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The current expert on retirement planning, Wade Pfau, has recently published a new book, “Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement.”

Although no plan is “safe”, Dr. Pfau’s approach comes about as close as you can get.

Longevity Risk

Here’s the problem we’re all facing. We’ve managed to scrimp and save for our retirement, and now we have a nice nest egg, perhaps a nice round number like 1 million dollars. How do we make this money last until the very end?

Our parents survived on Social Security plus a pension. Both paid you for as long as you were around. It didn’t matter if you kicked the bucket at age 75, 95, or 105. You were covered.

Our 1 million dollars sounds like a lot of money, right?

But you don’t know how long you’re going to live. Actuarial calculations may put you at age 85. But that’s just an average. You have a 50% chance of outliving that estimate.

What if you live to age 95, or 105?

No problem, you’ll invest aggressively with a high percentage invested in the stock market. A fee-free S&P500 index fund will do nicely.

But the stock market has its bull and bear markets.

What if you hit a bear market early in retirement? This is called sequence-of-return risk. Now you’re behind and will probably never catch up.

When estimating how much we need for retirement, many of us will run a Monte Carlo simulation. This analysis runs thousands of future market scenarios—the good, the bad, the ugly—and spits out a success rate. A success rate that our money will last to a certain age, such as age 95.

If you have a high risk tolerance a 75% success rate may be fine. That means you have a 75% chance your portfolio will last until the date you chose.

However, you have a 25% chance of running out of money before that date. And if you live longer, then your chances of success drop further.

And most of us are not good with only a 75% success rate, we want to see a 95% success rate or higher.

Even if you aren’t using Monte Carlo analysis, but instead calculating your financial needs based on expected return, odds are, you are using a low expected return to account for these worst-case scenarios.

Instead of using the S&P500 historical average of around 10%, perhaps you’re plugging only 6% into your equations.

When it comes to the math, the fact that you are aggressively invested in stock is meaningless. You are calculating the worst-case scenario of poor market performance. In addition, you are assuming your savings need to last for far longer than you actually think you may live.

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What about the 4% rule?

Back in the day, William Bengen wrote a seminal paper called “Determining Withdrawal Rates Using Historical Data” (1994).

Given a portfolio of 50% stocks, 50% bonds with returns that matched those of the past (or in this case, prior to 1992), and a retirement lasting 30 years (age 65-95), then withdrawing 4% of your portfolio every year was considered “safe”.

For your 1-million-dollar portfolio that would be $40,000 the first year.

In year two, hopefully, your portfolio will have grown such that you can take out around $40,800—which includes an additional two percent for inflation—without exceeding 4% of the total.

However, in a bad market year, you may have to take out less. Hopefully, you have some extra cash reserves stashed alongside your investment portfolio? These cash reserves are in addition to the 50:50 portfolio.

There are other problems with the 4% rule.

The biggest? Past performance is no guarantee of future success.

Lately, as in the last decade or so, interest rates have been ridiculously low. Bonds do not pay what they used to.

Indeed Pfau and his colleagues have been running numbers with today’s low interest rates and the 4% rule falls apart: “The 4 Percent Rule is Not Safe in a Low-Yield World” (2013).

3% might be safer. Maybe.

Second, what if you live longer than 30 years?

Many in the FIRE community (“Financial Independence Retire Early”) have embraced the 4% rule. But if you’re retiring early, then you don’t have 30 years. Instead, you may have 50 or 60 years.

How exactly is that going to work?

“Sustainable” payout rates for your invested portfolio

Spoiler alert: it’s a lot less than 4%

What about the 4% rule based on what we know today. For the book, Pfau ran Monte Carlo scenarios for a 65-year old with $1 million dollars. Their $1 million needs to last anywhere from 20 years (age 85) to 40 years (age 105). They invest in a 50:50 portfolio with returns and standard deviations based on historical averages.

Inflation of 2% is included.

Here are the withdrawal rates that our millionaire needs to stay below in order to have either a 90% or 95% success rate. Those are the odds they won’t run out of money by the designated age.

Sustainable withdrawal percentages for a 65-year-old with $1 million in a 50:50 portfolio. Age indicates how long $1 million will last given the spending percentage at either a 90% or 95% success rate. Calculations adjusted for 2% inflation. Adapted from Pfau, 2019.

In other words, if our millionaire wishes to be conservative, and stick with a 95% success rate, and thinks they won’t live past age 95, then they can withdraw 3.36% or $33,642 (0.0336 x $1 million).

That’s a lot less than the $40,000 they would get with the 4% rule.

And our millionaire could still live longer than age 95 or hit market conditions dissimilar to historical averages.

Not to worry, there is a solution…

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The benefits of risk pooling

Insurance works by pooling the risks of a large number of people.

If your house burns down, your insurance can afford to pay for it (and make a profit) because many people paid for fire insurance.

Everyone threw money into one pot in order to share the risk.

An annuity works in a similar way. You pay the insurance company a certain amount (a “single premium”) and they pay you an annual amount for the rest of your life.

This payout could be fixed, variable, or have a cost-of-living adjustment (COLA). Many different types of annuity products are available.

It doesn’t matter if you last until age 85 or 105, you’ll still get paid. You may even get back far more than you put in, plus interest.

This works because some people in the pool will die early. Sure, they probably paid more than they got back, but they’re gone now and don’t need the money anymore. (If money is still needed, see the section on Life Insurance below.)

That extra money will be effectively divvied up among the rest of the pool (plus a little profit for the insurance company). Therefore, the payouts you receive will be a bit higher, relative to what you paid in premium.

In addition, the insurance company uses your actuarial lifespan—say 85—to do their calculations.

It doesn’t matter if you live longer, because the pool as a large group should match actuarial projections. In other words, it all averages out.

When you were trying to fund yourself with your invested savings you were forced to use a long lifespan, at least until age 95 or 100.

The third advantage is that the insurance company has a larger pool of money to invest. No, they don’t invest in the stock market. However, they can delve into corporate bonds that pay better than government bonds (“Treasuries”).

They can get away with investing in more risky assets, because—say it with me now—the risk is pooled.

At any given time, only a percentage of their large pool of assets is being paid to customers. Therefore, it’s easier for them to weather a bad market year.

Annuity payout rates

Pfau reminds us that pricing for annuities is simpler than most of us realize.

• Your mortality rate based on your age and gender. Yes, guys will get the best “deal” on an annuity because you don’t live as long. If you are starting an annuity young, your annual payout will be less because it needs to last for more years.
• Interest rates. How much can the insurance company make on their large stash of assets?
• For the insurance company: overhead costs and a bit of extra to cover the risk of not accurately estimating how long their pool of customers will live.

There are “life only” products that end when you do. And other products—that obviously cost more—that will pay out a certain amount to your heirs.

Pfau ran some estimates of what a “life only” product should cost, then compared that to actual prices available from www.ImmediateAnnuities.com. The real products were a better deal, most likely because they are getting a better interest return than the conservative estimates Pfau used.

Remember the 4% rule? The one that no longer works with your invested savings.

Instead of a “withdrawal” rate, for annuities, you can calculate an equivalent payout rate. Simply divide the premium you paid by the annual payout.

Perhaps you purchase an annuity for $300,000 and receive an annual payout of $15,000. 15/300 = 0.05, or 5% payout rate.

Here are the payout rates Pfau found for immediate annuities available to purchase as of January 2019. The older you are when you purchase your annuity (and the more likely you are to die in the near-term) the higher the payout rate.

Payout rates for commercially available life-only immediate annuities from www.ImmediateAnnuities.com as of 01-2019. Age indicates the purchase age. Adapted from Pfau, 2019.

Men get the best deal, followed by women. The most expensive are for “joint” annuities for two people, usually spouses, that will pay out as long as one person still lives.

The later you start, the higher the payout rate. However, starting late adds its own set of risks. (More on that below.)

Note that at minimum the payout rate is 5%, far better than your old 4% rule.

In fact, annuities blow the 4% rule out of the water!

For most individuals who may start an annuity when they retire at age 65, the payout rate is a hefty 6.5% or more.

Immediate annuities pay right away. You also have the option of purchasing a deferred annuity that will start at a specified time in the future, perhaps decades from now. Not shown, but Pfau’s numbers for those products have even higher payout rates.

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Diversify, diversify, diversify… and rebalance

Realistically, you won’t want to put ALL your life savings into an annuity. Just a portion. For the remaining portion you may keep in your usual invested account of stock and bond funds.

Diversification is important. Not just when it comes to individual stocks and bonds, but also income streams, goals, and strategies.

Because a fixed annuity with a guaranteed income payout behaves more like a bond, it should be counted like bonds when it comes to your asset allocation.

For example, perhaps you’re a 50:50 investor with half your savings in stock funds and half in bond funds in a $1 million dollar portfolio.

And you take 30% (300K) of your portfolio from your bond allocation, sell it, and purchase an annuity.

You now have a 300K annuity, 200K remaining in bonds, and 500K remaining in stocks.

Your 700K of invested savings, on its own, has an allocation of 71% stock (500/700) and 29% bonds (200/700).

Moving forward, maintain your overall 50:50 allocation. Note that your invested savings will have a higher allocation of stock to make up the difference.

Pfau discusses several ways of pricing your annuity moving forward in order to maintain your planned asset allocation. But the key is that it counts like a bond fund.

Running the numbers with and without an annuity

Pfau ran the numbers so we don’t have to.

Picture a 65-year female retiree with a $1 million dollar portfolio, who needs $47,873 annually. Obviously, this represents a 4.78 withdrawal rate.

Her required spending amount will grow by 2% each year due to inflation.

Given her 50:50 invested portfolio, based on historical averages, her remaining assets will grow at a compounded inflation-adjusted (“real”) return of 3.5%.

Why $47,873? At this spending rate, her portfolio will be completely depleted in exactly 35 years, by the time she reaches age 100.

(For our retiree, this 35-year mark is at the median, or 50% success rate. This success rate is not something you’d want to use when making calculations in real life, but fine for demonstration purposes. As discussed above, in real life you need to be waaaay below a 4.78% withdrawal rate.)

• Scenario 1: she sticks with invested savings only. If she lives past age 100 her money will be gone.

In scenario 2, she purchases a fixed annuity for $300K. However, she adjusts her remaining $700 to a 50:50 allocation.

Considering that the annuity counts as a bond, she now has a much smaller overall stock allocation of 35% ((700 x .50)/1000).

• Scenario 2: invested savings + annuity. Allocation 65:35, “bonds” vs stock.

In scenario 3, she follows the recommendations in the section above and counts the annuity like a bond. She maintains an overall allocation of 50:50 which requires a higher percentage of stock within the invested portfolio.

• Scenario 3: invested savings + annuity. Allocation 50:50.

In scenarios 2 and 3, the 300K annuity has a withdrawal rate of 5.78% which provides $17,430 of income that now does not need to be withdrawn from the remaining 700K invested savings. That reduces the withdrawal rate on the invested savings to 4.36%.

Because less is withdrawn from the invested savings there is a bit less of a problem with sequence-of -return risk. In other words, if the market is having a bad year, she is selling fewer assets at a poor price, in order to withdraw and pay for living expenses.

*Scenario 2 hit $0 at age 98. Adapted from Pfau, 2019

There are a couple of takeaways:

• Keep your stock allocation up

Despite having the annuity to pick up the slack, scenario 2 ran out of money two years before scenario 1, because there wasn’t enough of the portfolio invested in stocks. Of course, our retiree will still get her annual annuity payout of $17,430. Let’s hope that’s enough for her.

• When your allocation is maintained, the addition of an annuity can significantly stretch your savings

Instead of hitting age 100 with nothing, in scenario 3, our retiree has $425K of invested savings left! That extra money can be used if she happens to live past age 100. Alternatively, it may go to the grandkids, or be left to charity.

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Want a legacy? Include whole life insurance

One downside of an annuity, especially a “life-only” annuity, is that there is nothing left over for your family when you pass.

As shown in the example above, an annuity can protect your remaining savings from depletion, but this is by no means guaranteed.

If having a legacy is important to you, then consider including whole life insurance.

Term life insurance vs whole life insurance

There are two major types of life insurance. Term life insurance works like other insurance that you may have, such as auto insurance or health insurance. While you pay the premium, you are covered for the event(s) listed.

In contrast, whole life insurance uses part of your premium to pay for the insurance itself, and the rest goes into a “cash value” that becomes a savings vehicle, albeit one with a very low return.

When you’re young, term insurance is significantly less expensive than whole insurance. But as you get older—and your odds of dying increase—term insurance becomes more and more expensive. At a certain age, you will become completely ineligible for term insurance.

Whole life insurance is intended for your “whole life.” As such, the premiums are fixed. You “overpay” when you’re young, but “underpay” when you’re old. Likewise, you don’t need to worry about being disqualified for bad health, if you started the policy back when you were young and in good health.

The main purpose of life insurance is to protect “human capital”. Say you’re the breadwinner in your family. If you were hit by a bus, your spouse and children may suffer financially now that the income from your job—and the income you would make for the next several decades—is gone.

Because term is much cheaper than whole, you can purchase more coverage for the same price. For younger families with a limited budget, term is the clear choice.

Once you retire, you no longer need human capital protection. And at this point, term insurance will be pricey. Go ahead and dump it.

However, once you retire, whole life insurance has some added benefits.

Remember that cash value? If your policy has been in force for a while it’s now quite a bit bigger. You can use that to cover unexpected expenses.

This cash also helps with sequence-of-return-risk. Bad market year? Tap your cash value rather than your invested savings.

Depending on your policy, you may even be able to tap your death benefit to pay for long-term care expenses.

Although you may wish to buy term life insurance when you’re just starting out, when you hit middle-age or so, you may wish to switch or add a whole life policy.

The biggest benefit of whole life insurance may be its ability to stretch your retirement savings while providing a legacy for your heirs.

Running the numbers with and without life insurance

Pfau created a case study of a fictional forty-year-old couple with two children. Their goal is to leave 500K to the kids. The easiest way to do this is to purchase life insurance with a 500K death benefit.

The husband, “Jerry” has the funds to max out his 401K and set aside $19,000 (the 2019 limit) in a target-date fund. (Once he hits age 50, Jerry will set aside the max of $25,000, adjusted upward for inflation.)

Jerry will use some of that $19,000 to pay for either term life insurance (scenario 1) OR whole life insurance (scenario 2), plus the taxes he would have avoided if the entire amount had gone into his 401K. He will stop paying for term life insurance when he retires at age 65.

Whatever is leftover from the original $19,000 goes into his 401K. So, in these scenarios, his growing 401K balance is much less than it would be if he didn’t buy life insurance and a lot less with the purchase of whole life insurance.

The cash value of the whole life insurance policy is included when his 401K savings is rebalanced. Therefore, he holds a larger percentage of stock to account for this.

In scenario 1, because Jerry stops purchasing term insurance at age 65, he and his wife will need to reduce their spending in order to make sure they have at least $500k left in their 401K at age 100 (90% success rate).

In both scenarios, taxes and inflation are accounted for.

Will the additional investment in the whole life insurance pay off later?

*500K of this number is the death benefit and the remaining $3612 is from the 401K. At age 65, the term life insurance has ended and only the whole life insurance has a cash value and death benefit. At age 65 the 401K balance may be higher or lower, but the median (50% success rate) value is shown. Likewise, the legacy may be much greater, but to insure a 90% chance that at least 500K remains, the sustainable spending rate needs to be followed. The discounted lifetime spending power depicts the present value of their total spending, assuming a 3% growth rate. It allows a comparison between the two scenarios. Adapted from Pfau, 2019.

Yes, the whole life insurance definitely paid off in scenario 2.

Even though the 401K was larger in scenario 1, this couple had to reduce spending down to 2.71% (around $24K per year) in order to have a 90% probability that at least $500K remained at the very end for the kids.

In scenario 2, they already had a $500K death benefit so 401K assets could be freely spent down to zero. As a result, they could spend a more generous 3.48% (around $29K per year).

The last line provides lifetime spending power. That value plus the value of the final legacy will give you a clear estimate of which scenario won.

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Life insurance + annuity

Even if legacy amounts aren’t critical, there are other uses for whole life insurance.

Pfau also ran scenarios with life insurance in combination with an annuity.

One scenario added a joint-life SPIA (single premium income annuity) to term life insurance. The joint annuity will continue to pay as long as one spouse is still living. However, as shown previously, joint annuities are more expensive than annuities for single people.

An alternative scenario was to purchase the cheapest SPIA, a single-life annuity for the husband. Instead of term insurance, whole life insurance on the husband’s life was included. In this scenario, once the husband passes away the annuity payouts will end.

But that won’t be a problem as the wife now has the tax-free proceeds from the life insurance. She can then invest this money and purchase her own SPIA.

If the wife goes first, the husband has his SPIA which will continue to pay, plus the cash value of his whole life insurance.

This alternative scenario was the winner with a 3.69% withdrawal rate. The joint SPIA plus term had only a 3.53% withdrawal rate. (Investments alone plus term, only 3.36%.)

So, if you’re married and/or have children, you may wish to incorporate a whole life insurance policy into your retirement plan.

How much annuity should you purchase?

The downside of annuities is that you lose out on the potential upside you can get with a strong stock market.

In the simplest annuities, your payout is fixed. You give up the upside in exchange for no downside.

There are compromises available. Variable annuities allow you to invest your savings in provided sub-accounts that are like mutual funds of stocks or bonds. Variable annuities will provide upside while protecting the downside. However, if the market doesn’t perform as anticipated, they may pay out less than what a comparable fixed annuity might pay.

There are always trade-offs.

Pfau is of the opinion that fixed annuities are the most efficient.

If you don’t wish to give up the upside, then keep a larger portion of your savings in traditional investments.

So how much of your savings stash should you use to purchase an annuity?

Map out your goals: Living, Lifestyle, Legacy, and Liquidity

All your financial assets can be divided into four major buckets, based on their purpose.

Pfau defines the four “L’s”:

• “Living” are you basic living expenses that you can’t live without. This includes housing, food, Medicare premiums, and transportation.
• “Lifestyle” is your fun money. Travel or golf. This category also includes gifts to others, including charities.
• “Legacy” is what you’ll leave behind when you’re gone
• “Liquidity” is needed for unexpected financial issues. An unexpected medical procedure or that family member who loses their job and moves in with you…

Living

“Living” is the most critical on this list. Therefore ideally, you should be using guaranteed income. If you have Social Security plus a pension this may already be covered.

But most likely not.

Some may choose a bond or CD ladder for this, but Pfau has shown that annuities work far better.

If you need 50K per year to cover basic living expenses, and social security pays 25K, then purchase an annuity to pay the remaining 25K.

Use the rest of your financial assets to divvy up between the three other goals.

Lifestyle

“Lifestyle” may depend on how successful your stock portfolio performs. In good years you may have extra to play with. In bad years, you hunker down and live off your guaranteed income.

If you are fortunate and have plenty of funds to make it to the end, you can invest more conservatively and use some of your income, either from bonds or an annuity, to pay for your fun.

Legacy

This includes your remaining invested assets; cross your fingers and hope for good market years. As discussed above, whole life insurance is more reliable.

Liquidity

Pfau reminds us that our invested savings aren’t really that liquid. Sure, we can sell them at any time if we need cash. However, other than planned withdrawals, our invested assets are intended to remain intact so that they may grow and generate the income we need in future years.

If we take from our savings now, we’ll be behind the curve. Permanently.

One option is to keep cash in reserve in a money market fund. We also have our whole life insurance cash value. Pulling the equity out of our paid-off house with a reverse mortgage is also an option.

It’s counter-intuitive, but an annuity actually helps with liquidity. As our “living” expenses are taken care of, we can afford to take a bit more from our invested savings. We may have less “lifestyle” in the future as a result, but that may be okay.

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When should you purchase an annuity?

When you purchase an annuity is completely up to you. Mathematically, the differences are small. In the examples above an annuity was purchased upon retirement at age 65.

Alternatively, you could purchase a deferred annuity at age 55. It will cost significantly less, as ten (or more) years of growth will be accounted for. Then annuitize, or start payouts, at a time that you’ve chosen.

If you’re confident in the growth of your invested assets, then wait a bit.

If longevity risk is your biggest concern, you may purchase an annuity to start payouts at a later date, such as age 85.

You may purchase this annuity as a deferred annuity upon retirement (eg, age 65). This approach will give you the best legacy at age 100, but if you die prior to age 85, the assets tied up in this annuity are gone.

Alternatively, you may wait until age 85 to purchase an annuity. There is a danger, however, that you’ll deplete the assets needed for the annuity prior to age 85.

Also, keep in mind, you can combine these strategies and purchase more than one annuity. Purchase a smaller one at age 65 and see how it goes. Layer on a second annuity a decade or more later.

What about inflation?

Annuities may be purchased either with or without a cost-of-living-adjustment (COLA). The COLA can be either 2% or 3%, depending on your comfort level.

When comparing two annuities of the same price, your initial payout will be much less with COLA, compared to an annuity without this feature. This is because your payout goes up over time with COLA.

So, would you prefer more money early in retirement or later in retirement?

Interestingly, Pfau is of the opinion that you don’t need COLA with your annuity.

Social Security has COLA. In addition, your invested savings should be growing at such a rate that the missing inflation can be made up there.

Worst case scenario, you can ladder on a second annuity later to make up the difference.

In summary:

• Most of us are afraid of outliving our money. This is called longevity risk. As a result, we may tend to underspend our invested assets to increase the probability that we won’t run out.
• To solve this problem, utilize a guaranteed income stream for life. This can come from Social Security, a pension (if you have one), plus an annuity.
• In addition, an annuity will take the pressure off your invested savings, allowing you more flexibility in the timing and amount of withdrawals
• Because an annuity is an insurance product, risks are pooled among many customers. Mathematically, you may have a much better “return” than invested savings alone.
• If you want a guaranteed legacy—money left over—then include whole life insurance in your retirement plan
• There is no ideal age to purchase an annuity. This decision, like any retirement strategy, involves trade-offs.

Additional Reading

• Will the Spend Safely in Retirement Strategy (SSiRS) Work for You?

• Will Social Security Still Be There When We Need It? Most likely

• Need More Money to Retire? Consider a Reverse Mortgage. One option to generate a guaranteed income stream for your remaining years

• How Long Will You Live? (According to the Government). Or more importantly, how long does your savings need to last?

This information has been provided for educational purposes only and should not be considered financial advice. Any opinions expressed are my own and may not be appropriate in all cases. All efforts have been made to provide accurate information; however, mistakes happen, and laws change; information may not be accurate at the time you read this. Links are included for reference but should not be considered an implied endorsement of these organizations or their products. Please seek out a licensed professional for current advice specific to your situation.