People planning to retire often tell me their greatest fear is running out of money after they stop working. They have a valid concern, but the risk is not really about living too long. Instead, the issue that could bring calamity is the risk of failing to consistently follow a reasonable retirement plan.
Retirement planning must consider a couple of main points: You might live a long and healthy life, in which case you need money to continue so you can pay your normal bills. That’s called “longevity risk.” Or you might incur large and perhaps unreimbursed medical and caregiver expenses.
Keep on track
You can prepare for both, but once you create your plan, the tough part for many is to stay the course. That’s true particularly when investment returns are volatile and negative. Studies show that investors lose 1% or more on their returns when they are not in the market. This could mean five or more years in lost income.
However, unlike the risk of market returns, which no amount of diversification can fully allay, you can control the “stay the course” risk. All it takes is a little adjustment in your retirement planning, based on a simple premise: Reduce the amount of your income that is subject to the market – or what we call “income volatility.”
With preparation, you can reduce your income volatility during retirement by 50% or more. And, with the proper investment, you can get a 20% increase in income that lasts a lifetime.
You can achieve these results with an Income Allocation plan.
As I have written previously, income allocation’s twin goals are to increase the amount of after-tax (spendable) income and to reduce income volatility (for more dependability).
How income allocation works
Here’s an example for two new retirees age 70, and how income allocation compares to a traditional asset allocation plan in which all income comes from withdrawals from savings.
“Investor A” follows an asset allocation withdrawal strategy and invests 50% in the stock market and 50% in bonds. Withdrawals are set to last for 25 years assuming a blended long-term market return of 4.5%.
“Investor B” follows an income allocation strategy, using both withdrawals from savings and guaranteed lifetime income from income annuities. Some of her savings are used to purchase an immediate annuity with income starting at 70. She also uses a portion to buy deferred income starting at age 85. The balance is invested in a managed portfolio of stocks, bonds and cash, with withdrawals set to last for 15 years.
Unfortunately, soon after the start of the plan, a market meltdown occurs, just like in 2008-09.
- Investor A, with all savings in an investment account with no guaranteed income loses $180,000 in account value.
- Investor B loses $90,000 but still receives guaranteed income from her immediate annuity. She also has the peace of mind of knowing that income after age 85 is guaranteed for life.
- Further, Investor B has a managed withdrawal program that takes some of current year’s withdrawal from the cash account. (I am preparing a study on managed withdrawal strategies and will post it soon.)
Who is less likely to stay the course?
Investor B is not happy with the market machinations, but her Income Allocation plan reduced her income risk. Investor A is more likely to change course. She might sell during the downturn in hopes of stanching the losses, or might reduce withdrawals – and her lifestyle – going forward.
Even the most expert advisor can’t protect against volatile markets. But when you consider all possible outcomes and create an income allocation plan as you prepare for retirement, you will be able to weather troubled times in the markets with confidence.