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Maximizing Predictable Income in Retirement
(Updated 1/17/10)
Preface This is a long article. Rather than separate it into shorter pages, I decided to have it on just one page for the sake of continuity. I have provided a table of contents. In this way, you can more easily pick up where you last left off in case it takes you multiple sittings to complete. Introduction After devoting a lifetime to saving and investing the hard-earned dollars they’ve accumulated during their career, soon-to-be retirees will be faced with the task of turning their nest egg into an income stream that will carry them through retirement. While numerous studies show how to take withdrawals from a nest egg composed of stocks and bonds, such portfolios are subject to market volatility. Rather than experience the ups and downs of the markets, some retirees may wish to convert their retirement assets into more predictable income. This article will focus on combining Social Security, TIPS (Treasury Inflation Protected Securities) and inflation-adjusted fixed immediate annuities to generate predictable income. I will show many examples describing how to maximize these predictable cash flows. Specifically, we will see how delaying Social Security and/or the purchase of fixed immediate annuities might or might not provide more inflation-adjusted income for a given dollar amount (lump sum) at the start of retirement. In this article, you will meet two cousins, Tom and Ted. Tom is a hypothetical 50-year old single male and Ted is a hypothetical 65-year old single male. Both Tom and Ted have been diagnosed with a rare condition. This condition will keep them in perfect health right up to their 95th birthday. Then they die. So both Tom and Ted plan to maximize their income and have it keep pace with inflation for all 30 years they will be in retirement.
In the real world, soon-to-be retirees have additional considerations. Are they in good health? Will they want to spend more in the early years for hobbies and travel? Do they want to keep a portion of their nest egg liquid for such purposes like unplanned expenses or bequests? So while this article does not address these or other considerations, the examples provided here may open more possibilities to how you might plan.
The Conventional Withdrawal Plan The conventional approach consists of selecting a balanced mix of stock and bond mutual funds. However, such portfolios are subject to market volatility. This is illustrated with the following chart showing the inflation-adjusted annual returns that resulted from a balanced 50% stocks and 50% bond portfolio:
Data obtained from my Allocation Spreadsheet (xls) As a result of this volatility, remaining portfolio values can vary widely. The following chart shows portfolio values, adjusted for inflation, over the course of selected 30-year retirements.
Data obtained from withdrawBengen Spreadsheet (xls) Each portfolio starts with $1,000,000 with $500,000 in stocks and $500,000 in bonds. In the first year, $40,000 was withdrawn. Subsequent withdrawals were increased to keep pace with inflation. Rather than experience the ups and downs of the markets, some retirees may wish to convert their retirement assets into more predictable income. The rest of this article will describe an approach to maximize predictable income. The elements of this approach consists of social security, inflation-adjusted fixed immediate annuities and TIPS. The amount you receive from Social Security depends on your earnings during your working career as well as when you start receiving benefits. Generally, the more you earn and the later you begin receiving benefits, the higher your benefit check. Once you start receiving benefits, the amount rises annually to keep pace with inflation as measured by the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). In this article, I will use the Quick Calculator from the Social Security website. The data in the following table was derived from the Quick Calculator and will be used for the examples in this article.
In exchange for a lump sum, an insurance company pays you a predictable income stream. While there are several annuity options available, this article will use the lifetime option with annual inflation adjustments. I chose this fixed immediate annuity option to keep an apples-to-apples comparison with social security and TIPS, both of which annually adjust their payments with inflation. (The reader is encouraged to conduct thorough research prior to purchasing an annuity. Links to additional reference materials are provided at the end of this article.) One concern potential annuitants might have is that if they purchase a fixed immediate annuity today, they will lock in low payouts. However, the historical evidence shows that interest rates and payouts have been low for some time.
Source: www.immediateannuities.com No one knows if interest rates and payouts will rise in the future or by how much. This article assumes payouts will remain at current levels. Payouts for the examples in this article have been obtained from Vanguard’s Quote Page. Other providers of inflation-adjusted fixed immediate annuities are listed in Note 1. A TIPS Ladder is a way of generating predictable income from a portfolio. While the individual TIPS bonds that make up a TIPS ladder may fluctuate due to changing interest rates, these fluctuations will be of no consequence so long as each bond is held to maturity. In this respect, it may be helpful to think of a TIPS ladder as having the same properties as a CD ladder. The individual TIPS bonds that comprise the ladder used in the examples for this article will have 10-year maturities and a 1.3% real rate. 10-year TIPS have had a real rate above 1.3% for most of its brief history.
Source: Federal Reserve Bank of St. Louis As mentioned in the introduction, our hypothetical retiree is planning to live 30 years in retirement. At a 1.3% real rate, a TIPS ladder lasting 30 years can support an inflation-adjusted initial withdrawal rate of 4%. This is shown in the simplified chart below:
This table was created using my Simple TIPS Ladder Withdrawal Spreadsheet (xls) The above table assumes a retiree will have accumulated $1,000,000 in the year before retirement (Year -1). At the end of the year, the portfolio earned a real rate of interest of 1.3%. The amount earned was $13,000 ($1,000,000 x 1.3%). Also at the end of the year, a withdrawal of $40,000 was made. This amount will be used for the retiree’s first year’s living expenses in Year 1. This procedure repeats for the remaining 29 years. At the end of the 29th year, the last withdrawal of $40,000 is made. This last withdrawal of $40,000 will be used for the living expenses in Year 30. (Note that all numbers have been expressed in real terms.) A more detailed procedure is provided at these links:
Chart
There are two important caveats to keep in mind when deciding to build a TIPS ladder.
As described in the introduction, Tom is a 50-year old single male. Tom is ready to get serious about planning how much money he will need when he retires at age 65. Tom makes $40,000 a year and would like to maintain that $40,000 income, adjusted for inflation, through his 30 years in retirement. However, at this point, Tom doesn’t know how large a nest egg he will need. Tom would like to explore all the possible combinations using social security, a TIPS ladder and inflation-adjusted fixed immediate annuities. Tom has created this chart:
To summarize, Tom is considering starting social security at either age 65 or age 70, having a TIPS ladder or not, and starting an inflation-adjusted fixed immediate annuity at either age 65, age 70 or age 75. Tom will also consider splitting the annuity into three parts and start the first one at age 65, the second one at age 70 and the third one at age 75. This is the “Staggered” option. So let’s begin and look at each scenario.
In scenario 1, social security starts at age 65. The other income stream comes from the TIPS ladder. There is no annuity.
Recall that Tom is planning to maintain $40,000 he earns today throughout retirement. According to the Quick Calculator on the Social Security website, a 65-year old who earned $40,000 and starts benefits today would receive $13,344. This is shown in light yellow in Chart 1b above. The remaining amount, $26,656 shown in bright green in Chart 1b, would have to come from Tom’s portfolio. Tom anticipates that his TIPS ladder can last 30 years with a 1.3% real rate, provided he start with an initial withdrawal rate of 4%. This 4% initial withdrawal rate means that the portfolio has to start with an amount 25 times the first year’s withdrawal. (25 is the inverse of 4%.) Therefore, Tom would need $666,400 in order to generate $26,656 and adjust with inflation ($26,656 x 25 = $666,400). This amount is shown in bright green in Chart 1a above. In scenario 2, social security starts at age 70. The other income streams comes from the TIPS portfolio. There is no annuity.
According to the Quick Calculator on the Social Security website, a 65-year old who earned $40,000 and starts benefits at age 70 would receive $18,756. This is shown in light yellow in Chart 2b above. To generate the remaining income, Tom sees it would be helpful to separate the TIPS portfolio into two parts. One part will be a TIPS ladder to produce an income stream of $21,244 over the full 30-year period (shown in bright green in Chart 2b above). This will require an inital amount of $531,100 (shown in bright green in Chart 2a). Again, it will be the same 25X formula or $21,244 x 25 = $531,100. The other part is just to fill the five year gap from age 65 to age 69 until social security starts at age 70. This will be $18,756 for five years as shown in light green in Chart 2b above. The amount needed from the nest egg will be $18,756 times 5 or $93,780 which is shown in light green in Chart 2a above. Adding the two parts ($531,100 + $93,780) means that the starting nest egg needs to be $624,880. When comparing scenario 1 with scenario 2, we see that delaying social security to age 70 will reduce the starting nest egg from $666,400 (the nest egg needed if social security starts at age 65) to $624,880. In scenario 3, social security starts at age 65. The other income stream comes from an inflation-adjusted fixed immediate annuity. There is no TIPS ladder.
As in scenario 1, social security starting at age 65 can provide an annual benefit of $13,344. This is shown in light yellow in Chart 3b above. The remaining amount of $26,656 will come from the annuity. This is shown bright blue in Chart 3b above. To determine the lump sum amount required to receive $26,656 and adjusted annually for inflation for life, Tom requests a quote from Vanguard’s Quote Page. This amount comes to $483,334 and shown in Chart 3a above. (All quotes were accessed on January 8, 2010.) Tom feels that exceeding the coverage provided by his State’s Guaranty Association would not be consistent with his goal of having predictable income. The maximum coverage for all annuities in the aggregate is typically $300,000. Therefore, Tom rejects this scenario. Tom decides that if he does choose to buy annuities, the amount he commits won’t exceed $300,000. (For more information on State Guaranty Associations, see the links in Note 2.) In scenario 4, social security, an inflation-adjusted fixed immediate annuity and a TIPS ladder all start at age 65.
As in scenario 1, social security starting at age 65 can provide an annual benefit of $13,344. This is shown in light yellow in Chart 4b above. Next, Tom requests a quote from Vanguard’s Quote Page for $300,000, which is the maximum amount that will be covered by his State’s Guaranty Association. Note that in actual practice, individual annuities are covered up to $100,000 in most states. So the quote Tom receives is a ballpark estimate and assumes that two other insurers can provide a similar quote. For a lump sum of $300,000, Vanguard provides a quote of $16,530 annual income starting at age 65. This is shown in bright blue in Chart 4b above. The lump sum of $300,000 will come from Tom’s starting nest egg and is shown in bright blue in Chart 4a above. So with income of $13,344 coming from social security and income of $16,530 coming from an inflation-adjusted fixed immediate annuity, in order to generate $40,000 total income, the remaining amount of $10,126 will come from the TIPS ladder. This is shown in bright green in Chart 4b above. Using the 25X formula, the amount required from the starting nest egg needs to be $253,150 ($10,126 x 25 = $253,150). This amount is shown in bright green in Chart 4a above. Adding the two parts ($300,000 + $253,150) means that the starting nest egg needs to be $553,150. Excluding scenario 3 because the annuity value exceeds $300,000, we see that, so far, scenario 4 requires the smallest starting nest egg. In scenario 5, social security starts at age 70. An inflation-adjusted fixed immediate annuity starts at age 65. And TIPS fill in the rest of the income stream.
As in scenario 2, a 65-year old who earned $40,000 and starts social security benefits at age 70 would receive $18,756. This is shown in light yellow in Chart 5b above. To fill the five year gap from age 65 to 69 before social security starts at age 70, Tom will spend $18,756 each year from TIPS. This is shown in light green in Chart 5b above. The amount needed from the nest egg will be $18,756 times 5 or $93,780 which is shown in light green in Chart 5a above. As in scenario 4, Tom can purchase an inflation-adjusted fixed immediate annuity at age 65 with a lump sum of $300,000. In return, Tom will receive $16,530 annual income. This is shown in bright blue in Chart 5b above. The lump sum of $300,000 will come from Tom’s starting nest egg and is shown in bright blue in Chart 5a above. So with income of $18,756 coming from TIPS stopgap and social security and income of $16,530 coming from an inflation-adjusted fixed immediate annuity, in order to generate $40,000 total income, the remaining amount of $4,714 will come from the TIPS ladder. This is shown in bright green in Chart 5b above. Using the 25X formula, the amount required from the starting nest egg needs to be $117,850 ($4,714 x 25 = $117,850). This amount is shown in bright green in Chart 5a above. Adding the three parts ($300,000 + $117,850 + $93,780) means that the starting nest egg needs to be $511,630. So far, scenario 5 requires the smallest starting nest egg. In scenario 6, social security starts at age 65. An inflation-adjusted fixed immediate annuity starts at age 70. And TIPS fill in the rest of the income stream.
As in scenario 1, social security starting at age 65 can provide an annual benefit of $13,344. This is shown in light yellow in Chart 6b above. Next, Tom requests a quote from Vanguard’s Quote Page for $300,000, which is the maximum amount that will be covered by his State’s Guaranty Association. As noted above, individual annuities are covered up to $100,000 in most states. So the quote Tom receives is a ballpark estimate and assumes that two other insurers can provide a similar quote. For a 70-year male paying a lump sum of $300,000, Vanguard provides a quote of $19,413 annual income starting at age 70. This is shown in bright blue in Chart 6b above. The lump sum of $300,000 will come from Tom’s starting nest egg and is shown in bright blue in Chart 6a above. To fill the five year gap from age 65 to 69 before the annuity starts at age 70, Tom will spend $19,413 each year from TIPS. This is shown in light green in Chart 6b above. The amount needed from the nest egg will be $19,413 times 5 or $97,065 which is shown in light green in Chart 6a above. So with income of $13,344 coming from social security and income of $19,413 coming from TIPS stopgap and an inflation-adjusted fixed immediate annuity, in order to generate $40,000 total income, the remaining amount of $7,243 will come from the TIPS ladder. This is shown in bright green in Chart 6b above. Using the 25X formula, the amount required from the starting nest egg needs to be $181,075 ($7,243 x 25 = $181,075). This amount is shown in bright green in Chart 6a above. Adding the three parts ($300,000 + $97,065 + $181,075) means that the starting nest egg needs to be $578,140.
Let’s compare scenarios 5 and 6. With scenario 5, social security is delayed to age 70 while the annuity begins at age 65. Scenario 6 does the reverse by delaying the annuity to age 70 while starting social security at age 65. Given that scenario 5 requires a smaller starting nest egg than scenario 6 ($511,630 for scenario 5 versus $578,140 for scenario 6), the logical choice would be to opt for delaying social security instead of delaying the annuity. In scenario 7, both social security and the inflation-adjusted fixed immediate annuity start at age 70. TIPS fill in the rest of the income stream.
As in scenario 2, a 65-year old who earned $40,000 and starts social security benefits at age 70 would receive $18,756. This is shown in light yellow in Chart 7b above. As in scenario 6, Tom can purchase an inflation-adjusted fixed immediate annuity at age 70 with a lump sum of $300,000. In return, Tom will receive $19,413 annual income. This is shown in bright blue in Chart 7b above. The lump sum of $300,000 will come from Tom’s starting nest egg and is shown in bright blue in Chart 7a above. To fill the five year gap from age 65 to 69 before social security and the annuity start at age 70, Tom will spend $40,000 each year from TIPS. This is shown in light green in Chart 7b above. The amount needed from the nest egg will be $40,000 times 5 or $200,000 which is shown in light green in Chart 7a above. So with income of $18,756 coming from social security and income of $19,413 coming from an inflation-adjusted fixed immediate annuity, in order to generate $40,000 total income, the remaining amount of $1,831 will come from the TIPS ladder. This is shown in bright green in Chart 7b above. Since the TIPS ladder needs to last 25 years instead of 30 years, we will need to use a different formula to determine the amount needed from the starting nest egg. The following chart provides an example similar to the one at the beginning of this article.
This table was created using my Simple TIPS Ladder Withdrawal Spreadsheet (xls) At a 1.3% real rate, a TIPS ladder lasting 25 years can support an inflation-adjusted initial withdrawal rate of 4.7%. This 4.7% initial withdrawal rate means that the portfolio has to start with an amount 21 times the first year’s withdrawal. (21 is the inverse of 4.7%.) Using the 21X formula, the amount required from the starting nest egg needs to be $38,451 ($1,831 x 21 = $38,451). This amount is shown in bright green in Chart 7a above. Adding the three parts ($300,000 + $200,000 + $38,451) means that the starting nest egg needs to be $538,451. In scenario 8, social security starts at age 65. An inflation-adjusted fixed immediate annuity starts at age 75. And TIPS fill in the rest of the income stream.
As in scenario 1, social security starting at age 65 can provide an annual benefit of $13,344. This is shown in light yellow in Chart 8b above. Next, Tom requests a quote from Vanguard’s Quote Page for $300,000, which is the maximum amount that will be covered by his State’s Guaranty Association. As noted above, individual annuities are covered up to $100,000 in most states. So the quote Tom receives is a ballpark estimate and assumes that two other insurers can provide a similar quote. For a 75-year male paying a lump sum of $300,000, Vanguard provides a quote of $23,748 annual income starting at age 75. This is shown in bright blue in Chart 8b above. The lump sum of $300,000 will come from Tom’s starting nest egg and is shown in bright blue in Chart 8a above. To fill the ten year gap from age 65 to 74 before the annuity starts at age 75, Tom will spend $23,748 each year from TIPS. This is shown in light green in Chart 8b above. The amount needed from the nest egg will be $23,748 times 10 or $237,480 which is shown in light green in Chart 8a above. So with income of $13,344 coming from social security and income of $23,748 coming from TIPS stopgap and an inflation-adjusted fixed immediate annuity, in order to generate $40,000 total income, the remaining amount of $2,908 will come from the TIPS ladder. This is shown in bright green in Chart 8b above. Using the 25X formula, the amount required from the starting nest egg needs to be $72,700 ($2,908 x 25 = $72,700). This amount is shown in bright green in Chart 8a above. Adding the three parts ($300,000 + $237,480 + $72,700) means that the starting nest egg needs to be $610,180.
Tom thinks there is a way to improve upon this scenario. The $300,000 to be earmarked for the annuity purchase at age 75 can be earning a real rate of interest by purchasing 10-year TIPS at age 65. Because the money can be earning interest at a real rate of 1.3% for 10 years, the initial amount needed at age 65 is less than $300,000. How much less? This can be determined by using a “Present Value” calculator like one at this website. So entering in $300,000 for “Future Value”, 10 for “Years” and 1.3 for “Discount Rate” results in a present value of $263,649. Consequently, Tom decides to change scenario 8 and allocate $263,649 for the annuity purchase instead of $300,000. This is shown in bright blue in chart 8c below.
When we add the three parts ($263,649 + $237,480 + $72,700), the starting nest egg now needs to be $573,829.
Let’s compare scenarios 4, 6 and 8. In all three scenarios, social security starts at age 65. The difference among these three scenarios is when the annuity starts. The annuity starts at age 65 in scenario 4, age 70 in scenario 6 and age 75 in scenario 8. Academic opinion says that it pays to delay starting the annuity. The reason has to do with something they call “mortality credits”. See Note 3. However, when we compare the starting nest eggs for scenarios 4, 6 and 8, the numbers tell a different story. The starting nest eggs for scenarios 4, 6 and 8 are $553,150, $578,140 and $573,829 respectively. The mistake of the academics is to view annuities in isolation and not considering the rest of the portfolio. Specifically, the additional income an annuity provides by waiting 5 or 10 years does not sufficiently offset what is being generated by the rest of the portfolio. For example, we can illustrate a “fair sceniario 8” that would be equivalent to scenario 4 and be indifferent. In other words, this fair scenario 8 would provide $40,000 annual income at the same starting nest egg as scenario 4 of $553,150.
The only change I made was to reduce the starting nest egg from $573,829 (scenario 8) to $553,150 (scenario 4). This was accomplished by reducing the lump sum used to purchase the annuity from $263,649 to $242,970. This is shown in bright blue in Chart 8e above. So an annuity under a “fair” scenario would cost $20,679 less which represents a reduction of 8%. In scenario 9, social security starts at age 70. An inflation-adjusted fixed immediate annuity starts at age 75. And TIPS fill in the rest of the income stream.
As in scenario 2, a 65-year old who earned $40,000 and starts social security benefits at age 70 would receive $18,756. This is shown in light yellow in Chart 9b above. The remaining amount of $21,244 will come from the annuity. This is shown in bright blue in Chart 9b above. To determine the lump sum amount required to receive $21,244 starting at age 75 and adjusted annually for inflation for life, Tom requests a quote from Vanguard’s Quote Page. This amount comes to $268,191 and is shown in bright blue in Chart 9a above. Tom needs to fill the gap while he waits to receive social security and the annuity. It may be helpful to think of the TIPS stopgap in two parts. Before receiving social security at age 70, Tom will need $18,756 for 5 years from age 65 to 69. He will also need $21,244 for 10 years from age 65 to 74 before the annuity starts at age 75. The first part will be $18,756 times 5 or $93,780. The second part will be $21,244 times 10 or $212,440. Adding the two parts becomes $306,220. This is shown in light green in Chart 9a above. Adding $268,191 to purchase the annuity and $306,220 to fund the TIPS stopgap means that the starting nest egg needs to be $574,411.
As in scenario 8, we can improve upon this scenario. The $268,191 to be earmarked for the annuity purchase at age 75 can be earning a real rate of interest by purchasing 10-year TIPS at age 65. Again, we can use the “Present Value” calculator at this website. Entering $268,191 for “Future Value”, 10 for “Years” and 1.3 for “Discount Rate” results in a present value of $235,695. Thus, we can change scenario 9 and allocate $235,694 for the annuity purchase instead of $268,191. This is shown in bright blue in chart 9c below.
When we add the two parts ($235,695 + $306,220), the starting nest egg now needs to be $541,915. In scenario 10, social security starts at age 65. The purchase of inflation-adjusted fixed immediate annuities are staggered in three parts with the first one starting at age 65, the second one at age 70 and the third one at age 75. And TIPS fill in the rest of the income stream.
As in scenario 1, social security starting at age 65 can provide an annual benefit of $13,344. This is shown in light yellow in Chart 10b above. Next, Tom would like to stagger his annuity purchases. Each annuity will be purchased with a $100,000 lump sum. The first will begin at age 65, the second at age 70 and the third at age 75. As before, Tom uses Vanguard’s Quote Page. In exchange for $100,000 purchased at age 65, Tom can receive $5,510. This is shown in light blue in Chart 10b. With a $100,000 lump sum at age 70, Tom can receive $6,471. This is shown in bright blue in Chart 10b. And for $100,000 purchased at age 75, Tom can receive $7,916. This is shown in dark blue in Chart 10b. Tom needs to fill the gap while he waits to receive the second and third annuities. It may be helpful to think of the TIPS stopgap in two parts. Before receiving the second annuity at age 70, Tom will need $6,471 for 5 years from age 65 to 69. He will also need $7,916 for 10 years from age 65 to 74 before the third annuity starts at age 75. The first part will be $6,471 times 5 or $32,355. The second part will be $7,916 times 10 or $79,160. Adding the two parts becomes $111,515. This is shown in light green in Chart 10a above. So with income of $13,344 coming from social security and income of $19,897 coming from TIPS stopgap and the inflation-adjusted fixed immediate annuities, in order to generate $40,000 total income, the remaining amount of $6,759 will come from the TIPS ladder. This is shown in bright green in Chart 10b above. Using the 25X formula, the amount required from the starting nest egg needs to be $168,975 ($6,759 x 25 = $168,975). This amount is shown in bright green in Chart 10a above. Adding all the parts ($100,000 + $100,000 + $100,000 + $111,515 + $168,975) means that the starting nest egg needs to be $580,490.
As in scenario 8, we can improve upon this scenario. The $100,000 to be earmarked for the annuity purchase at age 75 can be earning a real rate of interest by purchasing 10-year TIPS at age 65. Again, we can use the “Present Value” calculator at this website. Entering $100,000 for “Future Value”, 10 for “Years” and 1.3 for “Discount Rate” results in a present value of $87,883. Thus, we can change scenario 10 and allocate $87,883 instead of $100,000 for the annuity purchase at age 75. This is shown in dark blue in chart 10c below.
When we add all the parts ($100,000 + $100,000 + $87,883 + $111,515 + $168,975), the starting nest egg now needs to be $568,373. In scenario 11, social security starts at age 70. The purchase of inflation-adjusted fixed immediate annuities are staggered in three parts with the first one starting at age 65, the second one at age 70 and the third one at age 75. And TIPS fill in the rest of the income stream.
As in scenario 2, a 65-year old who earned $40,000 and starts social security benefits at age 70 would receive $18,756. This is shown in light yellow in Chart 11b above. As in scenario 10, Tom would like to stagger his annuity purchases. The first will begin at age 65, the second at age 70 and the third at age 75. In exchange for $100,000 purchased at age 65, Tom can receive $5,510. This is shown in light blue in Chart 11b. With a $100,000 lump sum at age 70, Tom can receive $6,471. This is shown in bright blue in Chart 11b. And for $100,000 purchased at age 75, Tom can receive $7,916. This is shown in dark blue in Chart 11b. As in scenario 10, Tom can place the $100,000 to be earmarked for the annuity purchase at age 75 into a 10-year TIPS earning a real rate of interest of 1.3%. The present value needed at age 65 is $87,883. This is shown in dark blue in chart 11a above. Tom needs to fill the gap while he waits to receive the second and third annuities plus social security. It may be helpful to think of the TIPS stopgap in three parts. Before receiving the second annuity at age 70, Tom will need $6,471 for 5 years from age 65 to 69. He will also need $7,916 for 10 years from age 65 to 74 before the third annuity starts at age 75. And finally, he will need $18,756 for 5 years from age 65 to 69 before receiving social security at age 70. To fill the 5-year gap from 65 to 69 before the second annuity starts at age 70, Tom will need $32,355 ($6,471 x 5 = $32,355). To fill the 10-year gap from 65 to 74 before the third annuity starts at age 75, Tom will need $79,160 ($7,916 x 10 = $79,160). And to fill the 5-year gap from 65 to 69 before social security starts at age 70, Tom will need $93,780 ($18,756 x 5 = $93,780). Adding the three parts becomes $205,295. This is shown in light green in Chart 11a above. So with income of $18,756 coming from social security and its TIPS stopgap and income of $19,897 coming the inflation-adjusted fixed immediate annuities and their TIPS stopgaps, in order to generate $40,000 total income, the remaining amount of $1,347 will come from the TIPS ladder. This is shown in bright green in Chart 10b above. Using the 25X formula, the amount required from the starting nest egg needs to be $33,675 ($1,347 x 25 = $33,675). This amount is shown in bright green in Chart 11a above. Adding all the parts ($100,000 + $100,000 + $87,883 + $205,295 + $33,675) means that the starting nest egg needs to be $526,853. We have examined each of the eleven scenarios Tom is considering. To narrow the field, we can list those scenarios which require the smallest starting nest eggs. The following table describes three scenarios which requires the smallest starting nest eggs:
There are two common characteristics. One common characteristic is that social security is started at age 70 instead of age 65. The other is the presence of an annuity (as opposed to not using an annuity). While delaying social security can be the optimal choice, delaying the start of the annuity may not. In order to match the starting nest egg for scenario 5 ($511,630), delaying the annuity to age 70 (scenario 7) would have to cost $273,179 or $26,821 less. This shown in bright blue in Chart 7c below. In percentage terms, the annuity quote would have to be 9% less.
As described in the introduction, Ted is a 65-year old single male. Like his younger cousin, Tom, Ted made $40,000 a year and would like to maintain that $40,000 income, adjusted for inflation, through his 30 years in retirement. Initially, Ted was planning to start social security at age 65 and fund the remainder with a TIPS ladder. This is shown in the chart below:
This is the same as scenario 1. For a detailed description, click HERE. Ted’s starting nest egg is $666,400. However after listening to Tom describe the various combinations of social security, TIPS ladders and inflation-adjusted fixed immediate annuities he has been considering for his retirement, Ted decides to do the same. Below is a table Ted put together:
Scenario 12 has already been discussed. So we will examine the rest of the scenarios starting with scenario 13. In scenario 13, social security starts at age 70. The other income streams comes from the TIPS portfolio. There is no annuity.
As in scenario 2, a 65-year old who earned $40,000 and starts benefits at age 70 would receive $18,756. This is shown in light yellow in Chart 13b above. To fill the five year gap from age 65 to 69 before social security starts at age 70, Ted will spend $18,756 each year from TIPS. This is shown in light green in Chart 13b above. The amount needed from the nest egg will be $18,756 times 5 or $93,780 which is shown in light green in Chart 13a above. Recall that Ted’s starting nest egg is $666,400. After carving out $93,780 for the stopgap, $572,620 remains in Ted’s starting nest egg. This amount, shown in bright green in Chart 13a above, can then be used to create a TIPS ladder for the full 30-year period. Using the 4% formula (4% is the inverse of 25), the amount of income that can be generated is $22,905 ($572,620 x 4% = $22,905). This is shown in bright green in Chart 13b above. Adding income from social security and TIPS stopgap ($18,756) with the TIPS ladder income ($22,905) brings total income to $41,661. In scenario 14, social security, an inflation-adjusted fixed immediate annuity and a TIPS ladder all start at age 65.
As in scenario 1, social security starting at age 65 can provide an annual benefit of $13,344. This is shown in light yellow in Chart 14b above. As in scenario 4, Ted can purchase an inflation-adjusted fixed immediate annuity at age 65 with a lump sum of $300,000. In return, Ted will receive $16,530 annual income. This is shown in bright blue in Chart 14b above. The lump sum of $300,000 will come from Ted’s starting nest egg and is shown in bright blue in Chart 14a above. After devoting $300,000 for the annuity, $366,400 remains in Ted’s starting nest egg. This amount, shown in bright green in Chart 14a above, can then be used to create a TIPS ladder for the full 30-year period. Using the 4% formula, the amount of income that can be generated is $14,656 ($366,400 x 4% = $14,656). This is shown in bright green in Chart 14b above. Adding all income sources ($13,344 + $14,656 + $16,530) brings total income to $44,530. In scenario 15, social security starts at age 70. An inflation-adjusted fixed immediate annuity starts at age 65. And TIPS fill in the rest of the income stream.
As in scenario 13, a 65-year old who earned $40,000 and starts social security benefits at age 70 would receive $18,756. This is shown in light yellow in Chart 15b above. To fill the five year gap from age 65 to 69 before social security starts at age 70, Ted will spend $18,756 each year from TIPS. This is shown in light green in Chart 15b above. The amount needed from the nest egg will be $18,756 times 5 or $93,780 which is shown in light green in Chart 15a above. As in scenario 14, Ted can purchase an inflation-adjusted fixed immediate annuity at age 65 with a lump sum of $300,000. In return, Ted will receive $16,530 annual income. This is shown in bright blue in Chart 15b above. The lump sum of $300,000 will come from Ted’s starting nest egg and is shown in bright blue in Chart 15a above. After devoting $93,780 to the TIPS stopgap and $300,000 to the annuity, $272,620 remains in Ted’s starting nest egg. This amount, shown in bright green in Chart 15a above, can then be used to create a TIPS ladder for the full 30-year period. Using the 4% formula, the amount of income that can be generated is $10,905 ($272,620 x 4% = $10,905). This is shown in bright green in Chart 15b above. Adding all income sources ($18.756 + $10,905 + $16,530) brings total income to $46,191. The observant reader will recognize this scenario is the same as Tom’s scenario 5. I bring this to your attention because, as we discovered in Tom’s summary, scenario 5 required the smallest nest egg. Likewise, this scenario produces the most income. The rest of the scenarios we will examine produced less income. In scenario 16, social security starts at age 65. An inflation-adjusted fixed immediate annuity starts at age 70. And TIPS fill in the rest of the income stream.
As in scenario 14, social security starting at age 65 can provide an annual benefit of $13,344. This is shown in light yellow in Chart 16b above. As in scenario 6, Ted can purchase an inflation-adjusted fixed immediate annuity at age 70 with a lump sum of $300,000. In return, Ted will receive $19,413 annual income. This is shown in bright blue in Chart 16b above. The lump sum of $300,000 will come from Ted’s starting nest egg and is shown in bright blue in Chart 16a above. To fill the five year gap from age 65 to 69 before the annuity starts at age 70, Ted will spend $19,413 each year from TIPS. This is shown in light green in Chart 16b above. The amount needed from the nest egg will be $19,413 times 5 or $97,065 which is shown in light green in Chart 16a above. After devoting $97,065 to the TIPS stopgap and $300,000 to the annuity, $269,335 remains in Ted’s starting nest egg. This amount, shown in bright green in Chart 16a above, can then be used to create a TIPS ladder for the full 30-year period. Using the 4% formula, the amount of income that can be generated is $10,773 ($269,335 x 4% = $10,773). This is shown in bright green in Chart 16b above. Adding all income sources ($13,344 + $10,773 + $19,413) brings total income to $43,530. In scenario 17, both social security and the inflation-adjusted fixed immediate annuity start at age 70. TIPS fill in the rest of the income stream.
As in scenario 13, a 65-year old who earned $40,000 and starts social security benefits at age 70 would receive $18,756. This is shown in light yellow in Chart 17b above. As in scenario 16, Ted can purchase an inflation-adjusted fixed immediate annuity at age 70 with a lump sum of $300,000. In return, Ted will receive $19,413 annual income. This is shown in bright blue in Chart 17b above. The lump sum of $300,000 will come from Ted’s starting nest egg and is shown in bright blue in Chart 17a above. For the next part, I used trial and error to arrive at the remaining numbers. (There may be a formula that will solve for the unknowns. But that technique is beyond my math ability.) To fill the five year gap from age 65 to 69 before social security and the annuity start at age 70, Ted will spend $44,850 each year from TIPS. This is shown in light green in Chart 17b above. The amount needed from the starting nest egg will be $44,850 times 5 or $224,250 which is shown in light green in Chart 17a above. After devoting $224,250 to the TIPS stopgap and $300,000 to the annuity, $142,150 remains in Ted’s starting nest egg. This amount, shown in bright green in Chart 17a above, can then be used to create a TIPS ladder for the 25-year period from age 70 to 94. As described in scenario 7, a TIPS ladder needing to last 25 years can support an inflation-adjusted initial withdrawal rate of 4.7%. Using the 4.7% formula, the amount of income that can be generated is $6,681 ($142,150 x 4.7% = $6,681). This amount is shown in bright green in Chart 17a above. Adding all income sources ($18,756 + $6,681 + $19,413) brings total income to $44,850. In scenario 18, social security starts at age 65. An inflation-adjusted fixed immediate annuity starts at age 75. And TIPS fill in the rest of the income stream.
As in scenario 14, social security starting at age 65 can provide an annual benefit of $13,344. This is shown in light yellow in Chart 18b above. As in scenario 8, Ted can purchase an inflation-adjusted fixed immediate annuity at age 75 with a lump sum of $300,000. In return, Ted will receive $23,748 annual income. This is shown in bright blue in Chart 18b above. Following Tom’s example in scenario 8, Ted can place the money earmarked for the annuity purchase at age 75 into 10-year TIPS earning a real rate of interest of 1.3%. The present value needed at age 65 is $263,649 and is shown in bright blue in Chart 18a above. To fill the ten year gap from age 65 to 74 before the annuity starts at age 75, Ted will spend $23,748 each year from TIPS. This is shown in light green in Chart 18b above. The amount needed from the nest egg will be $23,748 times 10 or $237,480 which is shown in light green in Chart 18a above. After devoting $237,480 to the TIPS stopgap and $263,649 to the annuity, $165,271 remains in Ted’s starting nest egg. This amount, shown in bright green in Chart 18a above, can then be used to create a TIPS ladder for the full 30-year period. Using the 4% formula, the amount of income that can be generated is $6,611 ($165,271 x 4% = $6,611). This is shown in bright green in Chart 18b above. Adding all income sources ($13,344 + $6,611 + $23,748) brings total income to $43,703. In scenario 19, social security starts at age 70. An inflation-adjusted fixed immediate annuity starts at age 75. And TIPS fill in the rest of the income stream.
As in scenario 13, a 65-year old who earned $40,000 and starts social security benefits at age 70 would receive $18,756. This is shown in light yellow in Chart 19b above. As in scenario 18, Ted can purchase an inflation-adjusted fixed immediate annuity at age 75 with a lump sum of $300,000. In return, Ted will receive $23,748 annual income. This is shown in bright blue in Chart 19b above. And like scenario 18, Ted can place the money earmarked for the annuity purchase at age 75 into 10-year TIPS earning a real rate of interest of 1.3%. The present value needed at age 65 is $263,649 and is shown in bright blue in Chart 19a above. Ted needs to fill the gap while he waits to receive social security and the annuity. It may be helpful to think of the TIPS stopgap in two parts. Before receiving social security at age 70, Ted will need $18,756 for 5 years from age 65 to 69. He will also need $23,748 for 10 years from age 65 to 74 before the annuity starts at age 75. The first part will be $18,756 times 5 or $93,780. The second part will be $23,748 times 10 or $237,480. Adding the two parts becomes $331,260. This is shown in light green in Chart 19a above. After devoting $331,260 to the TIPS stopgap and $300,000 to the annuity, $71,491 remains in Ted’s starting nest egg. This amount, shown in bright green in Chart 19a above, can then be used to create a TIPS ladder for the full 30-year period. Using the 4% formula, the amount of income that can be generated is $2,860 ($71,491 x 4% = $2,860). This is shown in bright green in Chart 19b above. Adding all income sources ($18,756 + $23,748 + $2,860) brings total income to $45,364. In scenario 20, social security starts at age 65. The purchase of inflation-adjusted fixed immediate annuities are staggered in three parts with the first one starting at age 65, the second one at age 70 and the third one at age 75. And TIPS fill in the rest of the income stream.
As in scenario 14, social security starting at age 65 can provide an annual benefit of $13,344. This is shown in light yellow in Chart 20b above. As in scenario 10, Ted would like to stagger his annuity purchases. Each annuity will be purchased with a $100,000 lump sum. The first will begin at age 65, the second at age 70 and the third at age 75. In exchange for $100,000 purchased at age 65, Ted can receive $5,510. This is shown in light blue in Chart 20b. With a $100,000 lump sum at age 70, Ted can receive $6,471. This is shown in bright blue in Chart 20b. And for $100,000 purchased at age 75, Ted can receive $7,916. This is shown in dark blue in Chart 20b. And like scenario 10, Ted can place the $100,000 earmarked for the annuity to be purchased at age 75 into a 10-year TIPS earning a real rate of interest of 1.3%. The present value needed at age 65 is $87,883 and is shown in dark blue in chart 20a above. Ted needs to fill the gap while he waits to receive the second and third annuities. It may be helpful to think of the TIPS stopgap in two parts. Before receiving the second annuity at age 70, Ted will need $6,471 for 5 years from age 65 to 69. He will also need $7,916 for 10 years from age 65 to 74 before the third annuity starts at age 75. The first part will be $6,471 times 5 or $32,355. The second part will be $7,916 times 10 or $79,160. Adding the two parts becomes $111,515. This is shown in light green in Chart 20a above. After devoting $111,515 to the TIPS stopgap and $287,883 to the annuities, $267,002 remains in Ted’s starting nest egg. This amount, shown in bright green in Chart 20a above, can then be used to create a TIPS ladder for the full 30-year period. Using the 4% formula, the amount of income that can be generated is $10,680 ($267,002 x 4% = $10,680). This is shown in bright green in Chart 20b above. Adding all income sources ($13,344 + $5,510 + $6,471 + $7,916 + $10,680) brings total income to $43,921. In scenario 21, social security starts at age 70. The purchase of inflation-adjusted fixed immediate annuities are staggered in three parts with the first one starting at age 65, the second one at age 70 and the third one at age 75. And TIPS fill in the rest of the income stream.
As in scenario 13, a 65-year old who earned $40,000 and starts social security benefits at age 70 would receive $18,756. This is shown in light yellow in Chart 21b above. As in scenario 20, Ted would like to stagger his annuity purchases. Each annuity will be purchased with a $100,000 lump sum. The first will begin at age 65, the second at age 70 and the third at age 75. In exchange for $100,000 purchased at age 65, Ted can receive $5,510. This is shown in light blue in Chart 21b. With a $100,000 lump sum at age 70, Ted can receive $6,471. This is shown in bright blue in Chart 21b. And for $100,000 purchased at age 75, Ted can receive $7,916. This is shown in dark blue in Chart 21b. And like scenario 20, Ted can place the $100,000 earmarked for the annuity to be purchased at age 75 into 10-year TIPS earning a real rate of interest of 1.3%. The present value needed at age 65 is $87,883 and is shown in dark blue in chart 21a above. Ted needs to fill the gap while he waits to receive the second and third annuities plus social security. It may be helpful to think of the TIPS stopgap in three parts. Before receiving the second annuity at age 70, Ted will need $6,471 for 5 years from age 65 to 69. He will also need $7,916 for 10 years from age 65 to 74 before the third annuity starts at age 75. And finally, he will need $18,756 for 5 years from age 65 to 69 before receiving social security at age 70. To fill the 5-year gap from 65 to 69 before the second annuity starts at age 70, Ted will need $32,355 ($6,471 x 5 = $32,355). To fill the 10-year gap from 65 to 74 before the third annuity starts at age 75, Ted will need $79,160 ($7,916 x 10 = $7,916). And to fill the 5-year gap from 65 to 69 before social security starts at age 70, Ted will need $93,780 ($18,756 x 5 = $93,780). Adding the three parts becomes $205,295. This is shown in light green in Chart 21a above. After devoting $205,295 to the TIPS stopgap and $287,883 to the annuities, $173,222 remains in Ted’s starting nest egg. This amount, shown in bright green in Chart 21a above, can then be used to create a TIPS ladder for the full 30-year period. Using the 4% formula, the amount of income that can be generated is $6,929 ($173,222 x 4% = $6,929). This is shown in bright green in Chart 21b above. Adding all income sources ($5,510 + $6,471 + $7,916 + 18,756 + $6,929) brings total income to $45,582. We have examined each of the ten scenarios Ted is considering. To narrow the field, we can list those scenarios which produce the most total income. The following table describes three scenarios which produces the most total income:
Scenarios 15 and 21 are functionally equivalent to two of the three best scenarios that Tom was considering. Recall that the initial scenario that Ted was considering, starting social security at age 65 and no annuity, produced total income of $40,000. However, by delaying the start of social security to age 70 and devoting $300,000 of the starting nest egg to an annuity purchase at age 65 (scenario 15) produced the most income of $46,191. This represents an increase of 15% from the inital scenario of $40,000. Those on the verge of retirement will need to decide how they want to structure their financial assets in order to generate income to carry them through their golden years. The conventional approach consists of selecting a balanced mix of stock and bond mutual funds. However, such portfolios are subject to market volatility. This article presented a framework for soon-to-be retirees to explore alternative ways of producing predictable income. For example, we saw that delaying social security from age 65 to 70 was one way of maximizing retirement income. Purchasing an inflation-adjusted fixed immediate annuity was another way of maximizing retirement income. We also saw that, contrary to academic opinion, delaying the start of inflation-adjusted fixed immediate annuities might not result in greater retirement income. This is because the additional income an annuity provides by waiting 5 or 10 years might not sufficiently offset what is being generated by the rest of the portfolio. However, I must caution that, while this analysis holds true as of the time of this writing, there may come a time in the future when insurance companies make payouts high enough whereby it might make sense to wait. Therefore, the reader is encouraged to repeat their analysis, using the framework provided in this article, when choosing the optimum approach. And finally, this article left out important considerations. These include the health of the retiree, whether to spend more in the early years for hobbies and travel, as well as deciding whether to keep a portion of the nest egg liquid for such purposes like unplanned expenses or bequests. Your retirement plan must be tailored to your specific needs and circumstances with all considerations taken into account. |
| Note 1 |
I am aware of four insurance companies that offer fixed immediate annuities with inflation-adjusted payouts. American General offers them through Vanguard, the Principal Group through Elm Income Group and Vanguard, MEMBERS Immediate Annuities through CUNA Mutual Insurance Society, and Lincoln Financial Group. Vanguard account holders can obtain a quote online via Income Solutions. Principal only offers sample quotes through their website. Lincoln and MEMBERS do not display any quote information. Instructions for Vanguard account holders to obtain annuity quotes Sample Quotes from Principal Group MEMBERS Single Premium Immediate Annuity Brochure (pdf)
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| Note 2 |
The following links provide information about State Guaranty Associations: Life and Annuity Guaranty Associations by State What Happens When an Insurance Company Fails? Drop-Down List of State Guaranty Associations
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| Note 3 |
Excerpt from: Pros and Cons of Annuities -- Bankrate.com, October 06, 2009
Annuities are insurance against outliving your money, and the reason they make sense for some people is the mortality credits. |
Immediate Annuities Links Page A Safer Withdrawal Plan - Part Two Treasury Inflation-Protected Securities - Markets Data Center - WSJ.com |
