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By Christine Benz | 06-26-2013 01:00 PM

How to Plan for Your Retirement Time Horizon

Financial expert Michael Kitces details the pros, cons, and trade-offs of common longevity-planning strategies as well as tips for how retirees can be realistic about their life expectancies.

Christine Benz: Hi, I am Christine Benz for Morningstar. How do you decide on a time horizon for retirement planning? Joining me to discuss that topic is financial-planning expert, Michael Kitces.

Michael, thank you so much for being here.

Michael Kitces: Thanks, Christine. Great to be here.

Benz: Michael, you had a really provocative Q&A on a couple of months ago where you looked at longevity assumptions that underpin a lot of people's retirement plans. A lot of planners do say to plan for age 95, and I'd like your take on the pros and cons of planning for such a long lifespan.

Kitces: I think the pros and cons get pretty straightforward. As we stretch out this time horizon that we're sort of protecting against or worried we're going to live through, we have to keep ratcheting our spending lower and lower in order to protect against the risk that we're going to live this long. Or we have to look at annuitizing our money and getting a lifetime stream of income that will let us go that long.

And as we really elongate that time horizon, we really do get to some pretty profound trade-offs in spending. We use sort of the safe withdrawal-rate research. The safe withdrawal rate when you're going out 30-plus years is much, much lower than what you get when you're only going to plan for 15 or 20 years, and suddenly you have to cut your spending by a quarter or a third or more because you might sort of maybe live out to 95. And certainly, no one wants to outlive their money.

But not a lot of people want to die with a huge pile of money left over because they were hedging a long life that never occurred. And I think that's just a really fundamental challenge and trade-off that we have to face. But I think sometimes we don't spend enough time really looking at what those numbers and facts look like and what those trade-offs really entail.

Benz: So, how should people approach that question? As you said, most people would say, "My ultimate goal is to not run out of money." So, if that's a goal, how should you plan for your own time horizon?

Kitces: Well, ultimately we get two ways that we can classically do it. Number one, we simply go buy a lifetime annuity and take the question off the table. So the fundamental trade-off we get by annuitizing money is the company will pay us payments as long as we're alive, and that's the deal. So, if I don't live very long, I have a shorter life expectancy, I'll get the payments as long as I live. If I turn out to live an unexpectedly long time, I'll get payments as long as I live, and that's how the annuity companies function. And it's pretty easy for them to do the math with large numbers to figure out how to make it work even though it's difficult for us to do it with sort of our sample size of one of me.

The alternative method that's out there is we simply pick a conservatively long lifetime, life expectancy. We determine some safe withdrawal rate that's feasible for that time horizon. And we go down that road just acknowledging, all right, the good news is I didn't sacrifice some of the liquidity, the constraints of annuitization. The bad news is: A, I'm going to dial my spending down in case I live a long time, though we see those numbers are often not far off from the annuity numbers; and B, we still entertain some arguably remote risk, but some risk that I'll live past my time horizon particularly if I didn't pick a really long one.

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