Social Security checks provide a portion of monthly income for most older people. Some also receive monthly checks from a traditional pension plan. These sources typically form the foundation of a retiree's income plan. But to maintain their standard of living, many people also need additional monthly income during retirement. How to build that additional income stream is the challenge.
For many, the discussion revolves around two questions: "Should I just take withdrawals from my savings and investment accounts whenever I need money beyond my Social Security or pension check? Or, should I purchase financial products - like annuities - that will pay me a guaranteed income stream?"
The choice between taking withdrawals and purchasing an income annuity involves many trade-offs, so it pays to look at the issue from many angles before reaching a decision.
A good place to start is to assess how much flexibility you are likely to need. Early in retirement, for example, people may have considerable flexibility to spend discretionary funds on hobbies or vacations. In the later years, however, this flexibility may decline or uncertainty may rise concerning health care costs or long-term care costs.
Early Steps
An early step in the retirement planning process is to project future sources of income and estimated expenses. Sources of future income may include Social Security, work-related pensions, or income from continuing to work.
Some income items will adjust for inflation, like Social Security, and others, like most corporate pensions, are fixed for life.
For future expenses, experts suggest splitting them into two categories: 1) required living expenses, including taxes; and 2) discretionary expenses.
Individuals who have mortgage debt at the time of retirement need to decide whether to pay down all or part of the debt. A key decision factor is the amount of assets and liquidity that will remain after paying down debt. Ask this question: Will the pay-down of debt be too constraining?
Those who have work-based retirement plans may have decisions to make before considering purchase of any retirement products.
Prior to separation from the company, retirement plan participants will likely be given a choice between: 1) Leaving your money parked in the plan; 2) Take a lump-sum distribution; 3) Roll the money into an IRA; 4) Take periodic distributions; or 5) Purchase an annuity through an insurer recommended by the plan sponsor.
Keep in mind that employer offers usually come with a fixed time frame for making a decision. Also, if the participant is married, they will have to consider the impact their choice might have on their spouse.
Products with Lifetime Guarantees
Once an individual chooses an approach and income plan, he or she will need to scope out the available products that can help implement the plan. To the extent that future required living expenses exceed future income, people may decide to fill the gap with a product containing guarantees. Some examples follow.
Income annuities. The most straightforward choice would be an income annuity. This is an insurance policy. The purchaser pays a certain dollar amount up front and the annuity pays a fixed amount per month for life. Income annuity products come with various features that make them adaptable for individual situations. For example, income annuities:
- Cover either single or joint lives.
- Come with various refund options - for example, a guarantee that payments will last at least 10 years even in event of death of the payee. (The more attractive the refund feature, the lower the monthly payment.)
- Pay a flat monthly amount for life, in most cases, or make payments that step up by a set percentage each year.
- May adjust the monthly payments each year for actual inflation. Not all income annuities do this.
Other products. Annuities, including variable annuities with a guaranteed lifetime withdrawal benefit (GLWB) , fixed annuities and fixed indexed annuities with guaranteed income riders, also
offer lifetime income that retirees may want to consider.
Bottom Line
When comparing regular investments versus products with longevity guarantees, retirees and their advisors will find some very attractively priced regular investment products available. These include index funds and exchange-traded funds, both of which cost a fraction of 1 percent a year.
Some retirees and near-retirees may prefer to invest in products with guarantees. The market for income annuities is competitive, and low-cost products are available.
In choosing these products, they will need to pay attention to the tax effects. Tax treatment varies among the different financial products, so after-tax results may look quite different from before-tax results. They should also pay attention to the financial strength of the insurance company selling the product.
It is essential to work with advisors who are experts in this market and who understand tax effects. Advisors and individuals who use financial projection software in their planning should check to be sure the software takes tax considerations properly into account.$
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