When you're ready to retire, how can you be sure you'll have enough money to last? And what's the best way to withdraw your savings over the years?
Steve Vernon, consulting research scholar at the Stanford Center on Longevity, set out to answer these questions by collaborating with the Society of Actuaries (SOA) on a research project: "How to 'Pensionize' Any IRA or 401(k) Plan." "What we wanted to do was identify a strategy that middle-income workers could use that's fairly straightforward and that they could do on their own," Vernon tells CNBC Make It.
After analyzing 292 different retirement income strategies, the research team identified the best way for most people to withdraw their money in retirement. They call it the "spend safely in retirement" strategy.
"This is a strategy that people can use to decide if they've got enough money to retire," says Vernon. "But also, a lot of people are uncertain as to when they'll retire and if they should work part-time for a while, so this strategy can help them think through those questions."
The winning strategy produces "more average total retirement income expected throughout retirement compared to most solutions we analyzed," Vernon reports, and "provides a lifetime income, no matter how long the participant lives."
Here are two key components of the "spend safely in retirement" strategy:
1. Delay Social Security payments until age 70. "For middle income people, Social Security is going to be the majority of their income [in retirement]," says Vernon. "It will be anywhere from 60 to 80 percent of their total income.
"And Social Security is nearly a perfect retirement income generator: It lasts the rest of your life, it protects against inflation, it doesn't go down if the stock market crashes, it's paid automatically into your checking account, part of it isn't subject to income taxes. No other retirement income generator has all of those positive features, so maximizing Social Security is a key part of this strategy."
The best way to do so is to delay receiving Social Security benefits until age 70, he says.
If you want to retire before then, one option is to work part-time and make just enough to cover living expenses until age 70, notes Vernon.
If working until 70 is out of the question for you, the next best thing to do is to use a portion of your retirement savings to substitute the Social Security benefits you're delaying, Vernon says: "Suppose Social Security at age 65 would have been $20,000 per year and you're delaying it for five years. That's $100,000. So you set aside $100,000 and that's what you withdraw from age 65 to 70."
You may also have to reduce living expenses during the delay period.
"Pessimists might point out that Social Security is subject to political risk; our leaders can change the amount of benefits paid to current retirees or older workers," the report notes, adding, "when deciding on a Social Security claiming strategy, older workers must weigh this risk against Social Security's other desirable features."
2. Create an "automatic retirement paycheck." To supplement Social Security income, the strategy recommends investing any remaining savings in low-cost mutual funds that are common in IRAs and 401(k) plans, like target date, balanced or stock index funds.
When it comes to withdrawing your savings, you'll want to generate consistent "paychecks" from your 401(k) and IRA savings that will last the rest of your life. Use the IRS required minimum distribution (RMD) to calculate how much of your retirement savings you would receive each year. (The IRS requires you to make minimum withdrawals from your retirement savings at age 70-1/2 to be included in your taxable income.)
The great thing about this strategy is that many IRA and 401(k) administrators can calculate your RMD and pay it automatically in the frequency you want, so you will essentially be creating an automatic retirement paycheck.
"The purpose of the RMD is for the federal government to capture taxable income from retirement accounts. It wasn't devised as a spend-down strategy," says Vernon, although "several analysts have studied the RMD as a drawdown strategy, and they have concluded it's a viable way to produce a stream of lifetime retirement income."
All in all, the "spend safely in retirement" strategy, which can be refined and modified however you like, can "help virtually anybody generate a stream of income in retirement," says Vernon, who plans to use a version of the strategy himself.
See the full report from the Stanford Center on Longevity here.
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