Savvy Ways to Tap Your Retirement Savings

By Thomas M. Anderson, Mary Beth Franklin

published 31 July 2007

You would think that after decades of saving money for retirement, the hard part of investing would be over. Think again. Devising a plan to turn a heap of cash into a stream of income that can last a lifetime is more art than science, and there is no one magic formula that suits every investor. "We'd all like to find one simple answer, but retirement is not simple," says Eric Sondergeld, vice-president of Limra, an insurance-industry trade group.

Consider one commonly accepted model: the 4% solution. The rule of thumb is to withdraw 4% from your portfolio to finance your first year in retirement, and increase that initial dollar amount in subsequent years to keep pace with inflation. This conservative withdrawal pace virtually assures that you won't run out of money -- one of the most frightening scenarios for retirees. But the meager income it generates -- initially $40,000 from a $1-million kitty -- may be insufficient for many retirees. Some opt to spend more early on and vow to cut back later.

Or you could buy an immediate annuity. You hand over cash to an insurance company, and in exchange it promises to send you monthly payments for life. This strategy may be good for someone who doesn't have a pension and wants a stream of guaranteed income to cover fixed expenses such as mortgage payments and utilities. One of the nice things about this approach is that you can invest the rest of your money more aggressively, knowing that your annuity payments, supplemented by Social Security benefits, will cover many living costs.

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But interest rates, which affect immediate-annuity payouts, are near historic lows, and inflation erodes the buying power of fixed-rate investments. As a result, retirees who buy an immediate annuity now may have to curtail their spending in the future or buy additional annuities to maintain their standard of living. Nowadays, a 65-year-old man investing $100,000 would receive about $690 a month for the rest of his life. Because of longer life expectancy, a 65-year-old woman would receive less -- about $635 a month. To get an idea of how much income your lump sum will produce, check out ImmediateAnnuities.com.

Unlike immediate annuities, these deferred annuities allow you to cash out your account balance without penalty once the surrender period expires (usually from two to seven years). Or you can continue withdrawing guaranteed annual payments for as long as you like. Although fees can run as high as 2% to 3% a year (that includes both insurance charges and the costs of the underlying funds), many retirees think the price is justifiable because they can benefit from holding stock funds while at the same time maintaining a guaranteed income even if the market tanks.

Just ask Bob De Angelis. He retired from his job as an estimator with a New Jersey plumbing company in 2001 in the midst of a horrific bear market. De Angelis, 67, and his wife, Dianne, 64, started withdrawing money from their investments, but they grew increasingly skittish -- with good reason -- as the stock market continued to sag. Withdrawing money from a shrinking balance can ravage a retirement nest egg.

De Angelis's financial adviser, Nick Spagnoletti, of Macro Consulting Group, in Parsippany, N.J., suggested that his client invest in a variable annuity with an income guarantee. So De Angelis bought an annuity for $100,000 in 2004 and a second one for $108,000 in 2005. Together, the contracts are now worth about $275,000 -- even after taking 6% withdrawals ($12,000) a year starting in 2006 -- because of appreciation in the subaccounts, which include funds that invest in foreign stocks and small-company stocks. "His most-aggressive investments are protected by the income guarantees," says Spagnoletti, who admits that he would never have recommended variable annuities before 2000. "The criticism of them was well deserved for years. They were expensive, and you didn't get a lot for your money. All that has changed with guaranteed living benefits."

Genworth Financial recently introduced a new variable annuity that lets you either start taking payments now or receive larger payouts later. You are guaranteed annual payments of at least 7% of your initial investment if you are 60 to 69 years old when you start withdrawing money; 8% if you are 70 to 74 years old; and 9% if you are 75 or older. You may qualify for even higher payouts if your investment choices perform better than the guaranteed withdrawal amounts. "For someone who is 75 or older, 9% is an unbelievably good deal," says Spagnoletti. But keep in mind that with this annuity, you can't change your mind and get your money back once you start taking payouts.

Remember, too, that you will generally have to pay income taxes on your annuity payouts. Annuity earnings grow tax-deferred, but payouts, whether from fixed-rate or variable annuities, are either partially or fully taxed at ordinary income-tax rates. If held in a taxable account, the portion of each payment that represents a return of principal is tax-free. Annuity payouts from IRAs, like any withdrawals from IRAs and other retirement accounts (except Roths), are fully taxable at ordinary tax rates.

If annuities aren't for you, you can still make do with traditional investments. But don't think you have to undergo an extreme portfolio makeover just because you have retired. "The act of retirement is not a defining point to start getting out of stocks and into fixed income," says Roger Gibson, a financial planner near Pittsburgh and author of Asset Allocation: Balancing Financial Risk. "The portfolio balance you have two or three years before retirement is probably the portfolio balance you should have two or three years after retirement."

The other major chunk of your portfolio should be in bonds or bond funds. Here, the mix should include corporate IOUs and Treasuries with short-term and medium-term maturities (long-term bonds aren't paying enough to justify their risks). If you're willing to take a bit more risk, you can add a high-yield, or junk, bond fund and an overseas bond fund (see our recommended portfolio using Kiplinger 25 funds).

To cut volatility, add some investments that don't move in sync with stocks and bonds. Two of our favorites are Merger fund (symbol MERFX; 800-343-8959), which invests in the stocks of takeover targets, and Fidelity Floating Rate High Income (FFRHX; 800-343-3548), which invests in bank loans whose interest rates reset every three months or so. As a result, Floating Rate performs well even when rising interest rates hurt most bond funds. It recently yielded 6.4%. Over the past ten years to June 1, Merger fund gained an annualized 7%, and since its start, in 1989, it has experienced only one down year.

Having a pension or other guaranteed source of income, such as an annuity, enables you to invest more aggressively in your other retirement accounts. Roy Pace, who retired four years ago from a job as a project engineer at Alcoa, keeps 60% of his IRA in stock funds, including substantial holdings in international and emerging-markets funds. A pension based on 35 years of service "gives me the luxury of going to Tahiti without worrying about how I'm going to pay for some things," says Pace, 61, who lives in Saluda, Va., near the Chesapeake Bay, with his wife, Glenna, 61.

Earning even a modest amount from a part-time job in retirement, as Pace does, can have a substantial impact on your income. "It can be very significant in terms of reducing withdrawal needs from your portfolio in the critical early years," says Michael Kitces, a financial planner in Columbia, Md. For example, he says, a part-time job producing $20,000 a year is the equivalent of having an extra $500,000 in savings, assuming a 4% annual withdrawal rate.

If you are uneasy about going it alone, many investment companies offer services to help manage your retirement income. When Pace rolled over about $300,000 in his 401(k) this year to a T. Rowe Price IRA, he got personalized financial advice about asset allocation. And he will receive annual updates as part of the firm's advice program, which charges a one-time fee of $250 for accounts of less than $100,000.

If you don't want the hassle of building a retirement investment portfolio of your own, you can select a ready-made retirement-income fund. Typically, these are funds of funds that either hold a static mix of stock and bond funds or gradually become more conservative as you get further into retirement (see Retire on Autopilot for a selection of funds with low fees and different investing strategies).

Time to draft a 30-year plan. This starter kit gives you a diversified portfolio with moderate risk using the Kiplinger 25, the list of our favorite no-load mutual funds. Add to or subtract from the stock funds according to your appetite for volatility. As you grow older, gradually reduce your stake in stock funds and boost your allocation to bond funds -- especially to Dodge & Cox Income because it has a broad mix of high-quality bonds. Generally, keep at least 20% of your portfolio in stock funds no matter what your age.