Dale Berndt and his wife, Carol, created a draw-down strategy that leaves their principal intact—allowing Dale to afford hobbies like building sophisticated model helicopters.
For previous generations, retirement planning generally meant one thing: saving and investing for the time when you would no longer bring in an income. Nowadays, with people living longer, health care costs rising, pensions disappearing and people increasingly embracing more active, adventurous post-career lives, retirees need to be a lot more deliberate about making their money last.
It's little wonder people are concerned about how to fund a retirement that could last 20 to 30 years, perhaps even longer. According to the latest Merrill Lynch Affluent Insights Survey, two-thirds of the women polled, and 54% of the men, are not confident that their assets will see them through a long retirement.
The financial challenges of today's retirees have been called a "retirement crisis," and according to David Tyrie, head of Personal Wealth and Retirement at Bank of America Merrill Lynch, that's no exaggeration. "It used to be that retirement planning consisted of accumulating enough assets to achieve the number—some target of how much money you needed before stopping work," he says. "Then you calculated how much income you could safely draw from those assets each year. But a static, simplistic retirement plan no longer works as well."
Indeed, there's nothing simple anymore about how people need to plan for their later years. The decisions don't end at 65, or whenever you leave the workforce. In many ways, they're just beginning, and the conversations you have with your Financial Advisor after you retire may be even more important than the ones you had while you were accumulating your retirement nest egg. In particular, how you draw down your assets can determine whether or not you outlive them.
That said, any strategy for spending money during retirement will inevitably run into detours—some voluntary, others not. "A long retirement presents many unknowns that can have significant financial consequences, such as how long you'll live, the state of your health, liquidity needs, risk tolerance and even big changes in your goals," Tyrie says. "To build income security as your retirement unfolds, you have to continually course-correct your income strategy."
Planning for the Unexpected
In 2000, when Dale Berndt was 60 and his wife, Carol, was 56, they understood that it was time to create a draw-down plan—a way to deploy their savings that would meet their needs in retirement, but also be able to accommodate unforeseen changes in their lives. Working with their Merrill Lynch Financial Advisors, Peter Vickery and James Bowe, Dale and Carol began by considering all their sources of income. They decided they would each begin drawing Social Security benefits as early as the law allowed, at age 62, and stretch their other resources—pensions and 401(k)s from their jobs, rental from real estate they own, and investment interest and dividends—so that they could avoid tapping their principal until necessary. This approach, they hoped, would give them sufficient income however long they lived and enable them to provide an inheritance to their children.
Almost immediately upon retiring, the couple saw that their new life was going to be different from what they envisioned. First, they decided that traveling extensively was not for them after all. Looking for a hobby closer to home, Dale, a former electrical engineer at Honeywell, began building sophisticated model helicopters. He also decided to supplement his income with part-time consulting work, which he continued for several years. Then he became passionate about another project: converting a gasoline-engine car into an all-electric vehicle, at a cost of $35,000 and counting.
During these first dozen years of the couple's retirement, Vickery and Bowe have recalibrated the Berndts' income plan several times; for instance, when they wanted to help one daughter buy a condo and the other with a major house addition. Because both cases required the couple to dip into their investment principal, their Financial Advisors were able to show them how to restore their savings by reducing their spending for a time.
A Draw-Down Strategy That Fits Your Needs
As the Berndts' story illustrates, retirees today require a thoughtful approach that's tailored to their circumstances—aligning their spending expectations with their income sources, longevity risks and other factors. Your Financial Advisor can help you create a customized draw-down strategy through a step-by-step process that's grounded in the following questions.
What kind of life do I want in retirement?
The amount of income you'll need is based on a number of considerations: where you'll live, how much you'll travel, to what degree you may continue to work, and many more. For couples, this conversation may involve making compromises about what they both want. Or you may decide, as Dale and Carol Berndt have, to create parallel strategies that reflect different attitudes about investment and longevity risk. Because Carol is more concerned than her husband about the possibility of running out of money during a long retirement—a realistic concern, because women have a longer life expectancy than men do—her approach is somewhat more conservative than his.
"People who worry about living a very long time should focus on spending less now to give themselves more later," says Moshe Milevsky, professor of finance at the Schulich School of Business at York University in Toronto and author of the upcoming book The 7 Most Important Equations for Your Retirement. Those less concerned about their longevity are likely to decide that their 3% chance of living to 100 isn't enough to discourage them from a higher standard of living early in retirement. "We all face these decisions, and they belong in the same conversation in which we talk about our attitudes toward financial risk," Milevsky says.
How much will I spend?
First, it's important to determine the basic costs that must be covered—mortgage or rent payments, utilities, food, Medicare premiums and the like. Then you can consider the things you'd like to do. On Dale Berndt's wish list, for example, is coming up with a way to patent and sell an idea based on his work on the all-electric car. "Or I might start a consulting business," says Dale, who already has 25 patents to his name. Carol, meanwhile, is thinking about relocating to Denver to be closer to one of her daughters. "I'm thinking ahead 10 or 15 years and realizing I might need a daughter to be my advocate in medical matters," she says. You might want to make a list of your wants along with your needs, ranking them in order of priority.
As you do, however, bear in mind that many people tend to overestimate how much they can afford to spend in the early years of their retirement. When calculating your optimal spending rate with your Financial Advisor, consider such factors as your age, risk tolerance, liquidity needs, time horizon, asset allocation and whether you want to leave a sizable inheritance. According to a recent Merrill Lynch Affluent Insights Survey, half (51%) of affluent Americans who have not yet retired say they would rather retire later than make tradeoffs to their current lifestyle. But once they realize they might need to spend less to help their assets last, 81% admit they would cut back, including downsizing their home or leaving less to their children.
What strategies can help me make the most of my potential sources of income?
Although it's easy enough to look to pensions, retirement accounts, Social Security and other possible resources (such as the Berndts' rental income), you need to consider a range of options before you decide how to make these resources work in concert with one another. Most experts would counsel you to find a guaranteed source of monthly income to cover the costs you can't avoid. While some of that may come in the form of a corporate pension or your Social Security benefits, you may also need a supplemental income stream. Annuities can offer another potential source of income. These insurance products, which come in myriad forms, can be set up to provide guaranteed income for a specified period or for as long as you live. That can be particularly helpful for women, who often don't have pensions and do have longer life expectancies.
"Annuities can have great value in helping you meet essential living expenses in retirement," suggests David Laster, director, Investment Analytics at Bank of America Merrill Lynch. "The larger the shortfall, the greater your annuity payment should be."
In what order should I consider tapping my assets?
You could choose to take money from taxable brokerage accounts first, because your long-term investment profits will be taxed at capital gains rates—currently a maximum of 15%—whereas withdrawals from an IRA or 401(k) plan are taxed as regular income at rates as high as 35%. (Tax rates for all kinds of income are scheduled to increase in 2013.) But if investments in taxable accounts have appreciated substantially—or if you think they have great potential to grow—you could earmark those assets for your heirs, as the Berndts have done. That way, your heirs may be able to avoid being taxed on asset growth that occurred during your lifetime.
If you and your spouse both have 401(k)s or other personal retirement accounts, that adds another twist to your planning. Vickery and Bowe, the Berndts' Financial Advisors, suggested a balanced approach that gently draws down both spouses' IRAs and taxable accounts, minimizing the amount of principal that's consumed and avoiding depleting any of these income sources. "If you exhaust your taxable accounts first and then have large medical costs or buy a house, you're stuck taking the money out of your IRA, which can be very expensive if you have to pay a quarter of it in taxes," Vickery says.
Should I roll my 401(k) accounts into an IRA?
Although you don't have to roll your 401(k) accounts into an IRA once you retire, doing so will give you more investment options designed to generate income and may make it easier to access your money. "Having money automatically deposited from your IRA to your checking account every month helps people make a smooth transition to retirement," Bowe says. Consolidating multiple 401(k)s into one IRA also helps you keep track of when you must take required minimum distributions, says Bill Hunter, director of Personal Retirement Solutions at Bank of America Merrill Lynch. That can be important, as missing a deadline could result in a penalty of 50% of the amount you should have withdrawn.
For those who can afford the immediate cost, converting retirement accounts to a Roth IRA is another option to consider. Doing so could both reduce tax obligations and enable you to pass along tax-free income to your heirs.
What about Social Security?
"If you begin benefits at 62, the earliest allowable age, instead of waiting until full retirement age at 66, you're locking in a permanent discount of 25% in your monthly checks," Hunter says. If, on the other hand, you can wait until age 70, you'll get nearly a third more than if you had started at full retirement age—and about 75% more than by opting to begin benefits at 62. A further reason to consider electing a later start date for Social Security benefits is that you'll be ensuring a higher monthly check for your surviving spouse.
The Berndts have made several course corrections to their
draw-down plan, working with their Financial Advisors Peter Vickery, left, and James Bowe.
How will I continue to grow my assets?
"Retirees today have to view themselves as long-term investors," Laster says. That means keeping part of your portfolio in stocks, which over the long term have outperformed bonds and other fixed-income investments. "People who want to maximize how much they can spend during retirement should allocate roughly 40% to stocks, though older retirees can afford to hold fewer equities than younger ones," he notes. If you're concerned about losing value in a market downturn, you might think about market-linked investments. Some of these may preserve your principal or at least limit any market losses.
Carol Berndt considers herself a conservative investor, but she still maintains a 50-50 mix of stocks and bonds in her IRA, which she may need if her health care expenses increase later in life. Carol can also afford to be sanguine about Dale's expensive hobbies, because he funds them from the required minimum distributions he must take from his own IRA, which is invested in more aggressive equities than the kind that Carol wants in her account.
What about inflation?
The inflation rate for retirees can be as much as a percentage point higher than the rate for the population as a whole, according to the Bureau of Labor Statistics. That's largely because retirees spend more on fast-rising health expenses. Meanwhile, even inflation of just 2.5% annually—the long-term rate projected by BofA Merrill Lynch Global Research—will reduce a retiree's spending power by more than half after 30 years, Laster observes.
One way to help your income keep pace with inflation is to allocate a substantial portion of your bond portfolio to Treasury Inflation-Protected Securities (TIPS). "Today's low inflation expectations are built into the cost of TIPS, so you can get an inflation hedge at a very attractive price," Laster says. The Berndts' strategy of living on dividends and interest also preserves principal while outpacing inflation. It generates an annual income of roughly 3% to 4% of the value of their assets.
What about health costs and longevity risk?
"Even if you have a couple of million dollars in assets, an illness such as Alzheimer's disease or Parkinson's could totally exhaust your wealth," Laster says. Adds Vickery, "For the past 10 years, we've stressed the importance of having long-term-care insurance to clients to ensure that a catastrophic medical event doesn't wipe out assets for the surviving spouse or an inheritance you planned to give." The Berndts feel relatively confident that they would be able to afford nursing home care with assets from their IRAs and the potential sale of their rental properties, as well as possibly downsizing from their current home.
Meanwhile, what should be a happy surprise—living longer than expected—could ultimately imperil your retirement assets. One hedge against outliving them is longevity insurance, a kind of annuity that delays payments until age 85 or so but pays out a higher-than-normal percentage of the money you've invested each month. The earlier you buy the insurance, the greater your benefits.
Do I need to adjust my strategy?
Revisiting your draw-down strategy and making necessary course corrections along the way is a critical component in its long-term success. "Enjoying your wealth in retirement without fear of outliving your assets is a challenge for many retirees," Laster says. "But by regularly reviewing your draw-down strategy with your Financial Advisor, you can make the changes you need to, no matter what crests and crevasses appear in your retirement landscape."
Case studies are intended to illustrate brokerage and banking products and services available at Merrill Lynch. You should not consider these as an endorsement of Merrill Lynch as an investment advisor or as a testimonial about a client's experiences with us as an investment advisor. Case studies do not necessarily represent the experiences of other clients, nor do they indicate future performance. Investment results may vary. The investment strategies discussed are not appropriate for every investor and should be considered given a person's investment objectives, financial situation, time horizon, liquidity requirements and particular needs. Clients should review with their Merrill Lynch Financial Advisor the terms, conditions and risks involved with specific products and services.
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ABOUT TREASURY INFLATION-PROTECTED SECURITIES:The first risk factor of investing in TIPS is that the measurement of inflation is done through CPI. The CPI measurement may not be completely accurate so the principal balance of the TIPS may not increase along with true inflation.
Secondly, if interest rates spike higher, TIPS yields may rise as well. This would negatively impact the price of the bond in the short run; however, TIPS should still outperform in the long run.
Another downside of investing in Treasury Inflation-Protected Securities revolves around the fact that they do not pay the inflation adjustment out until the bond matures. This has an implied risk, albeit almost zero since the U.S. government is backing this security. Also keep in mind, the inflation adjustment that the bond receives will be taxable yearly, even though you do not receive this cash. Basically, you will be charged on income not yet realized.
Finally, and least importantly, there is a deflationary risk. While deflation has not been around for quite a few decades, it is a possibility and TIPS will adjust your principal lower to account for deflation. There is a safety net of sorts that does not allow the principal balance to drop below the original amount.
ABOUT ANNUITIES: All annuity contract and rider guarantees, including optional benefits and any fixed subaccount crediting rates or annuity payout rates, are backed by the claims-paying ability of the issuing insurance company. Long-term-care insurance coverage contains benefits, exclusions, limitations, eligibility requirements and specific terms and conditions under which the insurance coverage may be continued in force or discontinued. All guarantees and benefits of an insurance policy are backed by the claims-paying ability of the issuing insurance company. Guarantees and benefits are not backed by Merrill Lynch or its affiliates, nor do Merrill Lynch or its affiliates make any representations or guarantees regarding the claims-paying ability of the issuing insurance company.
For non-qualified and stand-alone qualified annuity contracts, annuitization must occur by the annuitant's age 95. At that date, any guaranteed minimum death benefit no longer will apply. Clients should contact the issuing insurance company prior to the maturity date to discuss options, including changing the annuitant, if permitted by the annuity contract. For custodially held qualified contracts, as a distributor Merrill Lynch will not require annuitization at age 95.
ARZ1I5Y5 | 6/12/2013