Below is an excerpt from the book Downsize Sooner than Later – 18 Rules for Retirement Success available on Amazon.com.
In this rule, we discuss the first of the two baskets introduced in the last rule and how to create a sustainable retirement income for life.
What ultimately devastates those who run low on funds in retirement is the burden of paying ongoing bills.
This means covering the cost of things like housing, healthcare, insurance, transportation, groceries, and utilities, etc. Running out of income in late senior age is like running out of air. This is because there is very little a person can do to fix the problem. It is likely too late to dust off a resume, and even if you did, would you have enough years left to rebuild your financial well-being? Further, would you have the physical and mental horsepower to become substantially employable again? Would your spouse have such an ability?
Almost 2,000 years ago, the Roman Emperor Marcus Aurelius wrote, “The impediment to action advances action. What stands in the way becomes the way.” It is my belief when it comes to retirement, the same sentiment is true.
The first step to overcoming the worry of running out of income to pay bills in retirement begins with accepting the fact that you will always have bills to pay. The second step is realizing that, just as when you were younger, the best remedy for paying your bills is an ongoing and steady paycheck.
This leads us to the critical question: “What is the most cost-effective and sustainable way to establish a lifetime paycheck in retirement?”
The financial industry offers several possible solutions for deriving retirement income. Nearly all are “portfolio-based” in nature. As discussed in the last rule, this means core funds necessary for future income remain invested and exposed to risk over time. Popular portfolio-based income schemes include a mix of stocks and bonds for income, dividend investing, and the “4%” rule. After a review of a variety of these options, I have come to believe the safest, easiest, and most reliable way to create sustainable retirement income, especially for those who are in better-than-average health, is “pooled income.”
What is Pooled Income?
While this term may sound new to you at first, I can predict that you are already familiar with the concept, just under other names. Pooled income has existed in various forms for thousands of years – well before our modern stock and bond markets were ever conceived. It is the foundation upon which retirement income systems such as Social Security, pension plans, and fixed-rate income annuities function.
Structures vary, but in its essential form, participants contribute funds to a collective “pool.”
• Either immediately or later in life, participants withdraw income from the pool based on amount contributed, age, and life expectancy.
• Income from the pool is promised for life, regardless of how long a person lives.
• In exchange for this promise, there is generally no – or very limited – inheritance provisions for heirs. However, income provisions for surviving spouses are common.
• As individuals in the pool pass away – some earlier, some later – unused funds stay in the pool to support income for those who continue to live.
To assure proper function of the pool, funding levels and reserves are determined by precise actuarial formulas. Depending on the pool – and especially for insurance company annuities – funds are subject to strict government regulation and oversight.
Due to its underlying structure, pooled income generally provides more immediate income per dollar allocated, when compared to other similar sources (such as intermediate and long-term bonds). And, uniquely, it can guarantee an income for the lifetime of the participant.
It is likely you already have at least some pooled income with your name on it. This is from either having been sufficiently employed, as a spouse, or as a beneficiary of some kind.
Doing the Math
At this point, we can begin to bring together some of the ideas previously discussed with a simple assignment.
1. Make a list of your anticipated monthly expenses in retirement and add them together.
2. Make a list of the anticipated monthly pooled income you will receive from Social Security, pension plan income, and any annuities and add them together.
3. Subtract your expenses from your income.
Need help? Click here for a FREE retirement income planning worksheet.
If your pooled income exceeds your total expenses, you have a surplus. Congratulations! You are well on your way to achieving retirement security and success.
If your pooled income is lower than your expenses, you have an income “gap” or deficit.
With an income gap, every month, for an unknown amount of time – potentially decades – you will have to break into your nest egg to pay bills or find some other way to make ends meet. If you pass away first, your surviving spouse will need to keep doing the same to keep his or her head above water.
Returning to the earlier analogy of setting off on a journey with holes in your boat, because certain bills never stop coming regardless of age, every month you will have to bail the excess water in order to stay afloat. This may not seem significant in the short-term, but can you imagine doing so for 20, 25, or 30 years or more?
If constantly feeding your income gap causes you to deplete your funds, it will likely deliver its hardest blow near the end of your journey – in late age. This is a time when you will be least able to protect yourself or your spouse from the resulting consequences.
Closing Your Income Gap
Imagine you discover that at age 70, you still need an additional $15,000 per year in income to cover your basic monthly bills. Mortality tables show your life expectancy to be roughly 15 more years. Let’s say you have $200,000 available to solve for your income needs. Which of the following options for solving your income gap would you choose?*
1. Put the money in a savings or checking account and withdraw what you need each year. At the end of 15 years, you get the income you need plus a little interest. You have total control. If you die early, your heirs get the remaining balance in your account. But, if you continue to live once the 15 years are up, in just three and a half more years, your funds will be depleted.
2. Invest the money. Use any portfolio-based approach you wish – mutual funds, individual holdings, dividend stocks, bond funds, a mix of all of these, etc. – and withdraw the income you need each year. The funds you don’t currently use for income stay invested. Maybe they boom, maybe they bust. Maybe a little of both. At the end of the 15-year ride, you either come out even, have a windfall, or fall short. No one knows for sure. Live longer than 15 years? Who can say where you’ll be? All bets are off.
3. Purchase a simple, fixed-rate immediate life annuity from a large, highly rated, insurance company. Perhaps choose an insurer old enough to have survived both World Wars, the Korean Conflict, the Vietnam War, the Gulf and Middle Eastern Wars and all the market corrections, depressions, recessions, and crashes over the last 100+ years. The annuity pays you the income you need every year. If you die early, your heirs may get little or none of the funds in return. But if you live 20, 25, 30 years, or more, even into your 100s, the $15,000 per year will continue to be paid to you regardless, effectively ensuring you income for the rest of your life.
Before you decide, a few additional facts to keep in mind:
1. Certain bills never stop coming, regardless of age.
2. No one knows for sure how long he or she will live.
3. Projected mortality is only an average. Half will live longer.
4. The long-term trend for those reaching retirement age is toward higher life-expectancy.
So, which would you choose?
One person I met who ran out of funds for income later in retirement told me she was unaware of the details behind option three altogether. At first, she told me she would “never buy an annuity.” Later, coming to understand what the security of a guaranteed income for life would mean for her peace of mind and security, she said, “I didn’t even know you could do this.”
That same person told me I should spend the rest of my career helping people secure their incomes in the same way that had been so helpful to her. I think about her words often, and it is because of her that I decided to write this blog.
Before our discussions together, I’m not sure what she thought or had been persuaded to believe a life income annuity was – a scam, a rip-off, a poor-performing, high-cost investment, a “Ponzi” scheme – but once explained in its proper capacity, a highly-regulated, safe, and time-tested way to insure income for life, she was a changed person. No longer comparing apples to oranges between investments and insurance, she realized that if she had pursued such an option years earlier, she would not be facing the difficult circumstances she found herself in now.
Even for a person with millions, carving out the $200,000 with the annuity in the above example to solve the $15,000 basic income need still makes sense. For a rich person, this is leverage. Why spend $200,000 of your own money on inevitable bills when you can transfer the long-term risk of your expenses to an insurance company? Especially since you are going to spend the money anyway and money spent on paying bills cannot be left to heirs. What’s more, if you live longer, the insurance company picks up the tab for life. For those in senior age, no other retirement income construct offers such a unique and powerful benefit.
Key Terms to Understand
I have tried to avoid financial jargon in the rules, but I think it is OK to introduce a few terms here. Given you have made it this far, you are ready. The following are terms economists use when discussing the inner workings of pooled income devices:
• A mortality credit is money left in the “pool” of a pooled income system by those who die early. This is where the funds come from, in part, to keep paying income for life to the remaining survivors.
• Longevity risk is the risk of running out of money because of living too long (i.e. ruin).
• Longevity yield is the rate of return generated by those who end up living longer.
Economist Moshe Milevsky, PhD. writes regarding the payouts of life income annuities to people living to older ages:
“…to replicate this enhanced yield by using conventional traded instruments (e.g. regular bonds) is virtually impossible. Moreover, for people at older ages, the implied longevity yield is almost impossible to beat.” (Life Annuities: An Optimal Product for Retirement Income, CFA Institute, 2013., pp 113.)
This quote points to the fact that for those who live longer, what they get back from owning the income annuity is an exceedingly favorable return. The same can be said for other pooled income constructs. I include this quote not to appeal to greed, but to highlight that protecting basic income security does not mean you must first agree to a bad deal. In fact, for those who end up living longer, quite the contrary.
At stake, however, is not the inclusion or lack thereof of a windfall. Aspirations for growth, compounding profits, and gains should be left to separate funds – which we will discuss regarding the “wealth basket” in the next rule. At issue here is solving for longevity risk, which is the risk of living too long and running out of income later in life.
To focus the point further, consider the following scenario:
Joey and Albert were the same age. Neither were ever married. Both worked in the same job. Both earned the same income. And both retired at age 70.
Joey and Albert contributed equally to ______. (Plug in interchangeably: Social Security, company pension, simple fixed-rate income annuity).
When they retired, both were given in exchange for their contributions the same size monthly check, and the promise that their monthly checks would continue for life.
Joey died five years later at the age of 75.
Albert lived for thirty more years and finally passed away at the ripe old age of 100.
Which of the two got the better deal?
Superficially, Albert appears to have had the upper hand. Look at all the extra income he received because he lived so long! But, the receipt of this income was indiscernible in advance because neither Joey nor Albert knew how long he was going to live. In reality, they both received the same deal. This is because, in exchange for their equal contributions, they both received the equal promise of income for life.
If you and I pay premiums for homeowners insurance, but only my house burns down, does that mean you should lose sleep thinking that somehow you got a bad deal? No. We both paid premiums to cover an identical and unpredictable future risk. By spreading the risk prudently, everyone receives an equal assurance of protection.
When does an income annuity not make sense?
There are always exceptions to any rule, but here are at least a few reasons – or sets of circumstances in which – either delaying or adding to an individual’s pooled income sources may not be the best solution.
If you have significantly impaired health, it may not make sense to delay the start of a pooled income benefit such as Social Security. If you only have a few years left to live, you may want to begin income payments earlier so that you will receive at least some income.
But even here, it depends. Say you are the major breadwinner in your family but are in deeply troubled health at age 68. If you don’t need the Social Security benefit now, it may make sense to attempt to delay it to age 70 to maximize the benefits for your surviving spouse.
In the case of an individual with significantly impaired health, purchasing a supplemental income annuity from an insurance company would rarely, if ever, make sense. An exception might be the purchase of a hybrid long-term care annuity, assuming he or she can qualify. Such annuities can be structured with a “rider” or policy endorsement to help cover long-term care expenses. If care ends up not being needed and the contract is never turned into an income stream, the unused principal and interest can be left to beneficiaries. For those who qualify, this is a unique and currently tax-favored way to cover long-term care risk and “get your premiums back” if you don’t end up needing the care – more on this in a later rule.
As stated earlier, for most people, it is exceedingly difficult to anticipate one’s mortality with regard to planning. I have seen some people who thought they were in bad health end up living a long time. I have also seen those who appeared to be in excellent health pass away early.
Ironically, some individuals with certain chronic health concerns often gain an unanticipated advantage that works in their favor. If their conditions are not immediately life threatening but require ongoing monitoring through regular visits to a healthcare practitioner, it can be life prolonging.
Take, for example, a man who occasionally sees a doctor to renew a prescription for erectile dysfunction drugs. At such visits, he will usually receive a routine health screen – heart rate, blood pressure, urinalysis, general wellness check, etc. Sometimes, these built-in screenings flag more serious issues that need attention. Does your dentist take your blood pressure? Do you wear glasses and regularly see an optometrist? Do you need minor surgery requiring pre-operative screening? All these instances provide hidden opportunities to bolster overall longevity.
Other times not to purchase an income annuity.
As mentioned above, individuals with serious health concerns should avoid purchasing income annuities and may be better off preserving their short-term capital. It is possible that some individuals in excellent health should also steer clear of supplemental income annuities.
No one should buy an annuity if it would consume all or nearly all their liquid or nest egg funds. “Experts” will tell you that at least some funds should be kept aside for short-term cash needs and emergencies. Usually, they recommend emergency funds equaling three to six months of income or, in some cases, even a year’s worth.
I find this advice helpful, but I don’t think it goes far enough. In my opinion, a person must have at least two indispensable elements in place before purchasing a supplemental income annuity. These are:
1. A sufficient liquid emergency fund (at least six months to a year).
2. A sufficient wealth fund.
A “wealth fund” is money you set aside to invest undisturbed for the future. It is money that even after retirement, you do not touch or use to pay ongoing bills. It is money that stays invested and benefits from the power of compounding. In time, this money helps protect you from inflation risk, helps establish legacy, and provides you with an added layer of security in older age.
But what if you feel you haven’t saved enough in the first place?
Many who read this may feel they haven’t saved as well as they might have wished for retirement.
To you, I say, take comfort!
The feeling of wishing you had saved more is common. Asking people if they believe they have saved enough for retirement is like asking people if they think they could be in better shape or exercise more often. Most people say they could on both counts.
If you really feel you are behind, you should first focus on reducing your expenses (see Rules 2, 3, and 4) and optimizing your current pooled income – especially from sources like Social Security. If you still experience a shortfall, you may wish to continue working at least part-time. Do not view this as a defeat! As we will discuss in later rules, the virtues of staying economically productive extend even to those who are wealthy.
If you must continue to work, try to begin setting aside savings to begin building or rebuilding your nest egg as soon as possible. This is crucial! Setting aside savings for growth is important at all ages.
This critical topic is the subject of our next rule.
Questions or comments?
I can be reached at this link – contact Ted Stevenot.
*Estimated rates were determined at the time of original writing in mid-2019.