Maximize Guaranteed Income in Retirement

Glaser: Welcome back. In this session, we're going to look at how you can trust a nonportfolio source of income, things like Social Security and pensions.

But before we get started, just a reminder. You can ask us questions by submitting them through the player, join the conversation on social media with #RetireFit on Twitter and Facebook and also, that we will provide recordings of these sessions to view later and we'll email everybody who is a registered user with those recordings when they are ready.

I'm joined again by Maria Bruno and Christine Benz to talk on the subject. Thanks for joining me again.

Maria Bruno: Thank you.

Benz: Jeremy, great to be here.

Glaser: So, let's talk about some of these potential sources of nonportfolio income. We have things like Social Security, you have pensions, you potentially have rental income if you own rental properties, annuities, and even part-time work as things that could come from outside the portfolio.

But before we get into the discussion, Christine, can you help us just kind of set the landscape a little bit about how this has changed so much, just the decline in pensions over time?

Benz: Yeah. We have seen a really fundamental change in the retirement planning landscape over the past, say, 40 years where in the late '70s we saw 401(k)s, the advent of 401(k)s and the extreme uptake of 401(k)s relative to defined benefit plans, pensions plans in particular. So, we've essentially seen the two chart completely opposite trajectories where we've seen dramatic uptake of 401(k) plans or what are called defined contribution plans that would encompass 403(b) and 457 plans, whereas defined benefits plans are ebbing away in importance. And so, you have very few workers, certainly in the private sector today, where if you're a new hire, you're offered a pension plan. So, this, I would say, combined with the fact that we have seen interest rates go this way, go downward that these two things have created a major challenge for people looking to plan their portfolios and plan for their retirements.

Glaser: So, that's the big implication, I mean, just that it makes planning that much more challenging because of these changes?

Benz: Exactly. And the other factor that we've seen, Jeremy, is that people's savings unfortunately haven't picked up where defined benefit plans left off. So, the Employee Benefit Research Institute estimates that roughly 25% to 30% of pre-retirees have no retirement savings whatsoever. When you look at median balances versus average balances, average balances in 401(k) plans look better, median balances look terrible. So, for people who are close to retirement, the median balance is like $12,000 currently. And a big issue and I think one that is finally getting some well-needed scrutiny is this idea that you've got a lot of people who do not have access to a defined contribution plan at all through their employers. So, you have seen that this constituency is particularly hobbled when it comes to retirement savings.

Glaser: Maria, why are these guaranteed sources, things like pensions, are just so important for retirement planning?

Bruno: Well, exactly, because they are guaranteed sources of income. So, usually, they are for life for either the individual or the individual and spouse and some will increase with inflation as well. So, they can help really provide a baseline of income to meet nondiscretionary expenses, things to keep the lights on, if you will, in terms of housing, food, like those types of things. So, that's the value of defined benefit plans or Social Security, for instance, or other type of income annuities. So, this baseline of expenses is met and then there's other financial assets that can be invested to help supplement to that.

Glaser: Let's start with pensions. I know we just talked about how they have declined, but I know whenever we do an event like this, we always get a ton of questions about pensions. And one of the big ones is, should you take it as an annuity or maybe it's just been offered as a lump sum? What's the right choice? And Mark Miller has done some research on this and here's his thoughts on it.

Mark Miller: If you are lucky enough to still have a defined benefit pension at retirement, one question that could arise at retirement is whether you want to take that pension as an annuity stream or as a lump sum. And many people are tempted to take it as a lump sum. But what the experts tell us who have really studied this, the actuaries and so on, is that most people come out ahead by taking the annuity stream. The calculations that are used to calculate the lump sums, the interest-rate projections where numbers were actually changed in the mid-2000s to be more favorable to plan sponsors than they are to the annuitant. We shifted for the interest rate. This is pegged to used to be treasuries; now it's corporate bonds. The higher rate translates into lower lump sums for annuitants. So, the one caveat to this is that if you're in poor health and don't have an expectation of living long, that could be a good reason to take a lump sum.

Glaser: If that's the best choices for pensions, Social Security is something almost everyone will have to think about, and Mark Miller has some thoughts on this. Then we'll come back and discuss it some more.

Miller: Really the best approach to maximizing Social Security is to consider delaying your filing. The way that Social Security works is, everything revolves around the so-called full or normal retirement age. That's the age at which you're entitled to 100% of your benefit and that's currently 66. It's slowly marching toward 67 as a result of reforms that were passed in the 1980s.

The way it works is, for every year you file before 66, you're going to get roughly 8% less lifetime and for every year that you wait past 66 up until age 70 is worth about another 8%. So, you do the math on that, and you can see it can be really substantial in terms of the differences.

Glaser: It seems like pretty compelling math to keep your Social Security or to wait for Social Security as long as possible. But Maria, you don't think it's always the best choice?

Bruno: No, I agree with Mark. In most situations, the value of the deferral is really quite financially advantageous. But in situations--and Mark had mentioned this in terms of taking the lump sum versus an annuity--generally speaking, if you're in poor health that could be a reason to not delay taking benefits. The other questions that I tend to get and you may as well, Christine, is that, well, I need money to life off of. So, if I don't take Social Security then I'll be spending from my portfolio and there's an interplay there. There are individualized situations, but running the numbers often will advocate for delaying Social Security because there maybe benefits in terms of maximizing the payout for both the primary earner as well as the spouse over the lifetime of both individuals and the tax benefits potentially in play in terms of drawing down. So, some interplay there. But generally speaking, the numbers do play out for deferral, but health situation is big one.

Glaser: How about spouses? Are there strategies, Christine, that you should consider if you have a spousal Social Security to try to maximize it or have most of those loopholes been closed?

Benz: Yeah, there used to be some terrific strategies and we had a lot of conversations with our Morningstar.com users who were taking advantage of them. Unfortunately, for people who are looking to maximize couples' benefits, the levers are fewer today, thanks to the closer of those loopholes. But I think that married couples can still look to maximizing couples' benefits by thinking about the higher-earning spouse and trying to maximize his or her benefits, especially if you had a person who did not have a high income during–-if the other spouse didn't have a high income, the name of the game is maximizing the payout for that higher-earning spouse which has implications for the spousal benefit as well as for the survivor benefit later on. So, the name of the game there is to try to get that payout for the higher-earning person to be as high as possible.

Glaser: We have a couple of Social Security questions that we'll talk now, I'm sure we'll get some later as well, the first being for someone who retired at 55 or is planning on retiring at 55, is there any implications on when they should think about taking Social Security, what their payout is going to look like?

Benz: Well, certainly, you would want to think about delaying in that case as well and the key reason is that there is an interplay with the portfolio if you're a very young retiree as would be the case with the 55-year-old, you'd need to take a very low initial withdrawal rate from that portfolio. So, you need to be very careful about not prematurely depleting that portfolio because your time horizon in retirement is really long. So, I actually think that that probably accentuates the virtue of delaying Social Security even though it's a little bit counterintuitive. If you're starting retirement early, you might think that you'd want to tap it early, but I think actually, the argument still lands on the side of delaying assuming that you're in average or above-average health.

Glaser: So, knowing that pensions are no longer a major part of most people's portfolios, annuities have gained a lot of attention as people try to replace some of that. And it's nice to have that guaranteed stream. And Michael Kitces talked to us a little bit about how to just consider some of the annuity products on the market today.

Michael Kitces: One of the most common questions I get from retirees through my site is, whether it's better to buy an annuity or invest in a portfolio to generate retirement income. Now, the challenge to this is, the word annuity is actually incredibly wide-label for a very wide range of products. Now, in the simplest sense, we can break these up into two camps. The first are what are called deferred annuities. In a deferred annuity, I put money into the contract, it grows tax deferred as long as it's in there and the contract may either give me some guarantees for cash flow income during life or maybe even at death that I can pay out to my heirs.

The second version of an annuity, which is actually what the original annuity was, is a guaranteed lifetime stream of payments, and so we literally get rid of our account balance and we just exchange guaranteed payments for life. So, I might go to an annuity company and say, here is $100,000, and the annuity company says, great, here is $500 a month for life no matter how long you live, even if you live to be 107 years old.

Now, when we get to the second variety, annuities that provide immediate income for life, there is both some pluses and minuses to the opportunity. The good news about annuities that pay income for life is a very unique structure for immediate annuities called mortality credits and the idea is to recognize that when a group of people get together and all put their money together to buy an annuity for life, we don't necessarily know who is going to die early and who is going to live a long time, but an annuity company that brings together a large group of people at once, actually can predict with a high degree of certainty how many people are going to pass away each year. They don't know who it's going to be, but the law of large numbers helps this to average out.

And what that means is that an annuity company can actually pay you more from a pool of money than what you could generate for yourself because you only get to take principal and interest but the annuity company gets to pay principal, interest, and what are called mortality credit which are essentially the shares of the people who didn't live as long as you did. And what that means is, for any particular fixed-income portfolio I can actually generate more income for life from an annuity than I can from the underlying bonds alone even if I literally buy the exact same investments that the annuity company was going to offer.

Now, the bad news to the annuity is that we get interest, principal and mortality credits on top; unfortunately, the interest component not terribly wonderful these days and we'll see how long it takes for rates to materially go up. The challenge when we buy an immediate annuity is that we do lock in those low interest rates today, but we still get to stack mortality credits on top that we may not have otherwise gotten. And what that means for most retirees when we go through the process is to say, look, if your plan was to buy mostly fixed-income investments anyways, you've really got to take a hard look at an annuity as an alternative because the potential for rising rates might mean your annuity could pay more in the future, but it's also going to be very damaging to your existing bond portfolio and locking in your interest rate plus your mortality credits on top can be relatively appealing. If you are investing for long-term growth, if you are more of a diversified equity investor, unfortunately low interest rates plus mortality credits make it fairly hard to lock in a pretty appealing rate and we see a lot of people on that end saying, well, I am going to wait for now but maybe we will revisit when payout rates get better in the future.

Glaser: Christine, Michael mentioned deferred annuities, so when you don't start getting the money immediately. It's something that could be a great way to remove the risk of outliving your assets. Why aren't those talked about more? Why haven't this been a bigger topic of conversation?

Benz: Well, one reason was that due to IRS rules and some Treasury rules that these products weren't allowable options in 401(k) plans or IRAs until recently. In the past few years though some changes in those rules have made them allowable options. And when you talk to planners, many of them say that this is really one of the purest forms of longevity protection that you can buy.

So, in a common example, common version of one of these deferred income annuities, you purchase the annuity upon retirement, but it doesn't start paying out until you're maybe age 85. So, you have 20 years to sit until that annuity starts paying you. The beauty of it is, you alluded to, Jeremy, is that it allows you to plan for a knowable time horizon for your portfolio. So, you may run the numbers and say, well, it looks very likely that I will have enough to last until we're age 85, but beyond that I'm little bit nervous. And so, that's where the annuity comes in. If someone does live to be 95 or 105, the annuity would pay them out throughout their lifetimes.

So, I ran a quote yesterday, just kind of looking at how this would in practice. This would be a deferred income annuity with no guarantee. So, if you died before you started getting payments from it, that would be tough luck on you. So, looking at this type of product, you pay $100,000 today at age 65, receiving payments at age 85, those payments would be about $3,000 a month with that sort of outlay. So, it can be an economical, a fairly economical way for someone to hedge against longevity risk. The problem though is that without any guarantees you are essentially forking over that money to an insurer that you may never see a dime of. So, certainly, some things to balance, but it's an interesting product. A lot of planners who I know are enthused about adding these products, especially as we begin to see a little more competition in the marketplace. A lot of planners are excited about being able to add these products to their clients' tool kits.

Glaser: Morningstar Investment Management's David Blanchett thinks that investors should consider annuities as well.

David Blanchett: A big reason to annuitize is based upon your preferences for that certainty, knowing that you have a guaranteed income for life. And then beyond that certain things kind of affect the decision. So, for example, beyond the facts do you want more guaranteed income it's, what is your longevity or life expectancy, the longer you are likely to live, the more value the annuity is going to be.

Next is, how do you feel about a shortfall? How would you feel if you would have to make a change to your consumption? Would that negatively affect you? And then also, what's really important is the quality of the product. And there is a huge spectrum out there in terms of good products and bad products. And the key with all of this, it's risk management. You buy an annuity not to maximize your wealth, but to kind of hedge this risk which is living a long time and it isn't always to get there. I think that for a lot of folks it makes a lot of sense to look for simplicity. There are more complex products I doubt that work, but again, it's understand what you are buying and how it actually fits your goals and needs.

Glaser: But Michael Kitces thinks that delaying Social Security also provides an annuity-like benefit and should be considered like that as well.

Kitces: Now, the biggest caveats that we see to annuities in today's marketplace, the first one to be aware of is the simple comparison of an annuity to delaying Social Security, because the reality is that choosing to delay Social Security from 62 out to age 70 is actually mathematically a mini annuity. The cost of the annuity is the eight years of payments you won't get between 62 and 70 and the payout from the annuity is the larger payments you get from age 70 and beyond.

And so, when we actually look at today's marketplace what we find is that the value of delaying Social Security is actually much higher than buying an equivalent annuity in the marketplace today and the reason is simply that the calculations for delaying Social Security were last set when we changed the system in 1983. And as some of you may remember, back in 1983, interest rates much, much higher than they were today and mortality rates, how quickly people die, also much higher than today. Or said another way, we now live longer than we used to and we get lower interest rates. Back then we lived short periods of time with higher interest rates, which means Social Security actually gives a much higher, arguably even a missed-priced lifetime stream of income when you chose to delay it compared to buying an annuity which regulators in a good way require that they pay out based on current mortality tables and current interest rates because we don't want our annuity companies go out of business.

And so, what that means is, even if you are looking at an opportunity like buying an immediate annuity for a lifetime income, your first stop should still be delaying Social Security until age 70, first. It's the best deal we've got out there for buying guaranteed lifetime income. If we want more above and beyond that, then we start down the road of looking at annuity solutions.

Glaser: Maria, we've mostly been talking about things like Social Security, pensions, annuities, more financial products. But there are other sources of income out there, part-time work, rental income. How should you consider that when assessing your retirement readiness?

Bruno: I would say those probably outside of the fixed-income sources are the two big ones. You really need to think about whether they are finite or not. So, you can't really-–it's not prudent to plan for a part-time income well into advanced retirement. That's not feasible for many retirees either for physical reasons or cognitive decline, for instance. So, my recommendation would be if you are in a situation where you're thinking about working part-time or if you have rental income, just be prudent in terms of the expectations in terms of how long those income streams could last, particularly with the working part-time.

We have done some work at Vanguard, some survey work, with our Center for Investor Research and it was a survey looking at pre-retirees and retirees. And what was interesting in that the cohort that we had asked in terms of pre-retirees that they expected to work part-time in retirement, they were four times more likely to say, yes, they were going to work than the actual retirees who actually experienced working part-time. And that could be because they got into retirement and felt that they didn't need to or for physical or other type of health reasons couldn't. So, it's just interesting in that we have a cohort of near-retirees who are really planning for working part-time in retirement, but the actuality may not play itself out. So, you can just think through the monetary implications of that.

So, if you're thinking through this as someone who is approaching retirement, really run the numbers in terms of with these types of variable income streams and just see what the sensitivity around that would be. That would be my recommendation.

Benz: It makes good sense.

Glaser: Christine, on that rental income question, you think some retirees maybe underestimating the amount of work and being a landlord?

Benz: Well, that's the issue. A lot of retirees have had a positive experience being owners of rental properties. They like those streams of income that they can add to their Social Security or whatever income sources they have. But there are some issues. Certainly, Jeremy, you alluded to the maintenance issue if you are a hands-on landlord where you are on the hook for some of that ongoing maintenance. That could be something that a retiree, especially an older retiree may not have such an appetite for.

There are also some idiosyncratic risks associated with holding a lot of your assets in a single property. And this is something I have talked through with our colleague David Blanchett, and he is really not particularly sanguine about the idea of having rental properties in retirees' tool kits, not as a reliable source of income. He just feels like the undiversified risk of having a lot staked in rental properties versus a well-diversified portfolio of publicly traded securities. He likes the basket of publicly traded securities better.

Glaser: And in terms of retirees working, have you seen any data that kind of backs what Maria said that people just aren't working in retirement?

Benz: Well, actually, when we look at the cohorts of workers in the U.S. where we've seen the greatest growth, it actually has been in the 65-plus group and this is particularly since the financial crisis where we've seen a lot of growth in people entering the workforce later in life or staying in the workforce later in life, I should say. But I think Maria makes the all-important point that many people have the goal of working longer. And if that's essential to making your retirement plan work, just be aware that there could be some disruption. Even if you're feeling great and your health seems great, these unexpected things can happen with caring for spouses, or whatever it might be, things can come out of the blue that can disrupt your ability to earn an income later in life.

Bruno: I was just going to add to that. So, if you see and think through any individuals who are retiring earlier, then yes, part-time income would be probably more of an integral part of that plan, but it may be different than what they are doing today, it may be consulting and with that, there could be some variability in terms of cash flows. So, those are the nuances I think that would come together on an individual situation to think through that.

Glaser: And I think talking of work is a great transition to the questions, because we have one here about someone who, if they go back work how does it interact with taking Social Security? How do those two things go together? Or do they?

Benz: You want to take that?

Bruno: They do. I mean, you need to think if you--think the situation where you haven't claimed Social Security yet but you're working part-time, for instance, the earnings--there's a formula in terms of how Social Security payments are calculated in terms of the benefit and the highest earnings test that come into play there. But if you are an early retiree and taking Social Security benefits, if you're above a certain threshold, the benefits could actually be reduced. So, you need to be thoughtful about some of those nuances.

Glaser: Speaking of Social Security, there's a couple of questions here that I'll lump together, they're related about the viability of Social Security in the future. So, if you're 20, 30 years away from retirement, if you're worried about means testing, if you're worried about different changes that could happen, is there any way to really handicap this? What's the best way to think about Social Security for people who are farther away from taking it?

Bruno: Well, I'll start if you want, Christine.

Benz: OK.

Bruno: I mean, I haven't worked with clients directly in quite a number of years, but there was always this fear around Social Security is not going to be there when I retire. So, I don't want to plan for it at all. That's a very extreme situation.

Benz: Yes.

Bruno: But there are some individuals who want to assume no Social Security benefits and to want to make sure that they have a handle on what their retirement looks like. That is a very extreme situation. What could be relevant would be thinking about maybe how the payout structure of Social Security could change, maybe it would be delayed payments or those types of nuances and doing sensitivity around that if you are farther out from retirement.

Benz: I think, another crucial point is that if you are a Social Security worrier or even naysayer, then take a hard look at the implications for your plan. So, a lot of calculators will come prepopulated with some sort of Social Security benefit being part of your retirement plan. Well, take a look at what the implications are for your savings rate if you take that out. If you take that Social Security out, know that that is really going to require quite a heroic effort on your part in order to make sure that you have accumulated assets for retirement.

So, really think through what that means, not to say that if that's your view that shouldn't persist, but take a look at what that means for your savings rate before you go any further. I think--I have talked about this with some planners and they have said at the extreme end with some younger clients maybe they've haircut expenses by like 25%, but planners typically would not advise taking the benefit all the way down to zero simply because I think most people who look at this do think that the probability of even very young people having no benefit in retirement is probably pretty low.

Glaser: Christine, let's talk about variable annuities. I know this is slightly different our track here. We have a question about if variable annuities are something you should consider. Even though they appear to be very high cost, can you do better without them?

Benz: I think it depends on the individual. The costs are obviously crucial. So, I would look at taking advantage of other tax-advantaged options before I would look to any sort of variable annuity, because the costs, especially when you think about what market experts are forecasting for returns from the major asset classes over the next decade or so, pretty low-return environment. Do you want to marry that with a very high-cost product? Maybe not. So, high costs are a headwind.

Complexity is--and we certainly saw that in one of the clips--complexity, another big issue with variable annuities. It's very hard to know what you're getting. It's hard to understand all of the different parameters around the product. So, I would say if you're working with an advisor who is endorsing a variable annuity, make sure that you have exhausted all of your, what you think are dumb questions--make sure you fully understand the product before you sign on the dotted line. I can't tell you how many times I have had someone come up at the end of the presentation and show me an account statement for something and I've looked at it and said, oh, this is a variable annuity and they weren't even aware that they had a variable annuity versus some other account type. So, make sure you know what you're getting. It's a devilishly complicated area. I would say get some unbiased guidance on that decision if you can. If you're getting the advice from an advisor to buy a variable annuity, maybe get another opinion from someone who is not going to earn a commission on whether you buy that product.

Glaser: Speaking of annuities, when is the right time to think about buying them? We have a question on what age is the right or how far from retirement should you be purchasing that contract?

Bruno: I think it can vary. I mean, we've talked about deferred annuities. These annuities where you would purchase maybe between 55 and 65, for instance, but they don't pay until later in retirement, say, 85 or beyond. The value of doing that is they are relatively less costly when you're basically locking in those payments earlier. In terms of regular fixed-income annuities, generally--certainly, the older that you get, the more expensive, the more costly, that insurance can be. So, you need to think through that. But you want to purchase an annuity when you actually need that income, when you're talking about something that's not outside of a deferred annuity. Would you agree, Christine?

Benz: I would. I think another thing to keep in mind, and Michael Kitces mentioned it in his clip, is this idea of the interplay between interest rates and annuity payouts. And so, a big headwind for purchasers of annuities, immediate annuities especially, is that part of what your payout is keyed off of is the current interest rate environment. So, the insurer knows if they've taken your money and they can't earn much on it in terms of safe return, that your payout will be that much lower. So, a strategy that I've heard some planners discuss is the idea of laddering a series of annuities, although I've heard planners talking about this for several years and the interest rate environment …

Bruno: Has gotten and remained low, yeah.

Benz: Gotten worse. So, that's one potential idea. If you think that rates may go up, that buying a series of annuities could be an idea. The other virtue of that strategy is that you are able to diversify across insurers and I think that that's another consideration is making sure you're checking up on the viability of the insurer, the ability to continue to make those payouts, diversifying across several insurers might be an idea to help reduce that risk.

Bruno: Just to add to that, not to digress but it's important to make sure when you're looking at annuity quotes, make sure that you're doing an apples-to-apples comparison in terms of the benefits because it can be-- you had mentioned earlier, ask the questions, because some may have CPI adjustments for the payments or some type of inflation rider or a benefit for the surviving spouse. So, you need to just really make sure that--and a lot of this is buried in the quotes--so you just need to do your homework in terms of what the criteria that go into that quote.

Glaser: So, we'll leave this session here. But thank you and please stay tuned for our next session. We're going to get started in just five minutes where we're going to look at what your portfolio can really provide in retirement. Does that 4% withdrawal rule still work today? Please stay tuned.