Does Guaranteed Income Provide a License to Spend?

For most of us, there is an accumulation-of-assets phase of our lives that is normally from age 18 to 65. Simply put—you systematically save and invest efficiently over time for the assets that you hope will get you through retirement. The more difficult phase of our lives is when we face the de-accumulation of assets once we reach retirement—typically age 65 or later. This phase requires us to start using those assets in retirement when many of us face the longest voluntary unemployment period of our lives. Statistically, those who reach the age of 65 are now projected to live well into their 80s. If married, at least one of the spouses will likely live into their 90s. The U.S. has the highest absolute number of those living to age 100 or beyond in the world, with nearly 100,000. Due to medical advances, the number of centenarians will only increase. Baby boomers began to retire around the year 2010 and continue to do so at a rate of 10,000 per day.

Some retirees, either on their own or in concert with their financial advisor, look at their retirement accounts and either rely on the old 4% rule (cashing out 4% of retirement assets annually) or on a “Monte Carlo” simulation to determine the chances they can make it through retirement with their retirement assets. If the market crashes near or in retirement, that 4% withdrawal could decimate your retirement assets for the remainder of your retirement. The Monte Carlo simulation is a tool used to provide you with the chances that you won’t outlive your retirement money. Just make sure when running the simulation, you run the model out to at least age 100. Remember, the simulation tells you how your assets might do, not definitively how they will do.

There are alternatives to relying on principal/income from retirement assets to get you through retirement. The first is Social Security, which almost all of us have. Social Security, while likely to be tweaked in the future is very unlikely to be eliminated. Second is a defined benefit pension plan, which the greatest generation has, but the luxury of which very few baby boomers have. Most baby boomers end their working lives with a 401(k) and/or IRA. Third are annuities (in several variations). These are insurance products that can guarantee a monthly check that will continue until the annuitant’s death.

David Blanchett, managing director and head of retirement research at Prudential Financial, and Michael Finke, a Ph.D. professor at the American College of Financial Services, recently released: “Why Annuities Work Like a ‘License to Spend’ in Retirement.” Below are some key points from that paper.

There is evidence from other studies that retirees spend far less in retirement when relying on a program of savings withdrawals, due to the fact that calculating the lengths of retirements and the returns on assets in the future can be difficult. Longevity risk (outliving one’s savings) is a risk that many rational retirees who rely on savings withdrawals are less likely to shoulder, so they’ll tend to spend less so as to preserve those assets. The alternative is to transfer some, if not most, of the longevity risk to a third party – the government, an employer-defined benefit pension plan or an insurance company. There are ways to optimize these three alternatives. One can decide to start receiving Social Security benefit payments as late as age 70, resulting in a greater payout. You could obtain employment with an employer that provides a defined benefit pension plan. You can also shop among insurance companies for annuities that provide the most favorable guaranteed lifetime payouts. Often, upon reviewing basic expense needs in retirement, Social Security payments or employer pension payouts (if any) may not satisfy those essential expense needs. In that case, the retiree must cover that expense need gap with either retirement savings withdrawals or an annuity.

The study also states that annuities, when used to bridge that expense gap, mitigate the risk of the unknown lifespan. This then leads to a retiree who is more comfortable spending down savings on expenditures that exceed basic needs. Surveys seem to clearly indicate that retirees were more comfortable with their lives when living off an adequate guaranteed income stream than the alternative of spending down retirement assets for basic expenses. In turn, the research showed that retirees would likely spend at least twice the amount each year if they shifted some of their investment assets into guaranteed income wealth which, in most cases, would be purchasing annuities that provide a lifetime income stream (payout or paycheck).

Anyone facing retirement now or in the near future should meet with an experienced advisor to weigh all options and alternatives available in order to establish a plan of action that could allow them to have a more stress-free retirement.