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How to Pay Yourself in Retirement

Avoid these common mistakes and consider buying an annuity.

How to Pay Yourself in Retirement

Key Takeaways

  • One of the top common mistakes for retirees is anchoring on current income and trying to subsist on whatever income their portfolio organically generates.
  • A lot of research has pointed to the value of being flexible in terms of how much you pull from your portfolio.
  • Higher inflation is not great for retirement plans.
  • Higher interest rates are a positive for retirement portfolios. They make retirement spending easier.
  • Annuities make sense as part of your retirement income survival kit.

Jason Kephart: Hi, I’m Jason Kephart with Morningstar. Like most people, I’m worried about running out of money in retirement. To help assuage my fears and yours is Christine Benz. Christine is Morningstar’s director of personal finance and retirement planning. She’s also the host of The Long View podcast.

Nice to see you, Christine.

Christine Benz: Jason, it’s great to see you.

Common Mistakes People Make With Retirement Income

Kephart: At this year’s Morningstar Investment Conference, you’re talking about retirement income with some peers from Pimco and T. Rowe Price. It’s a hot topic right now. A record number of Americans are set to turn 65 over the next few years. And there’s nothing harder than making the transition from getting a paycheck to having to pay yourself off your savings. When you think about retirement income, what are some common mistakes you see people make when they’re thinking about how to pay themselves?

Benz: Well, at the top of the heap would be just anchoring on current income and trying to subsist on whatever income my portfolio organically generates. There are a couple of problems with that. One is that when yields are higher as they are today, you’re living higher on the hog. But when yields are really, really low, as they were for a good part of the past decade, you’re forced to subsist on a lower income stream. So, that’s a big issue, just getting buffeted around by whatever is going on in the interest-rate environment. And then another related pitfall is that in order to generate a subsistence level of income, people oftentimes gravitate to very risky-looking portfolios. We oftentimes see portfolios that instead of holding that high-quality bond portfolio, people might hold a portfolio that’s kind of junky in its complexion. And so they end up with bonds that kind of act like the stocks in the portfolio. So, that’s the main thing that I see in investor behavior with respect to retirement income.

Flexible Withdrawal Strategies in Retirement

Kephart: I think the risky bond thing is something to definitely keep an eye on. You’ve done a lot of really cool research on different withdrawal strategies. How important is it to have a flexible withdrawal strategy in retirement?

Benz: Right. A lot of the great research that’s been done over the past couple of decades has really pointed to the value of being willing to be flexible in terms of how much you pull from your portfolio. So especially after a down year, if you’re willing to take less from that portfolio, that redounds to the benefit of a higher standard of living over the whole of your retirement. That means that you can take a higher starting withdrawal rate, oftentimes, and you can also take a higher lifetime withdrawal rate. So, just an example, we tested a variety of different flexible strategies in our retirement-income research. Our baseline conclusion was that people who want a very stable stream of income can take 4% initially if they want their money to last over 30 years. But for people who are willing to use a flexible strategy, they can take a starting withdrawal rate as high as over 5%. So, it’s a big deal. It can make a big difference in terms of people’s quality of life.

How Investors Should Factor in Inflation in Retirement Portfolio Withdrawals

Kephart: Another risk to the quality of life over time is inflation and what that can do to your savings over time. And inflation just keeps making headlines for all the wrong reasons, unfortunately. How should the investors factor in inflation into how they’re withdrawing from their portfolio?

Benz: It’s definitely an important consideration. And higher inflation is not great for retirement plans. I think it really points up the importance of thinking of inflation as another sequence risk. So, if high inflation occurs early on in your retirement, that’ll mean that the prices that you’re paying initially to buy all the things that you need to buy to fund your quality of life, that those will just kind of build upon themselves. And so it’s a negative, all else being equal, if you’re expecting high inflation throughout your retirement time horizon. You’d want to be more conservative in terms of that starting withdrawal percentage, but I would say one countervailing force and a positive for people when they’re thinking about retirement planning is that when we look at retirees spending over the lifecycle, retirees don’t spend in line with inflation. They tend to spend a little bit less as they move into their mid-70s and 80s and beyond. They spend less than the inflation rate. So, that is, I think, some comfort that arguably you could spend a little bit more initially if you’re OK with that assumption that you won’t necessarily keep up with the inflation rate in terms of giving yourself increases in your paycheck.

How Higher Interest Rates Can Impact Retirement Portfolios

Kephart: One of the other factors that inflation has caused is interest rates are a lot higher now than they have been in a very long time. You mentioned how people in the past have kind of been forced to stretch for riskier credits to maybe get that income, but now that interest rates are higher for even high-quality credit, how should that impact how investors think about their portfolio?

Benz: Well, it’s definitely a positive. It makes almost every other aspect of retirement planning easier. So when we initially did our retirement income research, we came out with the idea that if retirees wanted their money to last over a 30-year horizon, they should start with like a 3.3% withdrawal rate, that was back in 2021. When we revisited that same research, the same sort of baseline assumptions in 2023, we found that a 4.0% initial withdrawal percentage was safe. Interest rates explain most of that differential. They make retirement spending easier. They also mean that, all else equal, retirees can use a safer portfolio. Then would be the case when interest rates are really low. When we plug all of our data into our Monte Carlo simulations, they gravitate to a balanced portfolio because of that safe cash flow that you can get from safe securities today. So the highest safe withdrawal rate over a 30-year horizon actually corresponded with an equity allocation of just 20% to 40% in equities.

Should Annuities Be a Part of Your Retirement-Income Strategy?

Kephart: Annuities are tools that are designed to guard against longevity risk, but they can be very complicated, and it can be really hard to tell if you’re getting a good deal or not. Do annuities make sense as part of your retirement-income survival kit?

Benz: This is a controversial topic, but I would say that they do. I think especially the very vanilla annuity types, immediate annuities, just a single-premium immediate annuity where you’re getting that stream of income over the rest of your life, or perhaps a deferred-income annuity. Those would be the main things I would start with if I’m looking to increase my baseline of lifetime income. The annuity might go hand in hand with someone employing a flexible withdrawal strategy. So, if you have your sort of basic living expenses locked down with a combination of Social Security and possibly an annuity, that can give you more comfort. It can just make it easier to perhaps tighten your belt after a year like 2022 when stocks and bonds both fell simultaneously. I actually think those two things work really nicely together where you’ve got more-stable lifetime income paired with a portfolio where you’re potentially going to be a little bit flexible in terms of those withdrawals.

Kephart: Well, thanks, Christine. I’m feeling a lot better about my odds of success in retirement now, and I hope our viewers are, too.

Benz: Well, thank you so much, Jason.

Watch more from the Morningstar Investment Conference 2024 here.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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About the Authors

Christine Benz

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Christine Benz is director of personal finance and retirement planning for Morningstar, Inc. She is also the author of a new book, How to Retire: 20 Lessons for a Happy, Successful, and Wealthy Retirement (Sept. 2024, Harriman House). She co-hosts a podcast for Morningstar, The Long View, which features in-depth interviews with thought leaders in investing and personal finance.

Benz joined Morningstar in 1993. Before assuming her current role she served as a mutual fund analyst and headed up Morningstar’s team of fund researchers in the U.S. She also served as editor of Morningstar Mutual Funds and Morningstar FundInvestor.

She is a frequent public speaker and is widely quoted in the media, including The New York Times, The Wall Street Journal, Barron’s, CNBC, and PBS. In 2020, Barron’s named her to its inaugural list of the 100 most influential women in finance; she appeared on the 2021 list as well. In 2021, Barron’s named her as one of the 10 most influential women in wealth management.

She holds a bachelor’s degree in political science and Russian language from the University of Illinois at Urbana-Champaign.

Jason Kephart

Director, Multi-Asset Ratings
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Jason Kephart, CFA, is director of multi-asset ratings for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc. He is responsible for Morningstar’s multi-asset ratings methodology and shares responsibility for research priorities. Kephart leads the firm’s global and North American multi-asset ratings committees. Kephart regularly contributes to Morningstar’s thought leadership on target-date strategies, 60/40 portfolios, model portfolios, and other multi-asset outcome-based products. He has been the lead analyst for multi-asset strategies from firms such as Vanguard, BlackRock, T. Rowe Price, and Dodge & Cox.

Before joining Morningstar in 2014, Kephart spent seven years as a journalist for InvestmentNews, Fund Action, and SmartMoney, reporting primarily on the mutual fund and exchange-traded fund industries.

Kephart holds a bachelor’s degree in English from Florida State University. He also holds the Chartered Financial Analyst® designation.

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