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Investing Specialists

3 Tricky Decisions for Every Retirement Plan

Not even experts agree about the 'right' withdrawal rate, long-term-care insurance, and annuities.

This article previously appeared May 15, 2021.

When it comes to retirement planning, there are a few items that you can safely put in the “settled business” pile. In this era of ultra-low yields, for example, it’s a given that most retirees will need to have ample equity exposure if they want their portfolios to last. The current low-interest-rate environment also means that most retirees will need to derive some of their cash flows from trimming appreciated holdings rather than relying exclusively on income distributions to meet their living expenses. A shrinking share of retirees will be able to rely on pensions, which embellishes the value of delaying Social Security for many.

But for every matter of “settled business,” there’s another aspect of retirement planning that’s the subject of hot debate, even among the experts. Here are three tricky decisions that confront people planning retirement today, as well as how to get your arms around what to do.

Whether to Withdraw at a Popularized Rate
It’s no wonder there’s disagreement over withdrawal rates. How much you can safely take out of your retirement portfolio per year without running out of money over your retirement time horizon isn’t just debatable: It’s unknowable. You don’t know what the major asset classes will return or how high (or low) inflation will run during your retirement. Nor do you know how long you’ll live; your spending horizon could be 15 years or it could be 40. For all of these reasons, it’s impossible to say at the outset of retirement what the “right” withdrawal rate is. It’s a known unknown.

But you have to use something, and this is where the disagreements come in. Most retirement planning experts believe that today’s low yields and elevated stock valuations call for a lower starting withdrawal rate than would have been the case 20 years ago, when the yield on a balanced portfolio would have been much higher. In a 2013 research paper, for example, researchers Wade Pfau, Michael Finke, and David Blanchett argued that for conservatively positioned portfolios with just 40% in stocks, the standard 4% withdrawal guidance would result in an unacceptably high risk of running out of money--similar to a coin toss. Pfau reiterated that point last year, even more emphatically because cash and bond yields had dropped further still. Our recent research concluded that new retirees with 50% equity/50% bond portfolios should start with a withdrawal rate of well less than 4% if they’d like to have a 90% chance of not running out of funds over a 30-year time horizon.

Some other experts, meanwhile, believe that a higher withdrawal rate may be doable under certain conditions. In an interview with Michael Kitces, William Bengen, the creator of the 4% guideline, made the point that if inflation remains low, retirees may be able to take more than 4%. But he also acknowledged in a recent interview onThe Long View podcast that elevated inflation could put higher withdrawal amounts in jeopardy.

What to Do: While retirement experts disagree on a safe starting withdrawal rate, there’s a comforting consensus in a few key areas. Older retirees with shorter time horizons (life expectancies) can reasonably take higher withdrawals than should younger retirees with expected spending horizons of 25 or 30 years. In addition, much of the research on withdrawal rates points to the value of being flexible with withdrawals, especially taking less when the portfolio is down. Doing so leaves more of the portfolio in place to recover when the market eventually does.

Whether to Purchase Long-Term-Care Insurance
Long-term care is a topic that’s uncomfortable from every angle. The prospect of needing such care is unappealing, of course, in that it implies a loss of independence. And paying for long-term care can be financially devastating. In its 2020 Cost of Care survey, Genworth pegged a year’s worth of care in a long-term-care setting at more than $100,000--a 3.6% increase from the previous year. Most such care isn’t covered by Medicare, except for “rehab” following a qualifying hospital stay.

What’s up for debate is whether and how to protect yourself against those costs if they should arise. For one thing, the likelihood of needing long-term care is basically a coin flip: About half of people turning 65 will need some type of paid long-term care in their lifetimes; the other half won’t. Of course, if I told you the odds were 50/50 that you’d total your care during retirement, there’s almost no chance you’d decide to go without insurance. And 20 years ago, the standard prescription for covering long-term-care costs for middle- and upper-middle-income adults was to purchase long-term-care insurance. (Wealthier people could afford to self-fund long-term-care expenses if they arose, and lower-income adults would have to rely on long-term-care coverage via Medicaid.)

But the long-term-care insurance market is deeply troubled today: Thanks to the combination of low interest rates and poor claims experiences for insurers, premiums have increased and several insurers have gotten out of the business altogether.  Consumers who thought they were doing the right thing in purchasing insurance have had to choose between abandoning the policies they’ve paid into, settling for cuts in their benefits, or paying the higher premiums. That troubled environment means that purchasing pure long-term-care insurance is by no means a no-brainer. Hybrid products have come on strong, offering a long-term-care rider bolted onto a life insurance policy or annuity. But the products are complicated, and because they’re often purchased with a lump sum, buyers face an opportunity cost.

What to Do: While there’s no universal prescription for covering long-term-care costs, long-term-care expenses are a big wild card for many retirees’ spending plans. Only fairly wealthy retirees have the financial wherewithal to cover a big spending shock later in life. That argues for taking a hard look at your retirement portfolio to decide whether your assets are sufficient to self-fund, you’re likely to qualify for Medicaid, or you fall somewhere in between the two poles. From there, you can create what I call a long-term-care action plan.

Whether to Purchase an Annuity
Academic researchers have long championed the idea of purchasing simple income annuities for retirement, arguing that doing so provides longevity risk protection and a higher payout than would be available from fixed-rate investment products like bond funds. Annuities have been getting even more attention recently as a component of retiree tool kits, as rock-bottom yields have burnished the value of the risk pooling that boosts the payouts from annuities relative to pure investment products. (That risk pooling simply means that some annuity buyers will die early, increasing the lifetime income for the annuitants who live longer.)

But annuity types vary widely, from ultra-utilitarian single premium immediate annuities to more complicated products that provide equity exposure, guaranteed minimum living benefits, and death benefits. In an interview on The Long View podcast, annuity expert Kerry Pechter noted, “There’s no such thing as annuities generally,” because the products are so incredibly varied.

The disconnect is that the annuity products that retirement researchers generally like best--the plain-vanilla immediate and deferred income annuities that David Blanchett discusses here--have struggled in the sales department. Research has demonstrated that the peace of mind that accompanies the purchase of a basic annuity is greater than would be associated with holding the same amount in investment assets. But fixed immediate annuity sales have remained sluggish. That likely owes to a combination of factors: Investors may be reticent to part with the capital to purchase such an annuity, and advisors may not have a strong motive to recommend such products.

What to Do: While there’s no consensus on whether annuities are a must-have in retirement or which types of annuities to buy, there’s little doubt that the lifetime income they offer is in short supply. That’s especially true given that only about a fourth of baby boomers retiring today have pensions, and that number trends down for the generations behind them.

The starting point when thinking about lifetime income isn’t an annuity, however. Instead, it’s maximizing your payout from Social Security, which is basically an annuity backed by the U.S. government. As Social Security expert Mike Piper points out, delaying filing until age 70 often makes sense for moderately healthy single people. For married couples, it often makes sense for the higher-earning partner to delay filing in an effort to elevate the couple’s lifetime payout. Only after maximizing lifetime income through Social Security should an annuity come into play, if a retiree needs an additional baseline income above and beyond what Social Security delivers. In a similar vein, annuities will be less useful for retirees who are deriving a healthy share of their income needs from pensions.