Making Your Money Last a Lifetime

(Image credit: ©JamesFoster2014)

published 4 September 2015

These days, protecting your savings as you approach retirement -- with the goal of making it last as long as you do -- is like navigating between a rock and a hard place. Now in its seventh year, the bull market is one of the longest on record. That means by most standards that a bear market is overdue. Interest rates are almost certain to go up in the coming years, and bond prices fall when interest rates rise. "I see risk at both ends of the spectrum," says David Blanchett, head of retirement research at the investment consulting branch of Morningstar.

The more distant future looks dicey, too. Over the next 10 to 30 years, we think stocks will deliver average annual returns of 6% to 8%, rather than the annualized return of 10.1% they have produced since 1926. If you buy a 10-year Treasury bond today, you know that you'll earn roughly 2.2% a year over the next decade. Expect a little more if you invest in individual high-grade corporate bonds. (Funds will be hard-pressed to match the return of investors who buy individual bonds and hold to maturity.) Inflation is projected to stay low, at 2%, but cash will earn less than that, with money market mutual funds yielding maybe 1.5% over the next five to 10 years.

In this low-growth world, calculating how much money you need in retirement and at what rate you can safely draw it down is challenging. Longer life spans further complicate such estimates. A 65-year-old man can now expect to live another 18 years, on average; a 65-year-old woman can expect to live another 21. "Longevity is a two-sided coin," says Maria Bruno, a senior investment analyst at mutual fund giant Vanguard Group. "There's the risk of outliving your portfolio and also the risk of underspending."

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Traditional wisdom has it that you invest heavily in stocks while you're young and scale back that part of your portfolio to, say, 50% as you approach retirement, keeping the rest in bonds and other fixed-income investments. Near-retirees who are still shell-shocked by the bear market of October 2007 to March 2009 may cringe at the idea of putting even half their money in stocks. But short-term thinking poses a bigger risk, says Debra Morrison, a certified financial planner in Morristown, N.J. "What skews people's retirement asset allocation is that they're planning for the immediate future. Unless you have a terminal diagnosis, we're talking about another 20 to 30 years."

That means entering retirement with a healthy portion invested in stocks for growth and gradually reducing that side of your portfolio to lower your risk as you age. "A portfolio of 40% to 60% in equities is a good starting point," says Bruno. The Vanguard Target Retirement 2015 Fund, which manages its investments for people retiring this year, allocates 49% of its assets to stocks and 51% to bonds. Over the next seven years, the fund will gradually change its mix until it reaches 30% in stocks and 70% in bonds. That's the model for all Vanguard target-date funds.

Don Herlitz, 61, plans to retire in four years or so. An engineer at Cummins, in Columbus, Ind., he has amassed a tidy sum in his 401(k) as well as in a cash-balance account (a hybrid with attributes of both a pension and a retirement savings account) the company set up when it closed its pension fund in 1997. Herlitz, who is saving for retirement on behalf of his wife, Paula, 58, as well, currently holds about 60% of his assets in stocks and has no immediate plans to change the mix. "I would hate to see the market crash right now because I don't have time to recover before I retire," he says. Still, if a downturn does happen, he and Paula are willing to ride it out.

Michael Kitces, a partner at the Pinnacle Advisory Group, in Columbia, Md., and Wade Pfau, professor of retirement at the American College, in Bryn Mawr, Pa., suggest a different approach: gradually reducing your stock allocation to, say, 30% at the point of retirement and then raising it in retirement to 70%. Their rationale: Day one of retirement is when you're most vulnerable to the risk that a bear market will cripple the long-term growth of your portfolio. If you start with a low allocation to stocks and the market declines, you haven't taken a huge hit and can gradually add stocks back with the expectation that share prices will rise, says Pfau. If the market does just fine, "your wealth grows and you'll have more capacity to take risk later," he says.

Which strategy you choose depends on your circumstances and risk tolerance, says Bruno. If you have a large portfolio and plan to leave money to your heirs, "a more aggressive allocation later can make sense for those who are comfortable with the additional market risk," she says. If, however, heavy losses in the stock market could affect your ability to cover living expenses, you may not be able to stomach that volatility as an 85-year-old.

To take advantage of rising yields, consider building a ladder of bonds that start to mature five years from now, says Pfau. According to this strategy, you buy a five-year bond now, then invest a like amount in new bonds in each of the next four years. If rates rise as expected, you'll earn more interest with each new purchase. When a bond matures, you can use that money for retirement expenses. If you invest in bond funds, it's the manager's job to make the most of rising rates while minimizing the negative impact on bond prices. (See How to Invest After You Retire.)

Five years out is not too soon to calculate how much you'll need to live comfortably in retirement and how much you can withdraw from your accounts without running out of money. On the savings side, one formula is to multiply your last year of preretirement expenses, minus Social Security and any pensions and annuities, by 25. When it's time to start withdrawals, the 4% rule is considered the standard. That is, you can safely take 4% of your savings in your first year of retirement and the same amount each year thereafter, adjusted for inflation.

One problem: Those formulas rely on historical market returns and don't reflect future returns, which are likely to be lower. To avoid lowering your living standard and to keep from running out of money, you'd have to save 33 times preretirement expenses (rather than 25) and drop your initial withdrawal rate to 3% or less, according to a 2013 study by Blanchett, Pfau, and Michael Finke, a professor at Texas Tech University. For instance, if your annual gap between income and expenses is $24,000, you'd need $600,000 ($24,000 x 25) to cover the gap at the 4% withdrawal rate and $792,000 ($24,000 x 33) to cover it at the 3% rate.

For most people, upping the savings goal dramatically a few years away from retirement probably isn’t realistic, says Srinivas Reddy, senior vice president and head of full-service investments for Prudential Retirement. You can, however, postpone retirement or work part-time after you leave your career job. Working longer "is a wonderful tool," he says, because it helps you save more and shortens the length of time you'll be withdrawing from savings. You can also postpone taking Social Security benefits. For every year you delay after age 62, benefits increase by about 8% until age 70. And anyone 50 or older can make catch-up contributions to retirement accounts. For 2015, you can add $6,000 to the $18,000 401(k) limit, and you can stash up to $6,500 in an IRA ($1,000 more than the basic contribution limit).

One certain way to avoid running out of money is to take a percentage -- say, 4% -- from your portfolio each year and forgo the inflation adjustment altogether. Another is to calculate your withdrawals according to the actuarial tables the IRS uses for required minimum distributions, which you have to take anyway from tax-deferred accounts starting at age 70 1/2. Both strategies depend on your investment performance, and they trade flexibility for safety. Plus, the RMD strategy may be overly conservative because it uses a life-expectancy table much longer than that used by Social Security.

Here's another idea: Use the 4% rule as a starting point but adjust it up or down (or skip the inflation adjustment) depending on how your investments do in any given year. In a good year, you can give yourself a bonus, maybe upping the withdrawal to 5%. In a bad year, cut back. "Rather than taking a vacation in the south of France, maybe it's South Carolina," says Warren Ward, a certified financial planner in Columbus, Ind.

This approach combines withdrawal and investing strategies. In one "bucket" you hold enough money in cash and short-term CDs to meet essential and discretionary expenses over three to five years, and you keep the rest in another bucket invested in stocks and bonds. As you spend down the first bucket, you replenish it by taking profits from the second. Some financial planners suggest creating three buckets, the first with cash and CDs, the second with short- and intermediate-term bonds, and the third with stock and bond funds.

A fixed annuity, which provides guaranteed income for life, can be a part of the strategy. You use the income from the annuity, along with Social Security and any pension money, to supplement or replace the part of your portfolio in cash and bonds. At today's interest rates, however, expect a modest payout. A 66-year-old man who buys an immediate annuity for $100,000 would be guaranteed $579 a month; a 66-year-old woman would get $554. To eke out more income, consider laddering annuities, or buy a deferred-income annuity (see Invest in a Deferred-Income Annuity to Reduce RMDs).

When you take money from savings for retirement, you're generally advised to tap taxable accounts first, then tax-deferred retirement accounts, and finally your Roth IRA. Here's why: If you've held the investment in a taxable account for more than a year, you'll pay the long-term capital-gains rate -- no more than 15% for most people. Plus, tapping taxable accounts first allows your tax-deferred accounts and tax-free accounts to continue to grow.

Generally, you should save drawing down your Roth IRA for last. You can withdraw your Roth contributions tax-free and penalty-free anytime; the earnings are also tax-free as long as you're 59 1/2 and have held the account for at least five years. Unlike traditional IRAs, Roth IRAs have no annual distribution requirement. So if you don't need the money, you can let it grow and leave it to your heirs, who can take distributions tax-free.

The exceptions. Now consider situations in which you might be better off departing from the standard advice. If you expect your RMDs to kick you into a higher tax bracket when you start taking them, it may make sense to take some distributions from your tax-deferred accounts before you reach 70 1/2 (as long as they don't put you into a higher bracket). That income will be taxed at your lower rate, and you'll lower the amount of future RMDs, says Maria Bruno, of Vanguard.

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The late Jane Bennett Clark, who passed away in March 2017, covered all facets of retirement and wrote a bimonthly column that took a fresh, sometimes provocative look at ways to approach life after a career. She also oversaw the annual Kiplinger rankings for best values in public and private colleges and universities and spearheaded the annual "Best Cities" feature. Clark graduated from Northwestern University.