Saving for the time when you can stop working for pay is hard enough. Setting aside the right amount of money and investing it in a way that will make the most of your hard earned savings is a challenge for anyone. But there are years to work on it, and if things don’t work out as planned you can make changes. Things get trickier as you approach the day when you give up your paycheck. For most, gone are the days when your employer will send you a pension check every month.
Can you create your own pension plan? The answer is yes, and there is more than one way to do it. You can buy an income annuity, or you can invest the money yourself using a disciplined preplanned withdrawal strategy.
The simplest approach is to buy an income annuity. An income annuity is an investment that is created by an insurance company. You can buy one through a financial adviser or an insurance agent. With an income annuity, you are buying your future income. You deposit your money with an insurance company, and in return they guarantee you a monthly payment. Your monthly payment consists of the interest income the insurance company is paying and a portion of your deposit being returned to you.
You can choose from a variety of contracts. The simplest is one that pays you a monthly income for life. With this contract the insurance company guarantees to pay you the same monthly benefit every month for as long as you live, whether that is another ten years or another fifty years. Fidelity offers income annuities from a variety of insurance companies. Using their calculator, a woman turning 65 could receive $507 every month for the rest of her life, or, alternatively, $407 per month to start, with annual increases of 2.0 percent, for every $100,000 deposited. Similar to a traditional pension plan, this type of contract ends when you pass away. There is no cash value left regardless of how long you held the contract.
However, if you are married, you can buy an annuity that pays out over both you and your spouse’s lives. If our hypothetical woman deposited $100,000 in an annuity to cover both her and her husband of the same age for both their lives, they would receive a payment of $450 per month, or $357 per month to start, with a 2.0 percent annual increase. If you are worried that you will die and the insurance company will get to keep all of your money, there are also options that guarantee your payments for a minimum number of years or your lifetime, whichever is longer. The longer the minimum period, the lower the monthly payments.
These days, many people choose the DIY approach. Too many don’t know what annuities are, and there is a general lack of trust in the insurance industry. If you were to create your own retirement plan and manage your investment yourself, what kind of payment could you reasonable take each month?
In 1994, William Bengen, a financial adviser, studied thirty year time periods beginning in 1926 to determine whether there was a withdrawal rate that a retiree could take and reasonably expect that their money would last for at least thirty years. His conclusion was that a withdrawal rate starting at 4.5 percent of savings and increased by the rate of inflation for all following years worked. In a 2012 Financial Advisor Magazine article, he revisited the study, and concluded that even if concerns about difficult financial markets were to come true, the withdrawal rate remains reasonable. His work and conclusions have become known as the 4.0 percent rule. Bengen isn’t certain how the 0.5 percent got lost in translation.
If you were to invest $100,000 with about half in stocks and half in bonds, as in Bengen’s model investment strategy, you could spend about $375 per month to start, with annual increases for inflation. That is a very similar payment to the $357 you and your spouse can get with an annuity that has a 2.0 percent annual adjustment. With Bengen’s approach, you can generally maintain your purchasing power for about thirty years, but if you encounter high inflation, particularly early on, you may not be able to make your money last any longer. With the annuity, your payments are guaranteed until you die, but if inflation is high, you may not be able to maintain your lifestyle even with 2.0 percent annual increases. So neither approach is perfect. Either will require making some adjustments as life plays out.
Of course, you don’t have to go all or nothing with either option. If you are worried about outliving your money if you manage it yourself, but not comfortable with forking over all of your savings to an insurance company, consider blending the two ideas. You could use some of your savings to invest in an annuity that is large enough to cover basic monthly living expenses. The remainder of your savings could be invested in stocks and bonds. With your basic expenses covered, you can be more confident that you won’t run out of money, and you can still retain control over a portion of your savings.
An annuity is a great option for many. After all, it’s much easier to just continue getting a monthly pay check, after you stop working, than it is to manage an investment portfolio and withdrawal strategy. It is possible to manage your savings on your own, but it takes some discipline and work. And the outcome won’t necessarily be better. Even if you do decide to manage on your own, consider an annuity to provide at least a foundational level of income that won’t run short.
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One thought on “Your Personal Pension Plan”
Hi Julie, I really enjoy reading your posts. Keep up the great work!
I have a question regarding long term health insurance. Do you think it’s necessary? And what age is the right age to start?
My mother is moving to a retirement living community. She’s 68 years old, and she had a stroke three years ago. Fortunately, she is independent albeit without the ability to use her left arm. She didn’t have long term health insurance, and she’s using the funds from the sale of her home last year.
I’m trying to plan accordingly as I don’t know what may happen to myself in 25 or 35 years.