Running out of money before you run out of life. It’s the biggest fear many retirees face. And, for baby boomers and succeeding generations without guaranteed pensions, it’s not just a night terror — it’s a realistic concern. Without adequate savings, a prudent lifestyle, and regular financial checkups, running low in retirement is a very real possibility.
In my last article I reviewed the two fundamental solutions when you find yourself running low in retirement — reducing expenses, and increasing income.
In that article, I went deeper into the two most powerful expense strategies: cutting discretionary spending, and downsizing your home. These are major levers you can throw on the expense side to modify your lifestyle, and salvage a financially independent retirement.
But they might not be enough. Or you might want to go further to ensure your comfort or security. So in this article I’ll explore the income-based solutions to running low in retirement.
As I’ve written, to be realistic, a retirement backup plan needs to be entirely under your control. It can’t rely on good fortune, the benevolence of others, or external economic conditions.
So, we won’t be discussing either working or inheritances here. Maybe you could return to some work in retirement. But that generally requires a cooperative economy or employer. And it may not be physically possible for older retirees. Or, maybe you can count on inheriting some family wealth, eventually. But inheritances are dictated by the life span and spending habits of others. You shouldn’t pin your baseline retirement comfort on factors you can’t control.
If you have investments, you may be tempted to try picking “better” ones that would outperform the market. But decades of research prove that it is impossible to consistently beat the broad market indexes. Not only do the majority of active stock pickers fail, but they also usually generate higher expenses along the way — a major headwind to success.
If your investment portfolio is very conservative — largely in cash, CDs, or bonds — you could allocate more to stocks to increase returns. But holding more stocks than is suitable for your risk tolerance is a dangerous game. You might bail out at a loss when the going gets tough. And it will get tough. Because, to potentially increase returns, you must add volatility to your portfolio and take on more risk of reducing returns. Selling at a loss would damage your perilous retirement finances even further.
Fortunately, you can still access a couple of powerful income-based strategies. You needn’t go back to work, hope for an inheritance, pick stocks, or change your asset allocation. There are other legitimate and safe approaches to increasing retirement income. But, they carry a critical prerequisite: You must have some assets — either investments or a home — to begin….
The first strategy for safely increasing retirement income is to purchase a fixed annuity. I prefer the plain vanilla single premium immediate annuity. With this type of annuity contract, you pay the insurance company a lump sum, and they then pay you a monthly income for life. There is no variability — no “upside,” or “downside” — in the income stream, other than perhaps inflation adjustments, if you pay for those. And fees are easy to assess, because you know precisely what you’ll pay, and precisely what you’ll get back, and when.
Fixed annuities are generally invested in bonds, yet they can pay more than the going rate on a typical bond fund. That is, they can substantially increase your investment income over what you could accomplish with your own investments, given a similar level of risk. How do they do that?
The first reason is simple: An annuity returns some of your principal to you, along with interest payments. That means you are consuming principal. When you purchase an annuity, you give up control over your principal and, in return, the insurance company returns portions of it to you over time to increase returns. But, you probably won’t get it all back unless you live longer than expected.
The second reason that an annuity can enhance returns is more complex. It’s called mortality credits — the technical term for the benefit you get by pooling your money with a large group of other people.
Individuals don’t know their lifetime in advance. If you’re managing money on your own, you must live conservatively to ensure you don’t run out. By contrast, an insurance company can know the statistical lifetimes of a large group quite accurately. That means the company can pay everybody a better income than they could afford on their own, confident that some individuals will die earlier than average, leaving assets to pay the incomes of those who live longer.
Add up both of these factors and you get a powerful result: When you purchase an annuity, you can usually increase your effective investment income yield by several percentage points, depending on your age. As a rough example, consider that as I write this, the SEC Yield on Vanguard’s Intermediate-Term Bond Index Fund (VBIIX) is about 2.5%. Yet ImmediateAnnuities.com reports that an equally safe fixed immediate annuity can pay a 65-year-old couple about 5.7% — more than 3 percentage points higher.
So, your liquid assets, whatever they may be, can go much further in providing retirement income as an annuity. Just understand that an annuity is not like your other investments. You don’t have access to your principal. So the downside, if you must put most of your assets into an annuity, is that it reduces or eliminates your cash reserve for dealing with unexpected expenses or leaving a legacy. But your heirs would probably prefer that you be self-supporting, even if it means they lose out on an inheritance. And an annuity can be instrumental in achieving that primary objective — baseline retirement security.
What if your investment assets are minimal or you’ve already maximized your income from annuities? Is there somewhere else you can turn to produce more retirement income? Yes, if you own or have substantial equity in your house, there is. It’s a somewhat complex and checkered financial product that has recently become more palatable. As noted retirement researcher Wade Pfau writes, “…recent research has demonstrated how financially responsible individuals can improve their retirement sustainability with a reverse mortgage.”
A reverse mortgage lets you generate income from your home equity, guaranteed for life as long as you stay in your home. You, or your heirs, may not own your home in the end, but you’ll never owe more on the loan than the value of your home. Government insurance protects you if the bank has problems producing income, and it protects the bank if you should consume all your equity before dying. From your perspective, the advantage is clear: using only your home, without requiring any additional assets, you now have access to an income stream that will last as long as you do.
Though recent reforms have reduced the costs and risks, reverse mortgages are far from a perfect solution. In my opinion, they should be considered a last resort. They remain complex, and expensive. They are sometimes sold aggressively in inappropriate situations. Used recklessly, they could result in losing your home. Why? Because you still must have cash flow to pay for taxes, insurance, and maintenance, or risk default. Given the expense and downside, the government requires financial counseling for reverse mortgages in most cases. But they are a legitimate choice in the right circumstances.
The biggest downside to a reverse mortgage in my mind is the expense. The transaction costs are similar to buying a home. At settlement there will be an origination fee (shop around for the best deal: only the maximum is set by the government), an upfront mortgage insurance premium (generally 0.5% of the appraised value), and other typical real estate closing costs. Then, for the life of the loan, the lender will draw down your home equity to pay its interest charge based on the market rate, an FHA insurance premium of 1.25%, and possibly a servicing charge. Those long-term charges will substantially erode your wealth, even though the effects may be hidden and muted by the regular income.
In my example calculations, about 5-7% of the available home equity disappears into fees at the start of a reverse mortgage. Then there are the monthly charges compounding for the life of the loan after that. If there is a cheaper way you can generate retirement income than a reverse mortgage, you should choose it instead. My figures show a reverse mortgage generating about a 3% draw against your total home equity for life, not adjusted for inflation. Compared to getting zero, that’s pretty good. But compared to annuitizing, or probable stock market returns, it’s nothing special.
The second biggest downside to a reverse mortgage is the complexity. The more complicated a financial instrument, the harder it is to determine the risks and value. You may have to rely heavily on mortgage professionals to understand and compare offerings. Two online calculators that I found useful in this process were from the Mortgage Professor and the National Reverse Mortgage Lenders Association (NRMLA).
Despite the drawbacks, reverse mortgages will likely be the best retirement income solution for many people who are “house poor” — stuck in large homes with inadequate cash flow. Downsizing would be preferable, but reverse mortgages are another option. Scott Burns writes, “Used for long term planning rather than emergencies, reverse mortgages are likely to become a major tool for the millions of Americans who have a lot more equity in their homes than in their retirement savings.”
How do these income-based strategies work in practice? For a typical retired couple, what is the potential financial benefit of annuitizing and taking out a reverse mortgage? To answer these questions, let’s analyze a simple scenario….
Assume a couple, both age 65, that is concerned about their ability to meet retirement expenses going forward. They have $500K in total saved investment assets, and they own their $250K home, free and clear.
For an initial retirement income strategy, they could try systematic withdrawals from their investments using a “safe withdrawal rate” (SWR), expected to preserve their assets over a 30-year retirement. What is that SWR these days? Well, it’s probably less than the historical 4%. In fact, Wade Pfau recently argued that it’s more like 2%. But, for our example, let’s give systematic withdrawals the benefit of the doubt, using a slightly more optimistic 3% SWR.
At a 3% SWR, this couple’s $500K in investments can safely generate about $1,250/month in inflation-adjusted retirement income. Coupled with Social Security, that might be enough, but it could be very tight, depending on their lifestyle. What if they want to live less frugally, and are willing to give up some control of their principal?
Well, as I write this, ImmediateAnnuities.com will let them buy an annuity with those investment assets that generates about $2,400/month. And the NRMLA reverse mortgage calculator shows they can take out a reverse mortgage on their home to generate about another $700/month for life. That’s a total of about $3,100/month in guaranteed retirement income.
So, by annuitizing plus using a reverse mortgage, this couple is able to nearly triple their available monthly retirement income versus what could be achieved using a safe withdrawal rate for their investments alone! By virtue of having some assets — investments and a home — and choosing to give up some control over their principal, they can significantly boost their retirement income. Though the final amount is not inflation-adjusted, it’s likely to exceed what they could safely draw from investments, for decades to come.
So that’s it. This article and the last have provided the ingredients for a backup plan on both the expense and income sides of retirement. The strategies I’ve described give you leverage to preserve a comfortable retirement, without charity from the outside, even in some of the worst-case financial scenarios.
The essential strategy for increasing retirement income is this: You give away some or all of your principal in exchange for more income. That also means that you lose some flexibility — for handling emergency expenses, gifting, or inheritance. But, in return, you get the peace of mind of guaranteed income for life.
Running low in retirement would be a nightmare. But there are solutions to keep you safe. If you are in this particular boat, you may have to give up pride of ownership in the vessel, but at least you can keep it afloat for the duration of the voyage!
Darrow Kirkpatrick is a software engineer and author who lived frugally, invested successfully, and retired in 2011 at age 50. He writes regularly about saving, investing and retiring on his blog CanIRetireYet.com.