Congratulations! You’re retired. Now what?

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For those who don’t have a traditional pension they can count on, turning retirement savings into income can be a tricky proposition. The financial industry has come up with several strategies and products to help the average Jane and Joe produce income from savings pooled in 401(k)s, IRAs or other retirement vehicles.

You can use annuities, which are mutual funds designed to produce retirement income or a withdrawal strategy to milk income from your investment portfolio. If you tap into your savings, experts recommend withdrawing no more than 4 percent of the total amount annually. That amount could be lower or higher, depending on how many years the portfolio needs to last as well as estate planning considerations.

“Morningstar has done some good work on withdrawal rates of portfolios and they say there is an 83 percent chance that you will not run out of money — or put it another way, a 17 percent chance that you will run out of money if you need to withdraw from a portfolio made up of 75 percent stocks and 25 percent bonds at a rate of 5 percent for 25 years,” says James Parks, a CFP from North Haledon, N.J., and member of the Financial Planning Association.

“So that is kind of a scary thing,” he says. “People may be retired for more than 25 years, and you’re starting with a 17 percent chance of running out of money.”

Tricky business
The objective is to make the money last as long as you do. What’s best for you depends on your age, goals and tolerance for risk. You might strongly consider hiring a financial planner for guidance.
Sources of income streams
  1. Immediate annuities
  2. Retirement-income mutual funds
  3. Withdrawal strategies
  4. Social Security

Immediate annuities
Immediate annuities guarantee payments for a certain amount of time, usually until you die. Basically, you hand over a lump sum to the insurance company and they start giving it back to you right away in monthly installments. If you die the next day, they generally keep all or part of the money, but if you hang on for another 40 years, the payments will continue until you draw your last breath.

“That’s really all it is,” says Certified Financial Planner Eric McClain, with Clark Financial Advisors in Birmingham, Ala. “You’re trading a block of money for a lifetime stream of income and they come in many different flavors. For instance, inflation-adjusted or not-inflation-adjusted. And they might have a joint provision or a return-of-premium provision.”

The joint provision means the income payments continue until the death of the second spouse, though the dollar amount of the monthly payments will be lower than for a single life. A return-of-premium provision means that besides getting a guaranteed payment for life, the recipient’s beneficiaries will get back at least the amount of the premium paid in the event of the recipient’s premature death. You can also get annuities where income payments go to beneficiaries for a certain term, such as 10, 15 or 20 years.

Immediate annuities can offer a fixed rate of return or a variable rate of return. Fixed-rate annuities carry a fixed interest rate while variable rate annuities are invested in stocks, mutual funds and bonds and can fluctuate in value.

Fixed annuities can be a good fit for some retirees. A constant stream of cash that lasts as long as the annuitant lives can be appealing for those who suspect they’ll live a long time and also want no exposure to risk for at least part of their retirement portfolio.

“It’s very much like if you were leaving a company and you had a pension with an option to roll it over or get a stream of income,” says McClain.

Variable-rate annuities, on the other hand, are invested in securities that can possibly lose value. Recent innovations in variable annuity offerings have mitigated some of the potential volatility.

“I’d never used annuities, but when they came out with the ‘living benefits’ with income and guarantee against market loss, that changed the whole picture,” says Certified Financial Planner Bill Garrett, president of Garrett Financial.

On a very basic level, living benefits guarantee to pay back at least the original amount that was invested, no matter how poorly the portfolio of investments performs. A guarantee against market loss sets a floor on the returns annuitants receive.

When investing $100,000, for instance, the distribution amount will always be based on the initial investment, even if the market value of the portfolio slips to $90,000. If, however, the value increases, the floor moves up and you get a new high water mark. If you were receiving 4 percent annually, you will continue to get $4,000 every year even if the total value of the portfolio drops. If it goes up to $150,000, your new payment would be $6,000.

Sounds great, right? But fees and taxes complicate the issue for immediate annuities, not to mention the fact that they can be fairly convoluted products in general. Anyone interested in annuities should do their homework, research them thoroughly and compare offers.

“It’s like anything with too much security — there are unintended consequences,” says Certified Financial Planner Joseph Birkofer, principal at Legacy Asset Management in Houston. “I have some clients with vast amounts of money tied up in variable annuities — every time they take out $1 it costs them 30 cents.”

“It comes at a cost,” agrees Parks. “You pay the company a significant amount so that the money will not run out within your lifetime.”

While the initial investment amount is considered a return of capital and will not be subject to taxes, any earnings gains are. If you use money from a qualified plan that gets favorable tax treatment, such as a 401(k), to purchase the annuity, then the entire investment is subject to taxes.

“They are taxed as ordinary income versus capital gains,” says Birkofer.

Long-term capital gains are taxed at rates as low as zero percent to as much as 15 percent until 2010 as compared to ordinary income tax rates, which can be as high as 35 percent for high earners.

Retirement-income mutual funds
Some mutual fund companies, such as Fidelity, Vanguard and Charles Schwab, have begun offering funds designed with retirees in mind. The funds come with low fees and provide a steady stream of income. Also, you’re not locked into a long-term commitment with the money; you can access it at any time.

Funds from Vanguard and Schwab provide income as well as capital preservation or appreciation. Fidelity Investment’s Income Replacement funds are more like target-date funds that dole out earnings, as well as capital over a prescribed period of time with an expected expiration date.

The Vanguard funds are structured similarly to university endowments, says John Ameriks, head of Vanguard’s investment counseling and research group and retirement expert. “The notion being that there would be a proportional amount of the investment spent each year, and periodically that amount would be adjusted to reflect changes in that fund. But over time you would want to have a regular payment stream and also sustain or grow the investment capital,” he says.

Schwab’s Retirement Income funds work similarly, with different funds available based on the amount of income needed or growth desired.

“We like to think of it as helping investors recreate their paychecks that they had at work once they are no longer working,” says Patrick Waters, director of retirement income products at Charles Schwab.

Other financial firms have joined the fray, including Russell Investments, DWS Scudder and TIAA-CREF. Expect more to do so. The big drawback of these funds: They offer no guarantees.

Withdrawal strategies
According to a recent study by Russell Investments, almost two-thirds of investment returns are earned during retirement — not before. In other words, your pie of retirement investments is not done cooking when you stop working — in fact, far from it.

“The old rule of thumb of investing your age in bonds is a rule of ‘dumb.’ If you go conservative early in retirement, inflation eats away at bonds, so at the middle and end of your life span you have diminished capabilities to purchase things right when they get more expensive,” says Birkofer.

As such, a healthy exposure to equities is necessary — but just make sure it’s not too much exposure.

It has to keep up with inflation, but you can’t take excessive risks with it, says Garrett.

“I divide assets into two different portfolios — either fixed-interest obligations, bonds or something else that would have a guaranteed income stream, perhaps an annuity,” he says. “My research has indicated that the optimal time you want to set this up for and have the ability to draw income, should be for 10 or 12 years.”

“So, if we have an income stream that we can depend on for 10 years, we can then have the rest of their savings put toward growth and let it stay there until we’ve hit a predetermined amount of money,” says Garrett.

For example, an investor with about $1.2 million could conceivably generate $48,000 of inflation-adjusted income per year for 30 years or more by funneling about 48 percent of their savings into fixed-income investments, one percent into high-yield dividend producing stocks and then pouring the rest into a diversified portfolio geared for growth.

A portfolio geared for income and growth

Profits are adjusted for inflation and then rolled into the income portion which is set up for about 10 years, though if possible, Garret says, “we do fudge a little bit when we first set it up, adding two extra years, maybe even more, to pad for potentially slower growth.”

Though it seems like a straightforward method of just reversing the process of a lifetime of saving, withdrawal strategies rely on variables that change from situation to situation. And the strategies also vary from one financial adviser to another. Some, for example, set aside an income portion designed to last two years rather than 10 or 12 years. It might be best to get free consultations from a few advisers before you commit to a particular strategy.

Social Security
When Social Security was first introduced, the average life expectancy of the American male was 60 years, says Garrett. “And you couldn’t touch it until you were 65 years old, so you had to be dead for five years before you could get Social Security.”

For at least the next 33 years, retirees can expect to get 100 percent of their Social Security benefits. Americans trying to cash in after 2041 will receive only 78 percent or less of their benefits unless changes are made, according to the Social Security Administration Web site.

The percentage of income that can be replaced in retirement by Social Security depends on the level of income earned throughout the working years. For example, the Social Security Administration Web site says that those who earn the minimum wage on average can expect Social Security to replace about 60 percent of their income.

A high earner will have only about 26 percent of their income replaced by Social Security. But most people whose earnings fall more in the middle can expect about 42 percent. The average monthly benefit received by a retired worker at the end of June 2007 was $1,050.

Anyone can easily figure how much they will be getting from their Personal Earnings and Benefit Estimate Statement, but the important question is when you’ll begin taking the benefits.

“You can start taking it at 62, and when you’re 70 and-a-half, they start paying you whether you want it or not. So you have all those ranges of ages between 62 and 70 to take the benefit,” says Olivia Mitchell, professor of insurance and risk management, business and public policy, and head of the Pension Research Council at the Wharton School, University of Pennsylvania.

Two considerations influence the amount of benefits retirees receive. The first is employment. If you are working in your 60s, it may not make sense to start drawing benefits.

For people under the full retirement age, for every $2 earned above the annual limit of $13,560, $1 gets taken out of Social Security benefits if they’re already being drawn. This is not money forever lost — you will at least get most of it back, if not all, eventually. To further complicate the math, the earnings limit increases the year you reach full retirement age, in 2008 it is $36,120, with only $1 for every $3 earned taken out. Finally, when you do reach the month you turn the full retirement age, there’s no earnings limit, and you can receive full benefits no matter how much you earn.

A second consideration is that monthly benefits are reduced if you begin drawing before full retirement age. But waiting may not always be the smartest move. Someone in poor health might assume they only have 15 years to live and begin taking benefits at age 62. If their mortality expectations prove correct, they will have gotten more money out of the deal than if they had waited four years to get the full benefits.

There is a breakeven point. “We generally find it to be around age 77 to 78,” says Parks. “If they collect Social Security early, at age 62, it will provide them with a greater income from age 62 to (age) 77 or 78, and then it switches.”

If they wait until age 66 to begin collecting and live beyond that breakeven point, “then they will have received more money.”

As with everything related to financial planning, what’s best for you just depends on your situation.