In part 1 of this series, I discussed the big issues that retirees face in investing. In part 2, I demonstrated the risks of becoming an income focused investor, and showed how to deal with several broad asset classes as a retiree. In this post, I'm going to talk about some ways to minimize sequence of returns risk by minimizing how much of your portfolio has to have a safe withdrawal rate applied to it.
Non-Portfolio Income
Many investors wonder how to include their Social Security, pension, or immediate annuity in their asset allocation. The beautiful thing about these non-portfolio sources of income is that you simply DON'T HAVE TO include them in your asset allocation. Instead, use these sources of income, especially if they are inflation-adjusted, to reduce your need for income. If you need $100,000 a year to live on, and Social Security will provide $30,000 a year for you and your spouse, then your portfolio only needs to provide $70,000 in income. This decreases your sequence of returns risk by 30%. If you also have a pension that provides $20,000 in income, your sequence of returns risk is now decreased by 50%, since the portfolio need only provide $50,000 in income. If you don't have a pension, you can buy one. It is called a Single Premium Immediate Annuity (SPIA), and can even be purchased with an inflation-adjustment. These common, competitively-sold, straightforward insurance products (in contrast to most annuities) are easy to understand. You pay one lump sum to an insurance company, and they send you money every month until you die. You can be much more cavalier about spending from your stock, bond, and real estate portfolio when you've put a floor under your retirement spending by using guaranteed sources of income such as a SPIA.
Social Security Planning
Many retirees fail to understand the importance of their decisions about Social Security. I blame the government for this overly complex system, just like I blame it for the difficult financial planning issues new doctors are facing in deciding how to deal with their student loans. Your only defense is spending the time to understand how the system really works. While every situation is a little different, there are a few general rules about when to take Social Security:
- If you are very healthy, take it later.
- If you are not healthy, take it earlier.
- If you are married, both spouses probably shouldn't take it at the same time.
- The higher earner should generally take Social Security at age 70, while the lower earner should take theirs earlier.
Every retiree needs to put Social Security planning on their retirement checklist. If you are doing your own planning, I recommend you read something like Mike Piper's Social Security Made Simple and perhaps even use one of the relatively low-cost online calculators. If you're using a financial planner, make sure this topic is covered in depth. If he seems to be glossing over it, it is probably because he doesn't really have a handle on this critical detail, a real concern for a financial planner.
How To Take A Pension
The author and his wife rock climbing above L'Index, Chamonix, France
Upon retirement, those who have earned a pension are often offered several choices about how to take it. They may be able to take a lump sum. They also may be offered payments for life, with several different categories if they are married. A typical offer might be a lump sum, 100% of a lower payment each month until both you and your spouse die, or a higher payment in exchange for a lower payment (perhaps 50-75% of the higher payment) after one of the two spouses dies. In each of these situations, it's best to run the numbers to decide what you should do. For example, in the lump sum vs annuity decision, it's pretty easy. Look at what the lump sum would purchase on the SPIA market. If there is an inflation-adjustment or a health care aspect to the pension, be sure to account for those benefits. If a SPIA available for the lump sum pays more than the pension, take the lump sum and buy a SPIA. If not, annuitize the pension. In general, I would caution you NOT to take the lump sum and toss it into the rest of your portfolio (or worse, spend it.) This is a time in life to be reducing your sequence of returns risk, not increasing it.
When trying to decide what type of annuitized option to take, consider the health of you and your spouse, the age difference between you, and the consequences of lowered income in the event of one spouse dying long before the other. If a 25% drop in that pension payment is no big deal, (especially with only one mouth to feed, clothe, house, and take on vacation) then the higher payment available is probably a great option. If it would be a big deal, then perhaps 100% payments until the second death would be best. You could also use an insurance product to evaluate how good of a deal you're being offered. For example, since a option where the second to die spouse only gets 50% of the payment pays more than one where the spouse gets 100% of the original payment, you could use all or a portion of that payment to buy a permanent life insurance policy on the first to die. Upon the first death, the death benefit can be annuitized to make up the difference in payments. The key is to compare the pricing of the insurance policy to the difference in annuity payments.
How to Buy A SPIA
I've written before about SPIAs. There are a few things to keep in mind when purchasing one. First, just like with Social Security the later you buy one the better. If you buy one when relatively young (say your 50s) the main effect on the payments comes from current interest rates. If you buy one when older (say your 70s) the main effect comes from your age, minimizing the effect of our relatively low interest rates. Plus, simply by their nature, they pay a lot more when you're older. You may only get 4-5% a year (3-4% if inflation adjusted) for a SPIA bought in your 50s, not much different from a 4% SWR. However, you could get 8-10% (6-7% if inflation-adjusted) in your 70s. The longer you wait to purchase one, of course, the longer you have for your money to grow at a rapid pace if invested aggressively. While there is risk there, the actual return from a SPIA isn't great. It's insurance against running out of money, and mixing insurance and investing usually lowers returns.
Second, give very careful consideration to planning for inflation with a SPIA. You can often buy an inflation-adjusted SPIA, but that inflation-adjustment may be capped at just 3%. If we hit an era of moderate or even high inflation, that isn't going to help much. You might be better off just buying a nominal SPIA, with a plan to either buy another one or two in a few years, or using more standard investments in the rest of the portfolio and getting your inflation adjustments there.
Last, remember that the guarantees in a SPIA are only as good as the insurance company backing them. Check into your state insurance guaranty corporation. They probably only “insure” up to $100-250K in annuity values for each spouse. If you wish to annuitize more than that (and many doctors will), consider using several different companies to provide some diversification against the risk of insurance company failure.
Rents as Non-Portfolio Income?
The further we go into this series, the more it is becoming obvious that for retirees, just like for young physicians, the complicated issues aren't necessarily investing issues, but financial planning issues. The actual investments just aren't that different. Paid-off real estate, however, can almost be looked at as “non-portfolio” income, especially with very stable rents. A good argument can be made that a very stable rental income stream can be used to reduce your need for portfolio income, just like a pension, Social Security, or a SPIA. There are no guarantees (and a new roof eats up a lot of that “guaranteed” income) but some would argue that the guarantees from a corporation, an insurance company, or even the US government aren't worth much anyway. Rental income, although taxed differently, spends just as well as Social Security income.
In Part 4, we're going to talk about some early retiree financial issues and discuss how to benefit from tax diversification.
What do you think about these sources of non-portfolio income? Do you plan on getting Social Security? Do you consider rental real estate as part of your portfolio, or a separate source of income? Comment below!
How do you feel about paying down or off your mortgage prior to retirement as a way to decrease your SWR? My parents recently moved near us. Helping them has opened my eyes to many retirement issues I had never considered. They ended up taking out a mortgage on their new home in their mid-70’s because taking a lump sum out of their 401K would have moved them into a higher tax bracket, so the mortgage costs them less. After seeing this occur, my husband got on board with paying down our mortgage and investing more outside of retirement vehicles to improve our tax diversification possibilities. Looking forward to Part 4. Very interesting reading.
Yes, an interesting concept. The life insurance guys always love to talk about how you can get money out of your life insurance policy tax-free (although they often fail to mention that it isn’t interest free.) It really isn’t any different than borrowing against your house in retirement. You pay interest either way. The “investment” may make more than you’re paying in interest, or it may not.
I’d be pretty careful passing up retirement accounts in order to invest in a taxable account. It’s usually the wrong move, especially for retirement money.
Agree with your last statement. We are maxing out all our tax-deferred options. We don’t have the tax-deferred “space” you do, but neither do we need it. We are left with taxable investing. At about 10-12 years out from retirement ourselves and after watching my parents, we have decided paying down/off the mortgage even at 3.125% will help decrease our SWR in retirement. Tell me if I am thinking about this wrong please. But, I consider that if we carry a mortgage into retirement that we are paying it with our highest marginal tax rate. So, to pay the mortgage from a tax-deferred account I am paying my highest tax rate to access that money for the mortgage which effectively to me increases the payment. I know that I may be passing up some taxable investing now that could do better than the mortgage. But, it has to do better than not just the interest rate on the mortgage but also the marginal tax rate I would have to pay in retirement to make the payment. We don’t have access to Roth money yet. By early retirement, when we are in lower tax brackets, Roth conversions, if still available, would make sense. Would love the hear if anyone else has considered this issue of paying down even a low interest mortgage to decrease SWR from tax-deferred retirement accounts.
You’re right that lowering expenses is a fantastic way to improve your financial status in retirement. It lowers income needs and risk (although some would argue it also lowers return.) I certainly don’t plan to carry a mortgage into retirement, even a low interest rate one.
Do you think it may be worth considering gender in deciding on social security and pension issues? I believe that SPIA’s are gender specific, thus a SPIA for a female will provide a smaller benefit for a given cost compared to a male. I think social security and pensions are unisex so the cost is equal. This despite the fact that the female life expectancy is longer. If this is true then it would be relatively more advantageous for a male to take social security early. This does not apply to married couples. Also it would be relatively advantageous for a married male to choose a joint and survivor pension compared to taking a single live pension. It may be relatively advantageous for a female to take single life pension. What do you think?
That’s a good example of why it is important for every person (couple) to run the numbers for themselves. You want to take all those gender-specific and gender-agnostic payouts into consideration.
I’ve only read down to the photo, but I wanted to say I love the personal photos on this series. Haven’t ever wanted to visit Europe, my wife of course does, but those mountains and views are changing my mind.
OK, back to the post.
It was a great trip, and the Alps are an amazing place.
As I plan, I’m leaving Social Security out of the equation completely. If it is there, wonderful, but I have my doubts that the benefits can remain at their current levels going forward, if at all. (Earliest I could collect is 27 years from now)
That sounds wise and conservative. But realize what it means. If SS will pay you and your spouse $35K a year, that’s like an extra $900K or so in your nest egg. How much longer will you have to work and how much more savings will you have to not do in order to get an extra $900K? Still want to ignore SS?
At any rate, I think when you get within a decade of when you’ll get SS, you’ll know better whether you can rely on it or not. It’s not like you have to decide when you’re 35.
Thank you for covering annuities. I agree with your comment from the last post comment section about not needing increased income in your 80’s. I guess my point about deferred annuities is that if you know you have payments from a deferred annuity coming when you are 80, you don’t have to worry as much about spending down your principle on investments during you 60s and 70s. Also, as I mentioned, the deferred life annuities generally have a much better monthly payment for your buck than SPIAs so $10-20 thousand can actually go a long way, although factoring in inflation may make the numbers slightly worse. My hope is that my nest egg is so large that I don’t have to make gambles like this but I think for some it might be something to consider. And also from what I understand these policies are relatively widespread and competitive, maybe not to the extent of SPIAs but still worth looking in to…
Sure, it would be nice to have more money in your 80s. But it would be even nicer to have it in your 60s IMHO. If someone wants it in their plan, that’s okay with me. I just don’t see a big need for it I guess.
What if you set up the SPDA ~10 years prior to retirement for payment upon your retirement date? Sure you’re probably losing out in terms of interest compared to what you could have made keeping the money in equities, but in exchange you get some protection from sequence of return risk. This would probably be more useful if your expected retirement date is less flexible.
Could be useful. Insuring against sequence of returns risk is a useful concept. I suppose you could use a deferred annuity to do that. Good thinking. The big question is whether the insurance is too expensive or not.