Here at Wealth Daily, we give you lots of useful information about how to invest your savings to prepare for a comfortable retirement.
But what happens when you actually get there? What do you do with your nest egg after you’ve retired?
This aspect of financial planning is just as important as building a nest egg in the first place, yet it’s much less talked-about.
There are a handful of online resources out there about how to withdraw money from your retirement accounts, but they’re not very detailed. And most tend to argue one particular viewpoint — “buy annuities,” “never buy annuities,” “withdraw less than 4% a year to preserve principal,” “withdraw more than 4% a year to cover your expenses,” etc.
In truth, there are a variety of different approaches to withdrawing your savings in retirement. Each one has its own advantages, disadvantages, and use cases.
Below, I’m going to cover something that’s surprisingly hard to find on financial blogs: I’m going to thoroughly list the pros and cons of each withdrawal strategy. Let’s start with the most controversial thing to do with your money after retirement…
The idea behind an annuity is simple: You give an insurance company a lump sum of money — some or all of your retirement savings — and then they send you regular payments until you die.
You get steady income for life, and the insurance company gets a big wad of cash that they can pay out to claimants or invest for a profit. It’s a win-win, right?
In theory, yes. Buying an annuity is the only retirement account withdrawal strategy that provides consistent income regardless of your account balance or the state of the market. As you’ll see in a moment, every other strategy carries some risk of outliving your money or losing it in a market crash. These are both non-issues for annuity holders.
But in practice, these products have some large drawbacks that are important to consider.
For one thing, the “guaranteed” income isn’t as guaranteed as many people think it is. Annuities are legally considered non-deposit products, and thus they aren’t insured by the Federal Deposit Insurance Corporation (FDIC). If the insurance company issuing an annuity fails, the payments can be slashed or stopped altogether.
For another, annuities can be very expensive. Many come with heavy fees and commissions. And almost all annuity payment streams have a present value that is less than the lump sum you pay for them. In other words, annuities usually aren’t fair to the annuitant from a time-value-of-money perspective.
If you decide to go the annuity route in retirement, make sure you spread your money between a few different insurance companies to hedge the risk of insurer failure. And make sure you shop carefully for low-fee, inflation-adjusted annuity products to avoid getting ripped off.
The 4% Rule (Keeping Your Money in Stocks)
The anti-annuity camp argues that you should manage your own money after retirement. After all, DIY-ing your retirement account withdrawals means not paying exorbitant fees to financial institutions — and not worrying about what will happen if those institutions fail.
One popular DIY approach involves keeping your retirement account invested in growth assets, like stocks, and gradually spending the balance.
How much should you spend each year? An oft-repeated rule of thumb says 4% of your balance at the time of your retirement. This number is calculated by taking the long-term average return rate of stocks — roughly 7% a year — and subtracting a high-end inflation estimate of 3% a year.
Hypothetically, this strategy provides consistent, inflation-adjusted income without drawing down your principal or incurring any transaction costs (except income taxes from non-Roth accounts). But there are a few risks retirees should be aware of before they commit their financial futures to the 4% Rule.
Limiting your withdrawals to 4% a year takes a lot of discipline, and it assumes that you have enough money to live on a salary of just 1/25th of your balance. According to Transamerica, the median retirement account balance for 60-somethings is just $172,000. Four percent of that is $6,880 a year, which wouldn’t even cover health care expenses for many seniors.
And this strategy involves significantly more exposure to market risks than the others. Even if you religiously stick to 4% withdrawals, a long period of low stock market returns or high inflation could prematurely drain your savings anyway.
If you plan on keeping your money in stocks after you retire, make sure your portfolio is conservative and well-diversified — and try to withdraw less than 4% a year if you can.
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Living on Interest
If buying an annuity seems too expensive and keeping your money in stocks seems too risky, there’s a third way to withdraw your retirement savings. You can buy low-risk income investments like bonds and certificates of deposit (CDs) and then live on the annual interest.
This approach never touches your principal, allowing you to give your entire nest egg to your heirs (or your favorite charitable causes) when you pass on. It involves no transaction costs beyond taxes. And it doesn’t involve risking your money in the stock market after retirement. But like the other two approaches we’ve discussed, the fixed-income approach has its flaws.
For starters, the fixed-income approach offers no built-in protection against inflation. And although it doesn’t involve stock market risk like the 4% approach, it does leave you vulnerable to low interest rates.
The 10-year Treasury yield is just 2.692% at the time of writing, and most CDs yield even less. If you want a salary of $50,000 a year in retirement, you’d need a portfolio of at least $1.85 million to make that much in interest. That’s a lot more than most retirees actually have when they leave the workforce.
You might argue that today’s low interest rates are an anomaly. You could point out that Treasurys had much higher yields for most of the 20th century and surmise that they’ll go up again eventually. And maybe you’d be proven right. But, you know, maybe you wouldn’t.
Many mainstream economists, including Nobel laureate Paul Krugman, believe the current low-rate environment is a “new normal” that could persist for decades. Even if they’re wrong, it’s still possible that another major economic downturn could occur in your lifetime and interest rates could be slashed to near-zero levels again.
If you want to live on interest after retirement, make sure you have a big enough portfolio to provide a comfortable income at very low yields. And if possible, try to reinvest a portion of those yields to keep your balance rising along with inflation.
Our Retirement Recommendation
We wouldn’t blame you if you felt a bit glum after reading this. No approach to post-retirement money management is perfect; each one has unique flaws and vulnerabilities. And all these problems can make it feel like a financially secure retirement is out of reach for most people.
But consider this: None of the approaches we’ve discussed above are mutually exclusive.
Nothing is stopping you from dividing your retirement savings into three piles and implementing all three of these strategies. You can use one pile to buy annuities, another to buy bonds and collect interest, and keep the third one invested in stocks while withdrawing 4% a year.
In fact, a growing number of financial professionals are advising retirees to split their money this way. Mark Warshawsky, a visiting scholar at the Mercatus Center at George Mason University in Virginia, recently conducted a study of retirement outcomes since 1919.
His study, which was released in 2015, found that, historically speaking, the most effective post-retirement allocation has been a combination of stocks, bonds, and annuities.
As with pretty much everything else in finance, diversification is key.
Until next time,
Samuel Taube brings years of experience researching ETFs, cryptocurrencies, muni bonds, value stocks, and more to Wealth Daily. He has been writing for investment newsletters since 2013 and has penned articles accurately predicting financial market reactions to Brexit, the election of Donald Trump, and more. Samuel holds a degree in economics from the University of Maryland, and his investment approach focuses on finding undervalued assets at every point in the business cycle and then reaping big returns when they recover. To learn more about Samuel, click here.