I will by purchasing some of these ten year TIPS inside my 401(k) plan. Buying TIPS at auction is the best way to obtain a more predictable and fair price, compared to the secondary market.

For more on why I am doing this, go back and read my post on creating a plan for guaranteed retirement income.

Here is the link to the Treasury Auction announcement page.

Do any of you own or plan to buy TIPS at auction or on the secondary market?

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It turns out that most retirees are “cautious” spenders. This is the message from Emily Brandon’s post on retirement spending at Planning to Retire. The retirement spending and retiree wealth pattern data is from a study conducted by the Urban Institute. The study is titled How Quickly Do Older Americans Spend Their Wealth?

Although the study concludes that retirees spend carefully, the overall wealth patterns of retirees vary dramatically depending on pre-retirement income levels.

For example, retirees in the top income category managed to increase their net worth through age 85. Those in the middle income ranges held on to their net worth generally until age 70, at which point their net worth began a slow decline. For the lower income retirees, they quickly exhausted their meager retirement savings and entered a long period of being totally dependent on Social Security benefits and pension income, if they were lucky.

Take a look at the graphed data in the report – it is telling. Yet another report cited by the study authors states that 87% of surviving spouses die with some wealth left over. That’s good to hear.

The study authors made a prediction that is important to baby boomers. Social Security benefits are likely to change and Medicare premiums will increase. This will decrease the amount of income that retirees can replace with their Social Security benefits.

On this issue, recent comments from former Senator Alan Simpson are interesting.  Simpson is the co-chair of President Obama’s so-called “Government Debt and Fiscal Responsibility Commission.”

Most observers believe that this Commission should be called the “do something about Social Security and Medicare commission.” Simpson is known to dislike these government programs in general, which is probably why he was appointed.

On Fox News this past week, Simpson claimed that the problems with Social Security could be fixed in a half-day of work. Maybe so, but he added this:

But the thing that is really impossible to believe is that whatever adjustment we make and whatever has been suggested for the last 10 years in Social Security reform, from top to bottom, you know, new dates, more contribution, none of that affects anybody over 57. Where do I get my mail? From these old cats 70 and 80 years old who are not affected in one whiff. People who live in gated communities and drive their Lexus to the Perkins restaurant to get the AARP discount. This is madness.

(Source)

For the sake of many baby boomers, I hope Simpson is sincere about not applying radical changes to those over 57. Even with cautious spending, we need those Social Security retirement benefits to help us maintain a basic standard of living.

I would like to see more historical retiree spending data like that reported by the Urban Institute. I wonder if the millions of baby boomers can dial back their spending habits when the time comes.

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According to a Career Builder survey of over-60 workers who have decided to delay retirement, 72% say that the reason is financial. They do not feel they have enough money to support themselves if they stop working.

Also, 27% of business personnel managers report being approached by older workers who want to delay a scheduled retirement.

Reality hurts.

Source: Over 70% of workers delaying retirement cite money woes.

So what does one do to overcome this “too broke to retire” problem? For many, it’s a matter of making up for lost time.

Forbes published a recent article on what to do if you are over-50 and a late starter on retirement saving. The advice is typical and not ground-breaking. It applies also to folks who are older and need ways to save to generate more retirement income.

Having a specific savings goal is important in these situations. Just thinking “I have to wait – I need more money” is not particularly helpful or motivating. It’s actually depressing.

I would first estimate how much more retirement income you need. (See my article on a Simple Way to Determine Retirement Readiness. FYI – this article was a featured selection in the “Best of the Best in Money and Personal Finance #12.“)

As a simple example, let’s assume that you are 62 years old and have created a retirement spending plan. From that, you estimate you will need to find an additional $800 in monthly income to comfortably retire.

Instead of retiring and taking Social Security at age 62 as you had originally planned, you decide to wait until age 66, your full retirement age.  That alone could add another $500 to your monthly income, all from Social Security.

What about the other $300 monthly income shortfall  - where will that come from? How much more savings do you need to provide that?

At current rates, a 66 year-old can purchase an immediate annuity providing $300 in monthly income for life for a lump sum cost of about $45,000. (I’m not saying that you must buy an annuity. Rather, this is an easy way to establish a realistic savings goal.)

To accumulate $45,000 in four years, run the numbers through a simple savings goal calculator. In our simple example, and assuming a 4% return, you would need to find an additional $880 in monthly savings to reach your retirement income goal. That may not be easy to do but it at least gives you a target to shoot for.

There are other options to a delayed retirement forced by financial problems. One of those options is a phased retirement, perhaps including taking a different job with less stress and greater contentment.

The key is doing something. Floundering around or giving up completely – as so many boomers seem to have done – will make things worse.

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According to this article from Investment News, Putnam investments is introducing a new simplified retirement income calculator for its 401(k) plan participants. The most important feature of this new calculator is that every time a plan participant logs in to his or her account, they will see their account balance expressed as retirement income.

In my opinion, every 401(k) plan participant should not only have easy access to that retirement income prediction, they should be forced to look at it regularly. The calculation and display of the retirement income prediction should be automatic. Isn’t seeing the reality of what income your account balance may provide the best way to motivate a baby boomer to save more for retirement?

Watching an account grow (hopefully) is all well and good but not if the end-game leads to an inadequate retirement income, even when combined with Social Security benefits. If you see a 401(k) balance of $100,000 at age 58 you might think “I’m doing great.” If you see that your predicted lifetime income from that plan balance is $350/month, your level of contentment may change.

I receive similar income prediction information now from my 401(k) plan provider, but I have to use an optional retirement planning tool the plan offers to obtain it. Most people don’t take the time to use that tool. It takes work and it can be intimidating.

I hope that Congress amends ERISA or that the Department of Labor adopts rules that require all 401(k) plan providers to deliver realistic retirement income predictions to plan participants. Meanwhile, you should ask about this feature at work and agitate a little to obtain it. I’ve done that in the past for other aspects of our 401(k) plan, including increasing the diversity of investment offerings.

Remember, it’s not the size of the nest egg. It’s the retirement income that nest egg will provide.

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The report is not your standard investment performance report. Instead, it hits you in the face with a statement of how likely or unlikely your current investments and contribution levels will generate the retirement income that you have set as your goal. The report also indicates (on a scale compared to other portfolio types) the amount of risk you are taking. Finally, the forecast tells you where your retirement income will come from.

The Financial Engines retirement report methodology is supposedly proprietary. They do tell you that it uses Monte Carlo simulations of thousands of different investment scenarios and outcomes. The income projections are derived from an assumption that you would annuitize all of your retirement investments at your retirement age. You wouldn’t do that of course but it is a logical way to compare different outcomes.

The changes in our retirement income forecast through 2009 were quite dramatic. I selected a retirement income goal based on a retirement age of 62 and a retirement spending plan that was comfortable but neither spartan or luxurious.  I won’t fully retire at 62 but I wanted to know what would happen if I did.

When I first created this plan in 2007, my forecasts consistently exceeded a 95% probability of reaching our income goal. This means of the thousands of simulated economic and investment performance scenarios, our retirement income goal would be achieved in more than 95% of them.  On February 24, 2009 (just before the market turned north), I received an email report that the probability forecast had dropped to 36%! That’s a serious wake-up call to action.

According to my analysis, our best plan of action was to stay invested while increasing cash-equivalent holdings. My next report arrived on May 11, 2009. Now the forecast had jumped back up to 70%. Another retirement forecast report was sent on August 11. The forecast probability has increased again, to 80%.  On November 24, 2009, the last emailed report, the forecast was back ino my comfort zone of greater than 95%. The tool also tells me that 30% of our retirement income will come from Social Security and the balance from our personal investments. No pensions for us.

I can check these forecasts at any time by logging into my account where I can also receive automated advice on portfolio adjustments I could make to improve our odds. I have never used the Financial Engines advice , preferring to scenario test my own portfolios.

I like the Financial Engines retirement income forecast tool. It’s not perfect but watching how investment choices and market conditions affect retirement income predictions certainly keeps me engaged and vigilant.

What tools do you use to forecast retirement income success?

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There are many “rules of thumb” in personal finance. Lots of them are actually rules of “dumb.” The retirement income replacement rate or ratio is one of them.

In this article from CNN/Money, a reader asks what percentage of his income he should be saving for retirement. The writer – a well known personal finance pundit – refers the reader to this “What You Need to Save” calculator. This simple retirement planning tool contains only three inputs: your age, current income, and existing retirement savings. How can this tool accurately tell you how much you need to save, you ask? It can’t.

If you look in the calculator footnotes when the result is displayed, you read that the calculation assumes that Social Security and income from your savings will replace 80% of your pre-retirement salary. This 80% number is seen often in discussions of retirement income replacement ratios. Another “rule of thumb” that is frequently cited is that to maintain your current lifestyle in retirement, your income replacement rate should be 70%. Other writers go higher, even to 100%.

In my view, the concept of using an income replacement ratio for retirement planning  is flawed. Other experts (not that I’m claiming to be an expert) agree with me.

In a recent paper published by the University of Michigan Retirement Research Center, the authors addressed the question of “What Replacement Rates Should Households Use?”  According to their research:

The rule of thumb that replacement rates should be above 70% to maintain living standards in retirement is conceptually flawed.  In fact, no more than 15% of the population needed to replace 65% to 90% of their pre-retirement income. And almost 50% of the population needed to replace less than 65% of their pre-retirement income.

Replacement rates of low-income individuals and families would need to be higher than replacement rates for high-income individuals and families.

That data is quite a departure from a fixed percentage replacement ratio “rule of thumb.”

In this MarketWatch article on retirement plan building, Robert Powell discusses the study and quotes another well-known finance professor:

“The use of replacement rates to form financial plans does not meet a reasonable fiduciary standard,” said Larry Kotlikoff, a Boston University professor.

“Rules of thumb are, quite simply, rules of dumb,” he said. “Their use violates the financial planner’s Hippocratic oath: First do no harm.”

Kotlikoff is well-known for economics-based financial planning based on consumption smoothing.

So what should we do to determine how much of our pre-retirement income we will need in retirement? My recommendation is to prepare a real world retirement spending plan. Base it on what you spend now and on what you anticipate your expenditures will be when you retire. That number is what your estimated income needs will be. A little time on a spreadsheet goes a long way and gives you much more accurate data than using an income replacement rate.

That’s exactly what I did to generate my retirement income plan using the Failsafe Retirement System.

So skip the rules of thumb. Go right to the data, your data. Otherwise, you could end up over-saving or under-saving for your retirement.

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I came across yet another story about a relatively young retiree being forced to “unretire” because of losses in the stock market and poor planning. This baby boomer has all kinds of problems now, not the least of which is that he can’t find a job to unretire to.

I don’t like telling these stories because I feel sympathy toward those who thought they were well positioned to retire. Tom Wogan (age 60) had worked 36 years for the same company, had built a $1.1 million retirement portfolio, and his 55 year old wife was still employed. But he couldn’t stay with his retirement plan. Let’s briefly review the mistakes that he made.

1. He did not have a secure retirement income plan.

The Wogans had a large chunk of wealth invested in the market but no plan for how to use that wealth to secure a basic retirement lifestyle. This was the point of yesterday’s post on creating a plan for guaranteed retirement income. Most of us should not risk our basic retirement income needs in the stock market.

2. He retired with a mortgage.

It doesn’t matter when or where you retire, you need a place to live. The safest way to retire is to a place that you own, 100%. Retiring with a mortgage can place enormous financial and emotional pressures on you. If you want to retire but have a mortgage, consider downsizing or relocating to an area where real estate is more affordable. I have lots of resources on this site for finding places where the cost of living is lower.

3. He retired while still supporting three kids in college.

This is a hard one. You want to help your kids finish their education. I understand that because that’s what we are doing with our sons. But in some cases you cannot afford to retire and pay for your children’s education. I understand that too. The Wogan’s apparently put themselves in an untenable position by trying to do both. Sometimes you have to make a tough choice.

I am not picking on the Wogans. I feel bad for them. I also want to learn from what has happened to them and to others being forced out of retirement by finances.

We should hope for the best but plan for the worst.

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What is a Retirement Income Plan?

When most people discuss “saving for retirement”, they think and speak in terms of accumulating wealth, as in building a retirement “nest egg.” Less often do they specifically consider the more critical issue of retirement income.

When I retire, my first concern is having enough income to support a basic retirement lifestyle. This will allow me to work or not work, as dictated by my desires, not by financial need. Wealth can provide income but to provide a secure retirement, that income must have two characteristics.

• The income must be guaranteed to last – month after month and year after year.
• That basic retirement income must be protected against inflation.

Without these important security blankets, poor investment outcomes and/or high inflation could force me to “unretire” or to lower our standard of living to a level that we would find undesirable or even unsustainable. Market losses are known to cause sudden trauma to your retirement savings from which it can take years to recover. Inflation is a slow killer but can be equally deadly to retirement income.

For example, pensions and annuities are nice but in most cases, they are not indexed to inflation. Social Security retirement benefits have both characteristics: guaranteed by the government and indexed to the cost of living. Investments found in most 401(k) plans and IRAs have neither. They can lose value – big time as in 2008 – and are not guaranteed to keep pace with inflation.

My wife and I are counting on receiving Social Security retirement benefits. I have calculated that these benefits will not be enough to sustain our baseline retirement lifestyle. We have substantial investments in well-allocated mutual funds and exchange traded funds in my 401(k) account and in our IRAs. But most of those investments are not calibrated to throw off retirement income that is guaranteed and protected against inflation. That makes me nervous because the future clearly presents risks of further market declines and/or high inflation.

So we need a plan that will provide guaranteed retirement income – inflation protected – to supplement Social Security. It must be failsafe, meaning that no matter what happens to our investments or to the economy, our baseline income needs in retirement will be provided for.

Our Failsafe Retirement Plan

A core teaching of Prof. Bodie’s research is that investing in stocks does not get less risky over longer periods. This, he says, is a myth perpetuated by the investing industry. After studying his research, I believe him. Based on this, Prof. Bodie also believes that for most investors saving for retirement, stocks should not be counted on to provide needed retirement income. He has convinced me of this as well. Instead, he recommends that investors accumulate a portfolio of Treasury Inflation Protected Securities (TIPS) and I Series Savings Bonds (I-Bonds). The TIPS and I-Bonds combine to provide retirement income that is guaranteed and protected against inflation.

Bodie is not opposed to conventional investing in stocks, mutual funds, and ETFs and neither am I. His point is simple and logical. Secure your essential retirement income needs first. Use what’s left over to risk in the market if you wish.

We actually started buying I-Bonds in 2000 as a future inflation hedge. They are doing well, yielding 7% over the past year and over 5% since inception. Our plan is to supplement them with more I-Bonds (if the fixed interest rate goes up – it’s 0% now) and with TIPS bought at auction and on the secondary market.

To determine how much we needed to invest in TIPS and I-Bonds, I created an automated Excel worksheet that does three things.

1. It helped us estimate what our retirement income needs would be.
2. It calculated how much we would need to invest each year to provide the guaranteed income that Social Security would not.
3. It helps us create and track a portfolio of investments that we could purchase to provide this guaranteed retirement income.

Now we have a plan that we can implement that can give us a high confidence level in our retirement future.

Your Plan for Guaranteed Retirement Income

When I finished creating our retirement income plan, I thought that others might be interested in doing the same thing. Therefore, I enhanced the worksheet into a complete system for retirement income planning. I call it the FAILSAFE RETIREMENT™ System. It is now available for purchase and download from my new Failsafe Retirement blog site. That site has a lot more information about the system and the retirement investing research behind it. Read it and maybe you will reach the conclusions that I have. I will be periodically blogging from that site on issues related to retirement income planning. If those issues are of interest to you, head over there, select the “Blog” link, and subscribe.

To give you a preview, this is what the Failsafe Retirement™ Budget Planner looks like:

The Budget Planner Worksheet makes it easy for you to predict your retirement income needs without worrying about inflation. The right hand side of the Worksheet contains links to instructions and other resources on retirement income planning.

The second Worksheet is the Savings Calculator which looks like this:

The Savings Calculator Worksheet uses information about you and from the Budget Planner to calculate how much you need to save and invest each year to provide the guaranteed retirement income that you will need. There are more links to a lot of help and instructional resources.

The third component of the FAILSAFE RETIREMENT™ System is the Income Plan Builder:

This Worksheet helps you create and track a portfolio of investments that will fund your retirement income plan. There are links to resources that will teach you where and how to purchase these investments yourself, without using a broker or incurring any transaction costs.

Finally, the System includes a Plan Summary and Progress Report:

This Worksheet summarizes your work and your retirement income plan in plain English and reports your progress.

As I’ve said, there is much more about this System at the Failsafe Retirement site.

Why am I selling the System and not giving it away? Good question. The answer is that I am trying to add sources of passive income to our cash flow. This income will be used to purchase investments for our retirement income plan. I spent a lot of time developing the system and worksheet. I think it will deliver value to anyone planning for retirement. Think about it this way: The System costs less than three trips to Starbucks or a movie ticket with popcorn.

Final Thoughts, Giveaway and Thanks

First, I want to thank all of my readers for their support of Go To Retirement and my other blog, Tough Money Love. If you will leave a comment on this post prior to September 23 saying that you would like to own a copy of the FAILSAFE RETIREMENT™ System, you will be automatically entered in a random drawing for a free download. (Other comments will be deleted before the drawing.) Six random numbers will be generated by random.org on September 23. If your comment number is one of the six random numbers generated, I will email you a coupon code for a free download. (Be sure your comment uses a working email address.) My decision as to the winners will be final.

Second, I want to thank Mike at Four Pillars, John at the Mighty Bargain Hunter, Evan of My Journey to Millions, and Pinyo at Moolanomy for evaluating a beta version of the System and sending me some helpful feedback.

Finally, spend some time really thinking about where your retirement income will come from. Today I picked up some groceries at Kroger. The gentleman who packed my grocery bags had to be at least 70 years old. His name was Jerry. Bagging groceries for minimum wage is not the kind of part-time job most retirees would choose for fun or just to stay busy. Jerry didn’t look like he was enjoying himself. Don’t end up like Jerry. Make a plan.

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Here is the important stuff. First, let’s assume that you want to have a retirement income that puts you in the top 20% of all incomes. According to an Aon replacement rate study, that would require a yearly income of $70,000. If you were a young person, securing that income fore life would necessitate a nest egg of $3.1 million. But you are not a young person. Being older and then retired helps. First, you don’t actually need all of the $70,000 because of lower taxes, no work-related expenses, and no more need to save. Second, this means that in addition to living off the interest and dividends from your savings and investments only (as a young person would), you can spend a little of the principal.  Third, Social Security is going to replace about 42% of your pre-retirement spendable income. If you choose a moderately aggressive withdrawal rate of 5%, your nest egg requirement has now shrunk to $490,000. That’s quite a bit less than $3.1 million and it’s all because you will die sooner than a young person – the upside to death.

I like where Scott Burns is taking me with this vision. I plan on following this path of study a little more.

While you are thinking about your retirement income expectations, be sure to pay a visit to the Carnival of Personal Finance.

Photo credit:  Rosh PR

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So how can we make sure that our money lasts for our lifetime?  What long life and money strategies are available to us?

Understanding the Longevity and Money Problem

To me, the first step is actually understanding the task ahead. That includes realizing how long your money might have to last. I have compiled a list of online life expectancy tools that can help.

Another step is assessing what guaranteed income sources will be available to you in retirement. These can include pensions and Social Security.

If you will be receiving pension income, you should inquire of your employer’s pension or HR adviser and obtain the specifics of what monthly income or lump sum benefit options you will have when you retire. A key issue here is whether the pension will include any cost of living increases.

For Social Security, you should study your annual Social Security statement and/or use the online retirement benefit estimator. This will give you important information to help you determine the best age to start taking Social Security. In some cases, it may be beneficial to having your income survive until the end to actually delay Social Security even after you stop working.

Another step is to inventory other possible sources of retirement income that you can count on.

Finally, you should attempt to make some estimate of your income needs in retirement. One technique for doing that can be learned under the economic concept of consumption smoothing.

Lifetime Retirement Income Strategies

If you are fortunate, maybe you discovered that between a pension, Social Security, and other guaranteed income, you are set for life. Just remember that being “set for life” better include some inflation protection in your retirement porfolio.

Most of us are not that lucky. In fact, even a pension is not fully guaranteed unless perhaps it comes from the federal government.

So these are the strategies I would be considering for making sure that we don’t outlive our money.

1.  Spend Only Interest and Investment Income

If you have interest and dividend income that covers all of your expenses, spending only that income almost guarantees that you will not outlive your money.  It’s hard to say at this point what percentage of your savings and investment income will consistently be there. Most experts put that number at between 2.5% – 4% of your invested assets. The weakness in this strategy is that it doesn’t necessarily account for inflation. The positives are: (a) you will save your principal until the end, when you might need it for long term care; (b) you are not forced to sell investments during a down market; and (c) you may have something to leave to your children or to charity.

A variation on this strategy is to include very careful drawdowns of principal as needed to compensate for inflation or for unusual major expenses. This increases the chances that your money won’t last as long as you do.

Also, don’t fall for the trap that makes you think you can spend more in the early years because you will need less in the later years. That is not always the case.  You can plan for and practice “income diversity” such as by spending more of your own money in the early years after retirement so that you can afford to delay Social Security until the last possible date.

2. Purchase an Immediate Annuity

An immediate annuity gives you a guaranteed monthly income, assuming that the insurer remains solvent. This provides a high degree of security but you do lose control over your principal.  There are other financial risks with annuities that you should consider.

For information on what kind of annuity income you can purchase and at what cost, try one of these life annuity calculators.

Remember that deferred annuities are quite different and often more expensive.

3. Purchase Longevity Insurance

Longevity insurance is a new phrase the insurance industry has created to characterize annuities having some different characteristics. These features include purchasing the annuity now but not having it start distributions until you are much older, say 85. This makes it a deferred fixed annuity.

One example is a policy from MetLife that for a typical 65-year-old would cost $25,000.  The income from the annuity would not begin until age 85. At that point, annual income would be $20,649 for men and $16,551 for women.

Other companies are getting creative in the “longevity insurance” area. For example, Hartford Life Insurance Company offers a version of its Hartford Income Annuity that requires a one-time upfront payment. However, the buyer chooses the date to begin receiving the annuity income and is given some flexibility to change the date.

New York Life now offers a Changing Needs Option on some of its income annuities. The owner can increase the income from the annuity by up to five times the initial payment – or decrease it by half – as their needs change. The premium for an annuity with this option is greater. A 65-year-old man would pay $134,504 for an immediate annuity with $10,000 annual income guaranteed for life. If the owner wanted to double the payout ( to $20,000) beginning at age 85, he would have to pay an extra $13,979 (lump-sum payment of $148,483).

Final Thoughts on How to Make Your Retirement Income Last

This is obviously a complex subject for study for a lot of us. There are some wild cards as well, including possible changes to Social Security and/or introduction of a national health care plan. The need for long term care can also change the equation. But I don’t think it is ever too early to think about this issue and to explore all of your options. If you wait too long, you won’t have any options.

Photo credit: Sea Frost

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