Make Your Nest Egg Last as Long as You Do

October 20, 2011

Once you’ve saved and invested for financial independence, the final step will be figuring out how to turn that nest egg into an income stream that will last as long as you do. With people living longer and longer, this can be a challenge for all retirees but is especially difficult for anyone looking to retire early. There’s even a good chance you’ll live longer in retirement than you did working.

At first, it may not seem that hard. After all, if your investments earn 8-10% a year on average, can’t you just withdraw 5-7% for income and let your nest egg grow the other 3% to keep pace with inflation? The problem is that the market rarely actually earns 8-10% in any given year. Instead, it tends to move in long term cycles of high returns (remember 1982-2000?) and low returns (1968-1982 or 2000-today). If you’re unlucky enough to retire in one of those long down cycles, you’ll be selling your investments while they’re low and there may not be much left in your portfolio by the time the market starts to recover. (Some of our greatest minds armed with supercomputers haven’t been able to consistently predict when these cycles will begin and end, so don’t even think about it.) Let’s take a look at the pros and cons of some different options:

The 4% Rule

Pro: The financial services industry has developed and you can generally withdraw about 4% of the initial value of your portfolio and increase that amount annually with inflation with a minimal risk of running out of money. This could be even more effective with one of the low volatility investment strategies I mentioned in my last 2 blog posts.

Con: There are a couple of downsides though. The first is that some people will need more than 4% of their portfolio value to retire comfortably. The second is that there’s still a chance of running out of money if the market performs particularly poorly or your expenses rise more than expected. Both could happen simultaneously if our growing national debt sparks a run on the dollar.

TIPS

Pro: If you’re absolutely averse to any risk, the safest way to get income would be to invest in a laddered portfolio of TIPS or Treasury Inflation Protected Securities.  These are bonds that are guaranteed by the federal government to increase with inflation and pay a fixed rate of interest on that inflation-adjusted value every 6 months. To ladder your portfolio, you would buy a series of bonds maturing at different times. For example, you could have bonds maturing every year for the next 10 years. When the first group of bonds matures in a year, you would reinvest them in new 10 year bonds and keep the cycle going. This way, you’re not stuck with low-interest rate bonds if interest rates go up.

Con: Remember that old tradeoff between risk and return? Well, 10-yr TIPS are currently only paying a little more than 2% a year. That 2% will grow with inflation but you’d still have to be able to live on about 2% of your portfolio, and that’s before taxes.

High Dividend Paying Stocks

Pro: By living off stock dividends, you can earn about 3-4% income and you don’t have to worry about touching the principle and thus running out of money. Stock dividends have also been more stable than stock prices and tend to grow faster than inflation, which can help offset costs that rise faster than inflation, like health care. In addition, stocks that pay a high dividend yield have had better returns and lower risk than the market as a whole. Look for individual stocks if you can afford to buy at least 30-50 stocks or purchase a high dividend ETF so that as much of those dividends come to you rather than fund fees.

Con: The dividends aren’t guaranteed and your income will initially be a little lower than with most of the other options.

Immediate Income Annuities

Pro: If you’re older and need as much income from your portfolio as possible, buying an immediate income annuity from an insurance company will do the trick. These aren’t the high-fee deferred variable annuities that you may have heard about. Instead, the insurance company promises to pay you a fixed income for as long as you live, in exchange for a lump sum of money. You can also purchase them with an inflation adjustment, a survivor benefit, and even some access to your principal, all for a lower payout of course.

Con: You generally lose access to your principal, so make sure you keep some money set aside for emergencies. You also lose the potential growth on that principle and the ability to pass it on to your heirs. Finally, that promise is only as good as the insurance company’s ability to pay. While there may be  some protection from your state, you probably still want to check out the company’s ratings and perhaps spread the money between more than one insurer.

A final thought is that many retirees are reluctant to spend any of their savings. They’ve spent so long building it up that it just feels wrong to spend it down. If you’ve reached the point where you can retire, keep in mind that you’ve worked hard to earn and save your money. Now it’s time to make that money and make it work just as hard for you.