How to avoid outliving your money
If you can, delay taking Social Security benefits
Many risks await you in retirement, but two you really need to address are longevity and inflation.
One is the risk of outliving your assets; the other is the risk of losing your purchasing power.
How you allocate your assets to manage and mitigate those risks matters. Put too much of your money in one place, and you run the risk of not keeping pace with inflation. Put too much in another place, and you run the risk of running out of money or, as some say, lifestyle.
What to do?
No quick solution
Longevity and inflation risks are serious challenges, and there aren’t simple answers, said Steve Vernon, author of “Retirement Game-Changers.”
“It will take a while for people to understand the risks, learn about their options and make informed choices,” he said. “You can’t do this in an afternoon.”
Delay claiming Social Security
If a retiree or near-retiree is worried about longevity and inflation risk, there is “actually a silver bullet for this,” said David Blanchett, head of retirement research for Morningstar Investment Management:
Delay claiming Social Security retirement benefits.
“Social Security benefits are linked to inflation and guarantee income for life,” he said. “The payout, or really the effective return, from delaying claiming Social Security retirement benefits is quite a bit higher than buying a private annuity today, so it should likely be the first place the retiree goes to look for additional guaranteed income.”
Buy an immediate annuity
If you’re already collecting Social Security and are still worried about the risks of longevity and inflation, you have options. A pure life immediate or deferred income annuity is an ideal tool to mitigate longevity risk, said Michael Guillemette, an assistant professor in the personal financial planning department at Texas Tech University.
According to Guillemette, if you need guaranteed income now, then an immediate annuity, which pays out right away, may be a good option. If, however, you have sufficient assets in your retirement portfolio to pay expenses early in retirement, then a deferred annuity, which pays out later in life, may be a better option, he said.
“Annuities are superior to bonds in the academic literature because while bonds pay principal and interest, annuities essentially pay principal, interest and mortality credits,” Guillemette said. “The mortality credits help to mitigate longevity risk, as the survivors who die early in the annuity pool subsidize the annuitants who live longer than expected.”
The downside of annuities is that they don’t typically protect against inflation risk. Given that, Blanchette said you might consider an immediate annuity with payments linked to inflation or, better yet, an immediate annuity with a fixed cost-of-living adjustment, say 2 percent per year.
Traditional pension
If you’re eligible for a traditional pension plan or cash balance plan, that plan will pay you a guaranteed source of retirement income for the rest of your life, no matter how long you live, Vernon said. Don’t, however, elect a lump sum payment if you’re offered that option, he said.
“Such a pension protects you against longevity risk but typically not inflation risk,” he said. “Still, you’re usually better off taking the annuity than investing the lump sum, which subjects you to longevity risk, inflation risk and investment risk.”
Buy TIPS
If you don’t want to – or can’t – delay claiming Social Security, and you don’t want to buy an annuity, Blanchett said a great investment for inflation, especially today, is Treasury Inflation-Protected Securities.
TIPs are bonds, but unlike nominal bonds, the principal is indexed for inflation, Guillemette said.
Invest in equities
For inflation risk, the key is a portfolio with a higher return, which generally suggests a more aggressive portfolio, Blanchett said.
“I am hesitant to recommend an equity risk level beyond about 60 percent for most retirees given current market valuations,” he said. “So there definitely needs to be more risk, but not too much risk.”
Vernon also recommends investing in equities to manage inflation risk, as well as devising a thoughtful drawdown or withdrawal strategy.
“Use this income to cover discretionary living expenses, such as travel, hobbies and spoiling your grandchildren,” he said. “This income isn’t guaranteed to last for life or keep up with inflation, but with careful planning, you can increase the odds of addressing these risks.”
Consider using a low-cost balanced, target-date or stock-index fund for this purpose.
“If you achieve historical returns on stocks, you might keep up with or even outpace inflation,” Vernon said.
“Of course, you have the risk that you might lose money,” he said. “That’s why you use this money to pay for discretionary living expenses that you can reduce if necessary.”