We ask our retirement savings to do a lot. We want to have enough money to continue our pre-retirement lifestyles into retirement, preferably without added worry. We expect that lifestyle, and the money that supports it, to last for the rest of our lives. And we would like to leave some money for our children, or another relative or friend, or a favorite charity.
Individually, these goals are challenging. Taken together, they can be intimidating.
How can you achieve these goals? A long menu of retirement products, financial advisors, and investment advice awaits you, but there are only a few broad retirement income strategies worth considering. The menu is supposed to help you implement your preferred strategy. But you must choose a strategy. This article argues you should consider a strategy that includes guaranteed lifetime income.
"A long menu of retirement products, financial advisors, and investment advice awaits you, but there are only a few broad retirement income strategies worth considering."
Guaranteeing yourself a lifetime income — that is, regular “retirement paychecks” for the rest of your life (“guaranteed lifetime income”) — is one strategic option. By design, this strategy achieves the goal of retirement income for life. The adequacy of that income is not guaranteed; rather, it will depend on how much you save and how you invest those savings. The same can be said about leaving money for others. Achieving these goals is possible, but not certain.
An alternative strategy is to withdraw a small portion of funds from your retirement savings either when needed or according to a schedule (“withdrawal”). This strategy offers no guarantees. It may be possible to achieve your retirement goals with robust savings, cautiously managed withdrawals, successful investments, and a minimum of surprises. But again, nothing is certain.
A third option combines these strategies — guaranteed lifetime income and withdrawal (“hybrid”). Just about every American who has held a job — nearly nine out of 10 people age 65 or older in 2017, according to the Social Security Administration (SSA) — receives guaranteed lifetime income from Social Security. They receive a monthly check beginning at retirement and continuing until death, and potentially thereafter with survivors benefits.1 So, even withdrawal enthusiasts probably end up pursuing a hybrid strategy.
The problem is, Social Security replaces only a portion of pre-retirement income — around 40 percent, according to SSA.2 The question remains: How should you fill the gap between Social Security and the income needed to support you in retirement? That’s the strategic choice you must make.
Pension Paychecks: The Traditional Approach to Guaranteed Lifetime Income
Quantifying the goal may help guide your strategic choice. One measure of “adequate” retirement income is annual amounts worth 70 to 90 percent of your average pre-retirement income over several years. So, if you, or you and your spouse/partner, earned $100,000 before taxes, on average, in the few years before retirement, then retirement income of $70,000 to $90,000 before taxes should allow you to sustain a version of your pre-retirement lifestyle. If we roughly estimate $35,000 per year in Social Security benefits, you would need between $35,000 and $55,000 every year for life to fill this retirement income gap.
Our parents’ (or, for younger readers, grandparents’) generation had pension checks to fill the gap — that is, regular checks with a lifetime guarantee from an employer-provided “defined-benefit” retirement plan. Like Social Security, these pension checks typically replaces a portion of pre-retirement income, but not all. Together with Social Security, they usually provide enough money to sustain a pre-retirement lifestyle.
Pension checks were commonplace, but they are not today. According to the Labor Department, in 1975, 75 percent of working or retired Americans who had an employer-provided retirement plan were enrolled in a "defined-benefit" pension plan. In 2014, only 28.5 percent of Americans with an employer-provided retirement plan participated in these pension plans. Considering only those who were working, as opposed to retired, the picture gets worse. In 1975, these "active participants" in pension plans were 71 percent of total enrollees in all employer-provided retirement plans. In 2014, they were 16 percent.3 The steady decline in active participants has lasted more than three decades, while the American workforce has grown substantially.
Pension checks function like the paychecks most Americans receive from their jobs. Most important, they provide predictability and, with it, the ability to plan and manage your finances. The check arrives with regularity every week, two weeks, or month. Paychecks and pension checks provide visibility into any gap between your income and spending. You know how much money you will receive and when, so you can plan your spending and savings accordingly. If there is a shortfall, visibility allows you to know, plan, and respond. If you are still working, you can spend less, work more hours, take on a second job, or borrow money. If you are retired, you can spend less, return to work, or withdraw money from your retirement savings.
Pension checks and paychecks also provide reliability. Paychecks continue, unless you are fired or laid off, or you retire. Pension checks continue until you die, except in the rare event that the pension plan collapses. Because pensions provide guaranteed lifetime income, pensioners do not have to plan or take other steps to avoid running out of money, or calculate how to parcel out savings without knowing the length of the lifetime over which the money must be spread.
Creating New Retirement Paychecks
As noted, pensions are increasingly rare. Labor Department data shows that roughly one in 10 current U.S. workers is enrolled in a defined-benefit pension plan.4 Given their decades-long decline, pensions will not be widely available again any time soon. Any of the 90 percent of pension-less working Americans who seek guaranteed lifetime income today or in the future will need a different approach.
No retirement product in the market today faithfully mimics all aspects of a defined-benefit pension. Annuities with guaranteed minimum income benefits provide retirement paychecks similar to pension checks; however, they are different, in part because of costs and savings risk.*†‡ Employer-sponsors pay for their defined-benefit plans, and contribute the money that funds pension checks. By contrast, pension-less retirement savers pay for their own annuities or other retirement products, and any retirement investment and planning advice they receive. Also, unless their employers match their 401(k) contributions, individuals without pensions are responsible for all of their own retirement savings, including subsequent investment decisions.
Nonetheless, the good aspects of pensions — specifically, the predictability that comes from the regularity, visibility, and reliability of a retirement paycheck — can be re-created and, perhaps, improved upon.
"Nonetheless, the good aspects of pensions — specifically, the predictability that comes from the regularity, visibility, and reliability of a retirement paycheck — can be re-created and, perhaps, improved upon."
For these reasons, retirement planning conversations should begin with three questions about retirement income:
- How much guaranteed income could your retirement savings produce each year for your life after retirement?
- What is the cost of a guaranteed income product, like an annuity with a guaranteed income benefit (specifically, what fees, commissions, management fees, and administrative costs are involved, and how much will the guarantee cost)?*†
- How much will inflation and taxes reduce this guaranteed income?
Think of this as the formula that discloses whether your retirement paychecks will deliver an adequate income: income – (costs + taxes), discounted by inflation. Some online calculators can help with these calculations. An expert financial planner should help you construct illustrations that consider several variables and possible outcomes.
Retirement Paychecks that Improve on Pensions’ Flaws
Pensions have flaws that individual retirement savers might avoid. In particular, pension benefits are not liquid (i.e., accessible on demand). Pension participants cannot access the money in their pension plan before retirement and, after retirement, they receive only their scheduled benefits. No participant could, for example, withdraw money from a defined-benefit plan to pay for a medical emergency, avoid foreclosure, or fund a child’s college education.
Individual retirement savers can overcome this liquidity problem. For example, a hybrid strategy could consist of investing one portion of retirement savings in an annuity that provides guaranteed lifetime income, and a second portion in easy-to-sell money market funds or individual stocks. While smaller investments in guaranteed lifetime income products would yield smaller retirement paychecks, a more diversified portfolio can reduce investment risk, and the retirement saver could have ready access to some money. Further, some annuities include guaranteed minimum withdrawals as an option, and newer annuities are being sold with no "surrender charges."
Individual retirement savers also may be able to increase lifetime income payments in a way that pensioners cannot. Pensioners cannot increase the amount of money in their pension checks. For example, they cannot adjust the mix of pension fund investments to increase yields. By contrast, variable annuities allow individual retirement savers to shift their investments around so that savings and income can grow. With the purchase of a guaranteed minimum income benefit, retirement savers can also reduce or eliminate the risk that retirement paychecks will shrink or end prematurely due to bad investment outcomes.‡ Yet, because these products serve multiple goals, they can be complicated, and costs will be higher. The retirement saver must take care to include these costs in his or her guaranteed retirement income calculations.
In sum, while many of us have the same goals for our retirement, there may be different paths to achieving those goals. There is no one right answer for everyone. The task is to choose the best strategy for your circumstances. If our parents’ pensions teach us anything, however, guaranteed lifetime income is a strategy worth considering.
*What is an annuity:
Annuities, including variable annuities, are long-term, tax-deferred vehicles designed for retirement, involve investment risk and may lose value. Earnings are taxable as ordinary income when distributed and may be subject to a 10% additional tax if withdrawn before age 59½.
†Guarantees are backed by the claims paying ability of the issuing insurance company.
‡Optional benefits are available for an extra charge in addition to the ongoing fees and expenses of the variable annuity.
Investing involves risk, including possible loss of principal.
The opinions and forecasts expressed are those of the author and individuals quoted and should not be construed as a recommendation or as complete.