A new retirement study by the Stanford Center on Longevity, conducted in conjunction with the Society of Actuaries, “Optimizing Retirement Income by Integrating Retirement Plans, IRAs, and Home Equity,” presents a framework of analyses and methods that plan sponsors, financial advisers, and retirees can use to compare and assess strategies for developing lifetime retirement income.
Steve Vernon, a research scholar at the Stanford Center on Longevity and a co-author of the study, has had a long career as a consulting actuary for retirement plans, and he runs a firm that does retirement planning workshops, called Rest of Life Communications. He says the strategy suggested by the study is straightforward and simple to administer. “If a plan sponsor wants to put in more complex methods, that’s fine. There are lots of different retirement income strategies; this one is just not as complex or as involved as other strategies,” he tells PLANSPONSOR. “We’re not suggesting things that take a lot of expense—the strategy uses existing tools plan sponsors have as well as existing capabilities of providers.”
The authors of the study recommend a portfolio approach for retirement income strategies that integrates Social Security claiming decisions, investing and deploying retirement savings, and utilizing home equity if necessary. Social Security benefits, pensions, annuities, and tenure payments or lines of credit from reverse mortgages can be considered the “bond” or “guaranteed” part of a retirement income portfolio. If retirees achieve sufficient secure income from these sources, the analyses justify investing remaining savings significantly in equities, which are more volatile but have the potential for growth. The researchers acknowledge there can be behavioral constraints regarding this conclusion.
The study report notes that for most middle-income retirees, Social Security is the foundation of retirement income, providing anywhere from half to more than three-fourths of total retirement income. Social Security has several desirable features that, in aggregate, aren’t available with any other retirement income solution. As such, optimizing Social Security benefits through delayed claiming is often an important component of a retirement income strategy. Risk-averse retirees should consider drawing from savings in order to optimize Social Security benefits, before purchasing an annuity or investing in bonds. When middle-income retirees optimize Social Security benefits, they might have all the “annuity” income they need, particularly if they reduce their living expenses.
Researchers say it’s important for the target group of this report—workers and retirees with less than $1 million in savings—to understand Social Security’s critical role in their retirement security. Social Security retirement income has several valuable features:
- It’s paid for the rest of the retiree’s life, helping address longevity risk;
- It’s not subject to capital market risk, helping address investment risk and sequence of returns risk;
- It’s increased by the Consumer Price Index (CPI), helping address inflation risk;
- Part or all of Social Security income is exempt from federal income tax, helping address taxation risk; and
- Social Security benefits are paid automatically (and often electronically), helping address the risk of cognitive decline, fraud, and making mistakes.
“No other method of generating retirement income includes all these desirable features, so Social Security benefits represent a unique, valuable resource. This is one reason it’s important for middle-income retirees to optimize the value of their Social Security benefits,” the study report says.
Vernon agrees that the main factor in the success of the study’s strategy is to delay Social Security until age 70, but he says the strategy is not inflexible. “For every month retirees delay receiving Social Security, it increases lifetime income; they just get the biggest boost from waiting until age 70,” he says. “The strategy is targeted for people with less than $1 million in savings. For them, Social Security may be 60% to 80% of retirement income, so why not optimize that?”
While the study targets middle income retirees, it can be used for higher-income retirees. Social Security may provide less income for higher-income retirees than for middle- or low-income retires, so the higher-income will need to work with a financial adviser to refine the strategy.
While the study focuses on individuals with less than $1 million in retirement savings, Vernon says the less savings one has, the more Social Security is important. The strategy may not work for those who have $100,000 in savings or less unless they are able to work until age 70. He says those with $300,000 to $400,000 may be able to retire at age 65 and withdraw $20,000 from savings each year to delay claiming Social Security. Whereas if an individual has $100,000 or less, the strategy may deplete their savings.
The “Spend Safely in Retirement” Strategy
The researchers’ analyses show whether total retirement income can be expected to keep pace with inflation. For the solutions they analyzed, the solutions using the Internal Revenue Service (IRS) required minimum distribution (RMD) and fixed index annuities (FIAs) did the best job of keeping up with inflation. The analyses also show retirement income solutions with a high withdrawal percentage—7%—naturally spend down savings more quickly than a 3% withdrawal rate.
A strategy that enables delaying Social Security until age 70 and uses the IRS RMD to calculate income from savings produces a reasonable tradeoff among various retirement income goals for middle-income retirees. The researchers note that this strategy has a significant advantage: It can be readily implemented from virtually any IRA or 401(k) plan without purchasing an annuity (which many plan sponsors are hesitant to offer and many retirees are reluctant to purchase on their own).
For the purposes of this report, they call this strategy the “SS/RMD retirement strategy.” For worker and consumer audiences, they call it the “Spend Safely in Retirement Strategy.” The best way for an older worker to implement the SS/RMD strategy is to work enough to pay for their living expenses until age 70; if possible, they shouldn’t start Social Security benefits or begin withdrawing from savings to pay for living expenses.
The next best way to implement the SS/RMD strategy is to use a portion of savings to enable the delay of Social Security benefits as long as possible, but no later than age 70. Then, invest remaining savings and use the RMD to calculate retirement income from savings. The primary disadvantage of this approach is that it can use a substantial amount of savings to enable delaying Social Security; this is the reason the best way to implement the strategy is to continue working, if possible, the researchers suggest. They analyzed the approach, assuming the worker retires at age 65 but uses a portion of savings to enable delaying Social Security until age 70. In addition, the retiree uses the RMD to calculate retirement income with remaining savings.
The SS/RMD strategy offers the following results:
- Produces more expected average total retirement income compared to most strategies that were analyzed;
- Projects total income that keeps pace with inflation;
- Produces a moderate, compromise level of accessible wealth, for flexibility and the ability to change direction in the future. It produces more accessible wealth compared to strategies that use annuities. But it provides less accessible wealth than strategies that maximize flexibility, such as systematic withdrawal plans (SWPs) with low withdrawal rates and/or strategies that don’t use savings to enable the delay of Social Security benefits;
- Provides a moderate, compromise level of bequests, for the same reasons; and
- Produces low measures of downside volatility, depending on asset allocation.
The researchers note that the amount of retirement income generated from savings can be impacted by performance of retirement income approaches through:
- Asset use decisions, such as whether to use savings to enable a strategy that optimizes Social Security benefits, and allocation between invested assets and annuities;
- Asset allocation decisions, which is the mix of stocks and bonds in invested assets;
- Investment timing decisions, including selling stocks when the market is down;
- The level of fees charged for the management of retirement savings, and
- Annuity product features, including transaction charges and the competitiveness of insurance company pricing.
Vernon notes these are not necessarily all negative; the allocation between invested assets or annuities is a choice. The list reflects some mistakes and some preferences.
The researchers say their analyses confirm conclusions from their prior report, “Optimizing Retirement Income in Defined Contribution Retirement Plans,” which focused on solutions that employers could offer to their older workers for deploying in-plan strategies. Vernon says the new study offers solutions that can be implemented outside of plans; it reflects that a lot of people have both defined contribution (DC) plans and IRAs and many have home equity. It reflects the use of all available assets.
As for home equity, the report notes that reverse mortgages can be used to:
- Increase monthly income in predictable ways through a monthly tenure payment;
- Increase accessible wealth in predictable ways, to be used for unforeseen emergencies or long-term care expenses; or
- Reduce downside volatility and the chances that total income will fall below specified thresholds.
“A reverse mortgage should be one of the tools that retirees and their advisers consider on a case-by-case basis, using analyses to quantify how financial security can be improved by strategically deploying reverse mortgages. A reverse mortgage is most appropriate when retirees intend to stay in their house for an extended period, perhaps for the rest of their lives. They also need to understand the costs of reverse mortgages, which can be considerable, so they can decide if the costs justify the benefits,” the study report says. “Older workers and retirees will want to analyze the amount of retirement income they can realistically expect from all of their retirement savings sources. For some, this can be a retirement reality check if their income falls far short of their needs for living expenses. They could then analyze how they could deploy their home equity to boost their retirement income.”
Implementation strategies for plan sponsors and advisers
The SS/RMD strategy should be straightforward to implement in most employer-sponsored defined contribution retirement plans and IRA platforms, as many retirement plan providers can calculate the RMD and automatically pay it to the retiree according to the frequency elected by the retiree.
The researchers suggest the portion of savings that enables delaying Social Security could be invested in a liquid fund with minimal volatility in principal, such as a money market fund, a short-term bond fund, or a stable value fund in a 401(k) plan. In the years leading up to retirement, an older worker might want to start building a “retirement transition fund” that will enable delaying Social Security benefits. This fund can protect a substantial amount of retirement income in the period leading up to retirement, since the retirement transition fund should be invested in stable investments and Social Security is not impacted by investment returns. Vernon suggests plan sponsors can amend their plans to allow for systematic or periodic withdrawals. “That will really help out,” he says.
The researchers support investing the RMD portion significantly in stocks—up to 100% if the retiree can tolerate the additional volatility (which is modest because of the dominance of Social Security benefits). However, the asset allocation to stocks for a typical target-date fund for retirees (often around 50%) or balanced fund (often ranging from 40% to 60%) also produces reasonable results, and these funds are commonly available in IRA and 401(k) platforms, they say.
Financial advisers and institutions may need new business models to implement many of the strategies and retirement income solutions outlined in the report. Vernon explains that this includes recognizing what are the most important decisions those approaching retirement need to make—coming up with a delay strategy, deciding how to deploy a savings strategy in retirement, and how to claim Social Security benefits. He adds that many financial institutions charge asset fees on savings and transaction fees, which have no bearing on these decisions. “Getting a good return on savings is important, but it doesn’t have nearly the magnitude of a delaying Social Security strategy,” he says.
To communicate this strategy to retirees, plan administrators and advisers should characterize Social Security as a secure retirement paycheck that a retiree might use to pay for basic living expenses, the researchers suggest. They should characterize the RMD income as a variable annual retirement bonus that can fluctuate in order to pay for discretionary living expenses. “Many middle-income workers are accustomed to managing their finances with secure paychecks and variable bonuses, so it’s natural to continue this financial discipline in retirement,” the report says. The SS/RMD strategy works best when the retiree delays Social Security until age 70, but delays until earlier ages, such as 67, 68, or 69 still provide significant advantages. Employers can also offer alternative career trajectories that enable their older workers to continue working.
Vernon admits there are valid arguments for not planning to work until age 70. “We’re not saying this is easy for people to do; there is no magic bullet, but it can work if an employee retires earlier if he or she has enough assets,” he says. “A lot of employers have robust retirement plans, but another thing they could do is offer alternative situations for older workers that have health issues or have to take care of a loved one to help them work longer.”
For those who don’t have any retirement savings, any strategy is just not applicable, according to Vernon. Their only choice is to work longer or reduce living expenses, and Social Security will offer more income to lower-income retirees on a relative basis. Vernon says one possible saving grace is home equity, but some employees don’t have home equity; those are in a tough spot.
Vernon also notes that the future of Social Security is on the minds of lots of people, but he believes the thinking that future retirees will get nothing is extremely unrealistic. “If you think about how Social Security is funded—from current taxes paid by workers—in the worst case, if Social Security runs out of money, we still have a system where current workers are paying for benefits, and that still can be up to three-fourths of income for retirees,” he says. “As long as we have a Democracy, we will have Social Security.” He adds that he believes those ages 50 or older will get Social Security benefits as now described, but younger generations could see a program change which may affect their draw down strategy. “Legislators may push back the retirement age a little more or may raise Social Security taxes, but there will not be a wholesale devastation of the system, and tweaking is needed,” Vernon says.The Institutional Retirement Income Council (IRIC) suggests other retirement income strategies. How to employ retirement savings is an intimidating decision for employees, and they trust employers, so it is god for employers to look into different strategies. “Plan sponsors would be well served to review the study and the conclusions it makes regarding draw-down strategies participants can use when optimizing their DC account use in conjunction with Social Security optimization,” says Bob Melia, IRIC’s executive director.