Guaranteed income for life. That was the plan – now the fantasy – during the golden age of American business, when pension plans were the norm. You did your time as a loyal, hard-working employee, retired at 65 and then monthly checks from your former employer rolled in until you died. A modest livelihood was assured without worrying about depleting your savings.
It sounds so quaint. For most Americans, the responsibility to save and manage retirement money is now all theirs. The good news: There are ways for do-it-yourself investors-turned-retirees to create their own simple pension-like plans at age 65. They involve mixing investments ranging from Treasury Inflation-Protected Securities (TIPS) to annuities to equity funds. None of them can eliminate risk entirely, but they do help minimize the chance that you’ll outlive your money.
Below are three approaches to generating lifetime income for retirees:
Stephen Sexauer: Climb the TIPS Ladder, Then Annuitize
The lowest-risk way retirees can create lifetime income is to put around 85 percent of their savings in TIPS, says Stephen Sexauer, chief investment officer of U.S. multi-asset management at Allianz Global Investors. TIPS are U.S. government-backed bonds that increase in value as inflation rises. After putting that money into TIPS of different maturities, Sexauer’s strategy allocates the remaining 15 percent to a deferred Life annuity that kicks in when a retiree is 85.
TIPS help protect money’s purchasing power, and there’s no credit risk. A TIPS portfolio is actually better than a defined benefit pension plan, Sexauer argues: “The ‘golden era’ of pension plans wasn’t such a golden era – a lot of companies went out of business and quit writing checks.” Also, the payouts weren’t adjusted for inflation.
Buying TIPS maturing in different years – “laddering” – lets retirees live on the expiring TIPS’ liquidated value, as well as the portfolio’s overall income. It also helps investors because part of a TIPS’ “payout” is its twice-yearly inflation adjustment. Unlike a normal bond, TIPS not only pay income to shareholders but add value to the bond’s principal based on changes in the Consumer Price Index. To realize the total return of a TIPS portfolio the bonds must mature or be sold.
You can buy TIPS at TreasuryDirect’s web site only in increments of five or 10 years, however. For a fee, a broker can buy you bonds with in-between maturities that are already trading. A recent call to TD Ameritrade found it charging 0.125 percent to 0.25 percent of a TIPS order, depending on the bonds’ yields. More yield equals more fee.
Rather than go farther than 20 years out in TIPS, Sexauer recommends a deferred life annuity. These insurance products pay a fixed level of income if you’re still alive at a predetermined future date. If you don’t live to that date, you get nothing. These don’t adjust for inflation. Because about half of all people who reach 65 don’t live past 85, insurers are willing to sell such annuities fairly cheaply to retirees.
Of course, there are wrinkles to this strategy. A big one: With inflation expected to rise, TIPS are expensive, so much so that a 10-year TIPS pays only half a percentage point above the inflation rate. An all-TIPS portfolio for 30 years with no annuity would cost 30 percent to 40 percent more than the TIPS-plus-annuity strategy, according to Laurence Siegel, Sexauer’s co-author on an article about do-it-yourself pensions and research director of the CFA Institute, a group of Chartered Financial Analysts.
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William Bernstein: TIPS? Definitely. Deferred Annuities? No.
A TIPS-heavy strategy makes sense to William Bernstein, founder of money manager Efficient Frontier. It’s the annuity part of Sexauer’s plan that bugs him. Annuities have too much credit risk, he says, because issuers could go bankrupt. There are state insurance guarantee funds meant to help financially troubled insurers. But Bernstein thinks there’s too much systemic risk in the financial markets today to rule out a major implosion that would leave annuity holders hanging.
Instead of an annuity, Bernstein would use a Total Stock Market Index Fund. While not touching it for 20 years might be hard, over the long run stocks are very good inflation hedges. That’s because stocks are a claim on real assets, says Bernstein. If you buy $1,000 worth of Proctor & Gamble stock, you’re buying a company that has pricing power. If inflation comes along, you’ll almost certainly have a positive rate of return as the company adjusts its pricing, he figures.
There is one kind of deferred annuity Bernstein likes, and it’s even inflation-adjusted: Waiting to take social security. You get a 30 percent bump in income if you wait from age 62 to 66, and another 30 percent if you wait from 66 to 70, he says.
While Bernstein thinks an all TIPS portfolio would be ideal, few people could afford it. Typically, a traditional pension would replace about 70 percent of your working income, and with today’s skimpy yields, you’d have to invest a lot up front to reach retirement income goals.
To show how much money you’d need to invest in order to get the income you want from TIPS, Sexauer and Siegel created a website, DCDBBenchmark.com. It provides a table of current payouts for $100,000 invested in the 85 percent TIPS/15 percent deferred annuity strategy. This September, a 65-year-old putting $100,000 in the strategy would get just $4,486 in the first year of retirement. If inflation stays at 2.1 percent, that payout would rise to $6,728 when year 20 ends and the annuity begins. (The website projects inflation out 20 years based on long-term averages.) So to have a payout of about $45,000 this year you’d need to invest $1 million. Sexauer says it’s not as bleak as it sounds because Social Security would augment the income from TIPS.
Phil Blancato: Forget TIPS. Take some credit risk.
A better strategy than buying overpriced TIPS is to create buckets of income-producing assets during retirement, says Phil Blancato, chief executive officer of Ladenburg Thalmann Asset Management. He suggests a laddered portfolio with high-quality corporate bonds for one bucket, a junk bond mutual fund for another and perhaps income-producing equities or preferred stock for the third. “We’re in the lowest default cycle in probably 50 years,” he says, so investors should take some credit risk. For someone with a 20-year horizon, Blancato thinks the risk of default is worth taking as opposed to the other risk — not having enough income to live on.
Blancato uses an example of a 65-year-old retiree who wants her 500,000 portfolio to generate about 5 percent in average annual income. To get that, he’d take $300,000 and buy individual corporate bonds, and maybe some Treasuries and municipal bonds. The other $200,000 would go into a widely diversified portfolio that might include a high-yield bond fund, some master-limited partnerships and alternative income-producing products, maybe even preferred stock. Just know, he says, that these are your speculative investments and you’ll need to weather some periods of temporary loss.
That won’t have the same certainty as a pension, he says. But over time, he thinks it will provide a retiree the income they need. It’s undoubtedly a much more expensive strategy that that of Bernstein or Sexauer, and not exactly a do-it-yourself solution, though.
A cheaper way to take some risk in the bond portion of a do-it-yourself pension: Build a portfolio of exchange-traded funds that hold corporate or high-yield bonds of varying maturities. Guggenheim Investments offers a slew of “BulletShares”, ETFs that each invest in corporate bonds maturing in a specific year. Just remember that it’s the guaranteed part of an income-for-life strategy you give up when you take on credit risk.
To Your Successful Retirement!
Michael Ginsberg, JD, CFP®