Case study: Fred combines an annuity with portfolio withdrawals
(A hypothetical example)
Fred's a widower. He's done well, and he's been planning to retire at age 70, sell his house in the suburbs, and move to the city. He's healthy and intends to enjoy life—but he doesn't want to be extravagant.
Keeping to a plan
Fred is a good planner: He knows where his income will be coming from in retirement, and he's calculated how much he can afford to spend from his savings each year to avoid depleting them. Fred retires at age 70 with:
- $450,000 in his 401(k).
- $250,000 in an IRA.
- A house in the suburbs worth about $500,000; his mortgage is paid off.
- $1,600 in expected monthly income from Social Security.
Selling his house
Fred sells his house for $500,000 and rents an apartment for $1,500 a month. He now has $1.2 million in total savings, including the cash from selling his house, which he deposits into a money market fund:
|Proceeds from the sale of his house||$500,000|
Buying an annuity
Fred uses $400,000 of his cash—one—third of his total savings–to buy an income annuity, which will pay him about $1,400 per month for the rest of his life, adjusted for inflation. The income is guaranteed by the insurance company that sells the annuity.
Fred chooses two options for his annuity:
- The inflation adjustment; without this option, Fred's $1,400 monthly payment would remain static.
- A 20–year "period certain" option—meaning that if he dies before age 90, his son, Xavier, Fred's sole beneficiary, will collect the remaining payments.
Consolidating for convenience
At this point, Fred can count on $3,000 per month in guaranteed, inflation–adjusted, lifetime income (from Social Security and his annuity), and he has $800,000 left in his savings. And for the sake of convenience, Fred decides to consolidate his two retirement accounts into one. He withdraws his total 401(k) balance and rolls it over to his IRA account:
|Cash left over in his money market fund after buying the annuity||$100,000|
|Fred's total savings ||$800,000|
Withdrawing from savings
Fred plans to withdraw some money from his savings to supplement the guaranteed income he'll get from Social Security and the annuity. He decides to spend 5% of his total savings—or $40,000—in his first year of retirement, adding $3,333 per month to his spending money ($40,000/12 months = $3,333).
Getting the 'paycheck'
Fred's monthly Social Security and annuity income will be deposited automatically to his bank checking account. Similarly, Fred contacts his fund company to arrange that $3,333 be automatically withdrawn each month from his money market account and transferred to his bank checking account. From these three sources, Fred receives a monthly retirement "paycheck" of $6,333.
|Monthly Social Security payment||$1,600|
|Monthly annuity payment||$1,400|
|Monthly withdrawals from savings||$3,333|
|Fred's total monthly income in year 1||$6,333|
Fred is now set for his first year of retirement. He has enough income to support his lifestyle, and he still has substantial savings. But Fred has a few other things he needs to think about.
Coping with inflation
Fred wants to adjust his withdrawals for inflation, just as his Social Security and annuity payments will be adjusted. This is easy enough to do. In his second year of retirement, he'll check the website of the Department of Labor, Bureau of Labor Statistics, to determine the most recent annual inflation rate—as indicated by the Consumer Price Index (CPI–U)—and increase his withdrawal from his savings accordingly. So, if the inflation rate between year one and year two of his retirement is 2%, Fred may want to spend $40,800 from his savings in year two: $40,000 increased by 2%. The same process could apply in future years.
|Year–two withdrawal (2% inflation)||$40,000 x 1.02 = $40,800|
|Year–three withdrawal (3% inflation)||$40,800 x 1.03 = $42,024|
Fred shouldn't take these annual increases for granted, however. He should keep his eye on the markets and on the balances in his savings and investment accounts. If the markets go through a sustained negative period and the value of his savings falls, Fred should plan to reduce his spending in some years rather than increase them by the inflation rate.
Taking required withdrawals
In the first year of his retirement, Fred has more than enough cash from the sale of his house to cover his $3,333 monthly withdrawals. This means that, for at least one more year, he doesn't have to touch investments in his IRA, permitting them–if the markets are favorable–to continue to grow on a tax–deferred basis.
But starting in the year after Fred turns 70½—which will be his second year of retirement—the IRS requires him to begin taking minimum distributions from certain tax–favored retirement accounts, such as IRAs and 401(k)s, and to pay taxes on those distributions. Fred signs up for the automatic required minimum distribution (RMD) service offered by his IRA provider. Each year the company calculates (and distributes to Fred) the minimum amount he needs to withdraw from his IRA to comply with the law. Fred knows, however, not to confuse his RMDs with his spending plan. Regardless of the amount that the IRS requires Fred to withdraw from his IRA, Fred will discipline his spending. In some years Fred's RMD will exceed his spending plan, so he'll save the excess for the future; in other years Fred's plan may dictate that he withdraw more than the required minimum from his IRA.
Investing for the long term
Fred realizes that the rate at which he'll be spending from his savings (5% in the first year with annual increases for inflation) is somewhat aggressive. That is, he understands that there's some risk over a 20– or 30–year period that he'll run out of money, unless his savings grow at a rate that keeps pace, roughly, with his withdrawals.
That's why he's decided to keep long–term savings, such as his IRA, invested and diversified across the stock and bond markets, a strategy that has the potential to grow his portfolio over time even as he's spending from it. Fred isn't interested in making any radical changes to the way he's been investing over the past decade, which has been approximately 60% in stock funds and 40% in bond funds.
As he ages, he expects to reverse gradually those allocations and get somewhat more conservative—perhaps to 40% stocks and 60% bonds—still keeping enough of a stake in the stock market to capture some of its potential for growth.
Fred will keep his short–term savings—his spending money for the next year or so–in his money market fund, which is low—risk and highly liquid. Each year, in accordance with his spending plan, he'll liquidate some of his long–term savings and shift them to his money market fund. At the same time, he'll check the allocation of his long–term savings and rebalance them if necessary.
- All investments are subject to risk. Investments in bonds and bond funds are subject to interest rate, credit, and inflation risk. Past performance is no guarantee of future results.
- An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.
- Annuity product guarantees are subject to the claims-paying ability of the issuing insurance company.
- When taking withdrawals from a tax-favored account, such as an IRA or 401(k), before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax.
- The information provided here is for educational purposes only and isn't intended to be construed as legal or tax advice. We recommend that you consult a tax or financial advisor about your individual situation.