least annually, reassess your retirement assets and make sure that your withdrawals are reasonable based on your current balances. Market fluctuations can cause your asset allocation to get out of line, so you should rebalance at least annually. Even during retirement, you should allocate your assets among a variety of investment types, ensuring that your allocation is appropriate for your specific situation.
• Maximize other sources of income. While Social Security benefits and defined-benefit plan benefits will likely only provide moderate income, don't totally discount these income sources. Delay Social Security benefits as long as possible, until age 70, to maximize the benefits you will receive. These benefits are also adjusted annually for inflation. While defined-benefit plans are becoming increasingly rare, make sure you apply for benefits if you are covered.
• Look for other ways to remove risk from your retirement investments. There are a variety of portfolio strategies that can help cushion the impact of market fluctuations. If your portfolio is properly diversified, downturns in one asset class can be offset to at least some extent by the performance of other assets in your portfolio.
• Reach retirement with minimal expenses. Cut back on your living expenses before retirement, and try to enter retirement with as few debts as possible. Mortgage and consumer debt payments consume a significant portion of most people's income. Pay off those debts by retirement, and you can significantly reduce your cost of living. This can have a two-fold impact on your retirement. First, it frees up money to set aside for retirement. Second, you get used to a lower standard of living, which should also reduce the cost of your retirement lifestyle.
• Work as long as possible. While there is something very alluring about totally retiring from the work force, the reality is that a long retirement is very costly. Working a few more years can go a long way in helping fund your retirement. Those years are typically your highest earning years, so hopefully you will save significant sums during that period. Also, every year you work is one year you don't have to support yourself with your retirement savings. Once you are ready to retire, try to work at least part-time during the early years of your retirement. That doesn't mean you have to stay at your current job. You can find a totally different job or start a business. Even modest earnings can help significantly with retirement expenses.