So perhaps you’ve been saving and investing for years, and now retirement is in your sights.  The question now is, “How do I use the money in my retirement accounts and other savings to pay for things in retirement?”  Today I thought I’d discuss some considerations and ideas.

How much income can I receive each month?

The first consideration is how much spending money will you have in retirement.   This information might also point to the need for a part-time job or other source of income in retirement.  A fairly good rule-of thumb is that you can withdraw about 3-4% of your net worth per year from your retirement account without the value declining in value in real-dollar terms.  (Here “real dollar” means dollars adjusted for inflation so that you’ll have the same amount of spending power as the years go on.)  If you withdraw more than this, you will be spending your portfolio over time and eventually run out of money, assuming you live long enough.

For example, let’s say you have a portfolio (401k, IRA, savings, etc…) totaling $750,000.   You would be able to spend about 0.03*750,000 =  $22,500 per year without seeing the value of the portfolio decline and be able to leave your heirs about the same amount of money when you died.  Monthly this would be about $1875.  If you were just paying for a family of two, had the house paid off, drove old cars, and didn’t do much, this might be sufficient.  If you wanted a bit more of a lifestyle, you might need to work a part-time job to help with expenses.  You could also consider options such as selling your home and downsizing to increase the investment portion of your net worth.  If you pulled out $40,000 per year, the value would decline over time, meaning you might run into an issue in your 80’s or 90’s.

How can I generate the income I need?

The second aspect is how you use the money in your portfolio to generate the cash needed to pay for living expenses.  Here there are basically three options:  1)  Invest a portion of the portfolio in income producing assets to generate regular payment, 2) Sell some assets each year to raise cash, and 3) Buy an annuity to pay the income you need.  Let’s look at each of those options.

1.  Invest a portion of the portfolio in income-producing assets to generate income.

This is the traditional way of generating income for expenses.  It works well in times when interest rates are fairly high (not the current period).  Many people simply invested in bank CDs to generate income, but while the dollar value of bank CDs remains constant, value will be lost to inflation each year, plus the rate of return will always be lower than other options like bonds, real estate, and dividend-paying stocks.  You can choose this option if interest rates are sufficiently high to generate the income you’ll need and you’ll have enough left over to invest in growth assets like stocks to prevent inflation from reducing your rate-of-return in the future.

Typically the percentage of income investments when you retire should be around 50%, so if you can generate enough income from bonds and dividend-paying stocks using about half of your portfolio or less, while investing the remainder in growth stocks that will increase in value with time. this could be a good option.  Note that as you age, you would shift a greater percentage of your assets to income assets to increase the amount of income you receive each month to account for inflation.  When you were 80, you might be 70-80% in bonds and 20% in growth stocks.  You could buy individual. stocks and bonds, but it is usually easier to buy an income fund.  Also note that the higher the return you’re receiving, the higher the risk you’re taking.  It is generally a good idea to spread the risk out between safer, lower paying bonds and more risky, higher paying bonds.

2.   Sell some assets each year to raise cash.

The first strategy is probably best if you have just enough money to generate income for retirement.  If you have more than enough, you might still put a portion in bonds to help smooth out the volatility (having about 20% in bonds will greatly reduce the price level of value fluctuations in your portfolio without greatly affecting your total return), but plan on selling assets each year to raise cash for expenses.  Because growth stocks will provide greater returns than bonds and income stocks over long periods of time, this will provide more money to use in retirement and/or pass on to the next generation.  There will be volatility, however, so you need to have enough of a cushion to weather most market downturns that may occur.  This means you really should have at least twice the portfolio value required to generate the income level you really need since a 50% decline in stocks over a short period is not common, but it does happen once-in-a-while.

Part of using this strategy involves using cash to provide the money you need during the years when the market declines and you need to wait for the market to recover before selling more shares.  Since the market usually recovers within a year or less (although there are exceptions like the Great Depression), having a cash cushion will usually provide the time you need to avoid selling shares too cheaply and locking in losses.  Since having a loss over a five-year period is almost unheard of, having between three and five years’ worth of cash is a conservative strategy.  (Note “cash” here means bank CDs and money market funds – not $100’s in your mattress.)

If using this strategy, some level of opportunism should be used.  If there are years when the markets do really well, use the opportunity to raise some cash.  In years when the markets decline, maybe wait to sell unless your cash drops below some threshold, for example, 2 years’ worth of expenses.

3.  Buy and Annuity to provide a monthly payment.

When you buy an annuity, an insurance company invests your money and pays you a guaranteed amount per month for the rest of your life (or some other period depending on the terms of the annuity).  Because the insurance company wants to make money, they will always pay you less than the amount you could have received if you had just invested it yourself using strategies 1 or 2 above.  The difference is that the rate-of-return each year would vary if you invested yourself, where it would be guaranteed (provided the insurance company didn’t default) with the annuity.  The insurance company would get variable returns by investing your money, but make a higher return overall, where you would get a lower, but fixed (guaranteed) return.

Clearly, annuities have drawbacks.  The income they pay is often fixed in dollar terms, so your buying power may decline over the years due to inflation.  If you die young, your money may be gone so you may not have anything to leave heirs.  As stated above, you will not, on average, do as well with an annuity as you will do investing yourself (assuming you invest appropriately).  The exception may be if you live a really long time, but for everyone who lives exceptionally long, someone dies exceptionally early.

If you do choose to buy an annuity, avoid the fancy annuities that promise things like additional returns based on the market performance or other bells and whistles.  Just buy a simple annuity that pays a fixed amount (perhaps indexed to inflation), either immediately or at a certain age (if you’re worried about running out of money late in life) .    If you want to also get some market returns, hold back some cash and invest it yourself outside of the annuity.

Note finally that there is no reason to just choose one of these strategies.  You can mix and match them.  You could buy bonds and income stocks to generate some income, but also sell some stocks to raise cash to supplement what the bonds were paying, particularly in times like now when bonds aren’t paying much.   You could also buy an annuity to pay for something critical like food and basic necessities, then use bonds and growth stock sales to pay for luxuries like travel and home improvements.

Got an investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

In the first post in this series, Are Pension Plans Good Ways to Save for Retirement, Part 1, we looked at both pension plans and 401k plans and compared both the benefits and dangers of each.  This time we’ll look at pension plans from a company perspective.

Let’s say that you own a large company and have a pension plan.  Your company has agrees to pay your employees a certain amount per month after they retire until they die based on their years of service and their salary while working for your company.  Some plans also require employees contribute a certain amount of their salary to the plan while others do not.  Because the amount the employee will receive is specified, a traditional pension plan is known as a defined benefit plan.  How would you manage this to make sure you could pay your employees when the time comes?

Well, you would want to let the markets do most of the hard work for you, just as would any investor who was investing for retirement.  You would need to make sure that you had the cash needed for employees who were currently retired or will retire soon, however.  How would you approach this issue?

Well, for the people who were retired or will soon retire, you will have been making contributions for them and possibly been having them contribute for a significant period of time.  You would have invested this money while they were still a couple of decades or more away from retirement so that they money could grow.  The better your investment returns, the less you would need to put into the plan from your business.  Because they would be retiring soon, you would start to transfer the money into cash, buy annuities (that pay a specified payout), and/or move money from stocks to bonds to reduce volatility and start to generate the income you need to make the pension payments.

For the workers who were just starting, you’d know that you had a long time before they are going to retire.  Since you have a long period to wait, you would want to make your investment returns as large as you could while taking reasonable risks.  Remember that if your investments are doing well, it reduces the payments that the company needs to put into the pension plan to keep it solvent.  If investments do badly, however, they might need to add more, so they do not want to take any extreme risks.

How does this compare with a 401k?

Really if you look at the way the pension plan is invested, it is similar to the way that you would invest a 401k.  When workers are young, the company would invest mainly in stocks and other growth assets that can make good returns and that would grow with inflation.  When workers are getting near retirement, the company starts to move money into cash, bonds, and other income investments that are less volatile to reduce the risk that a market move would cause there to be not enough money available to pay the pension payments.

Let’s look at the risks of a 401k versus a pension plan:

Poor Investing:

Pension:  If a company’s investment do poorly, such that the amount of money in the pension plan drops below levels needed for solvency, the company will be required to add more money to make it solvent.  If the company fails, the pension will be covered up to certain limits by the federal government.

401k:  If you invest badly, there is no one to bail you out.  The company provides whatever they are going to provide at the start, and that is all they will provide.

Market event near retirement:

Pension:  The pension manager should be shifting funds needed for near-term retirees to cash, bonds, and other income investments.  As long as this has been done, there should still be money to pay benefits while waiting for the markets to recover.  If the pension manager does a poor job, the company will be required to add more money into the plan or the government will insure the pension up to specific levels.

401K:  The investor should start shifting to income investments and cash as retirement nears to give him/her the ability to pay living expenses while waiting for the markets to recover.  If this is not done, the investor may face difficulties in retirement and run out of cash quickly.  There is no issue if you manage your account correctly (or get good advice from a financial planner), but could be a big one if you do not.

Possible returns:

Pension:  A good pension manager should be leaning towards stocks and growth investments for the portion of the pension plan covering the younger workers, but if they invest too much money in this way and the market falls, the company might be forced to add more money to the pension plan.  Many managers would, therefore, err on the side of caution, reducing risk but also reducing long-term rewards.  Note that since the reward is predefined (you won’t get more money if the pension plan does really well), and because companies would tend to be cautious on what they would provide in the way of returns to make sure they can pay them with a bit of a cushion, possible returns will be lower than market returns.

401k:  Properly invested, choosing growth assets early in career and shifting to income investments late in career, an investor can get better returns with a 401k than with a pension plan.  Investors can also make bad choices, either moving money around, chasing returns, or investing too much in income (or worse, money market funds) early in their career.  A pension manager will probably not make similar mistakes.

Armegeddon

Pension:  Should the economy collapse, the investments in the pension plan would be wiped out, as would the company.  It is unlikely that the government, which gets its funds from the economy, would be able to bail anyone out.

401k:  In the event of an economic collapse, 401k funds would be wiped out.  An investor entirely in cash might be able to salvage some value, but inflation would probably quickly wipe out any cash reserves.  Gold would be of little use since people can’t eat gold.

So in conclusion, an investor who invests well in a 401k will probably do better than he/she will with a pension plan.  A pension plan will provide a return below what is possible with a properly invested portfolio, and also tend to be more conservative in how they invest.  The biggest reason that people tend to do better in pension plans than in 401k plans is the employee/investor.  Too many people invest poorly, doing things like leaving all of their money in the money market fund or keeping all of their money in stocks when they are close to retirement.  Even worse, many people take money out of their 401k plans before retirement age – something you can’t do with a pension plan – which means they pay penalties and taxes, miss out on all of the growth they would have gotten near retirement, and spent the money they will need later.  They then say pension plans are bad when they have no money at retirement.  You are your worst enemy.  If you can control yourself and just get a little bit of information on how to invest (or get a good investment advisor), you’ll be better off in a 401k most of the time.

Got an investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

I was reading an article from the one percenter on pension plans and thought that more should be said on the subject.  Defined benefit pension plans are often highly coveted, while 401k plans are seen as less generous and risky.  After all, in one case you are guaranteed a certain income or lumped sum, while in the other case your final return will be based on the fickle will of the markets, right?  Well, not exactly.  Let’s look at both plans.

Defined Benefit Pension Plans

As the name implies, a defined benefit plan has a prescribed benefit when you retire.  This benefit is often based on some really complex formulas, but, in theory, with some assumptions and some help from HR you should be able to predict what you’ll receive in retirement because the benefit is defined.  They were designed in the past to keep employees at the same company.   Most defined benefit plans pay you a specified amount based on years of service and your earning level during your highest earning years.  City and state workers are famous for taking advantage of this last factor, working lots of overtime during the last few years to increase their highest earning years, sometimes retiring with a pension that is higher than their salary when they were working.  Most corporate plans, however, base the pension on base salary, not including bonuses or overtime, so this trick will usually not work.

As an example, let’s say a plan will pay you, per year, 2% of the average of your highest three salary years for each year you work during your first 20 years with the company, then 1.5% for each year after that.  Again, this is an example – all plans have different rules.  Let’s say that you work for 40 years with the company and that you earn $69,000, $70,000, and $71,000 during your highest earning years (an average of $70,000).  You would earn 40% of salary for the first 20 years, then 30% of salary for the last 20 years, for a total of 70% of the average of your highest earning years.  When you retired, the pension plan would pay you 70%*$70,000, or $49,000 per year for the rest of your life.  Many plans also have spousal benefits where your spouse would get some portion of your benefits (maybe 50% or 100%) for the rest of his/her life after you died.

As you can tell, one issue with the traditional plan is that when you and your spouse die, your benefits stop.  There is nothing to leave the children.  If you both die a year after retirement, you’ll receive almost nothing in pension benefits.  If you’re lucky and live to be 105, you’ll make out like a bandit. To improve the plan, another benefit that some plans (fewer and fewer) offer is a lump sum payout.  In this scenario the company pays you a lump sum when you retire, usually based on the amount of money you’d need to put into an annuity to receive the same monthly benefits.  This means that the longer an average worker is expected to live, the higher the lumped sum will be, and the higher interest rates are at the time, the lower the benefit.  Many plans also put a cap on how low interest rates can be to keep from giving too large a payout.  In the current low-interest rate environment, many plans are just dumping the lumped sum option entirely since their payouts are getting too large.

A word of caution is needed here.  One of the assumptions needed to predict your benefits at retirement is that the plan will not change.  This can be dangerous since, while employers are required (by law) to pay you what you have earned, they are not required to honor any future increases in your benefits.  This means they can change the plan for future years even after you have started working.  Most employers try to live up to their side of the bargain, but you should not take it for granted that the plan when you turn 65 will be the same as it was when you signed on at 22.  For example, let’s say you worked for 20 years with the pension plan described in the example above.  At that point, the company decides to freeze their pension plan, such that you don’t earn any additional benefits.  Let’s also say that your average salary for the three years before they froze the plan was $40,000 per year.  When you retired, you’d receive 40% of $40,000 per year, or $16,000 per year, instead of the $49,000 you were expecting.  The company is required to pay what you have earned, but can change the rules for future years at any time.

401K (Defined Contribution) Plans

401k plans are defined contribution plans, where the company defines how much they are going to contribute.  Virtually all plans require the employee to contribute a portion of their pay to the plan (some pension plans do as well), and then provide a matching contribution.  For example, it is fairly common to match what an employee contributes up to 5%, such that if the employee puts in 5%, the company also puts in 5%, such that you’re saving 10% of your salary for retirement.  You could contribute more of your pay to the plan, but the company would provide a maximum of 5% of your pay.  For example, if you contributed 10% of your pay, the company would contribute 5%, for a total of 15% of your pay.

Once the company has put in whatever they agree to add, their part is done.  The employee invests the money, using a variety of mutual funds provided by the plan.  At retirement, the employee takes control of the money in the plan and is free to withdraw it or roll it over into another account such as an IRA.  At that point the employee will usually choose to keep the money invested in funds or buy an annuity to provide a pension-like payment each year.  There is no guarantee on how much money will be in the account – hence the term, “defined contribution.”

What are the advantages and dangers of a pension plan?

Advantage:  If nothing is changed, a pension plan has a predictable benefit.

Danger:  That benefit can be changed during the working career of the employee.  Only already earned benefits are guaranteed.

Advantage:  Pension plans are guaranteed by the government if the company pension plan fails.  Companies are also required by law to make contributions to the plan to keep account balances at a specified percentage of benefits owed to help keep the plans from failing.  This means the plan may still be solvent even if the company goes bankrupt.

 Danger:  That guarantee will not necessarily cover your full benefit since there are limits.  If you have a lavish pension plan, your benefits may be cut significantly if the government takes over.  Also, the guarantee will not provide future benefits, just whatever you’d earned when the company failed.

What are the advantages and dangers of a 401k plan?

Advantage:  The money is in an account you control, allowing you to see how much you have and control how it is invested.

Danger:  You’re in control, so there is no backup plan if you invest poorly.  The worst way you can invest is to put it all in the money market fund.  Putting the money into a target-date fund with a date corresponding to when you will retire, if available, or dividing the money into stock and bond funds are both good options.  If choosing the latter option,  a greater percentage should be in stocks when you’re young and about half bonds and half stocks when you’re near retirement age.  A rule-of-thumb is the percent of bonds you own should be equal to your age minus 10.

Advantage:  Every 401k plan is, by definition, a lumped-sum plan.  If you die early, even before you retire, you can leave the plan to a spouse or other heirs.

Danger:  For whatever reason, the government allows people to make withdrawals from their plan before retirement.  Some of these can be without penalty, under special circumstances, but most withdrawals before retirement age come with a 10% penalty, plus normal income tax payments.  Many people ruin their finances in retirement by taking the money out of their 401k early and wasting it.

In the next post, we’ll look at pension plans from a company perspective and see how they compare with a 401k plan.

Got an investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.