NEW YORK, NY / Forbes Magazine / Retirement / May 24, 2010
By Eric Fontinelle
These days the picture is much different. The defined-benefit pension is long extinct for most workers and social security is on the ropes, with many expecting benefit reductions. For the most part, workers are on their own to provide their retirement income.
Despite this huge increase in responsibility, the financial sophistication of the average American has not increased to fill the gap. Depending on which figures you believe, it may be that up to 50% of Americans are not saving enough for retirement. Worse yet, many of the workers who don't have enough don't know it.
How Much You Need for Retirement
Over the years a number of studies have been done to attempt to determine how much savings a retiree can safely withdraw from their retirement accounts each year without running out of money. This is known as the safe withdrawal rate. Generally these studies have indicated that over a 30-year retirement, it is often possible to withdraw about 4% per year from a diversified portfolio of stocks and bonds.
This 4% safe withdrawal rate figure has become the rule of thumb for determining whether your savings are sufficient. So in order to get a rough idea of whether you will have enough for retirement, you could simply multiply your desired level of expenses by 25 (the inverse of 4%). So for example, if you wish to withdraw $40,000 per year in retirement, you will require $1,000,000 in savings when you retire. However, this rule of thumb will typically overestimate the amount needed for retirement because it doesn't take into account the income your investments will be making during your retirement.
Catching a Shortfall Early
When it comes to the danger of outliving your retirement savings, catching the situation early is key. With time on your side, smaller incremental changes can usually mitigate off the risk of outliving your savings.
For example, if you realize your retirement funds are inadequate early on, working a few extra years can make a huge difference. This is the approach many workers are taking after the market crash. Working a bit longer can help immensely for a couple of reasons. First, you can save more money as you work through this time. Second, your retirement investments should hopefully increase in value given this extra time.
Shortfalls Later in Retirement
If you are a bit later into retirement when you realize the shortfall, you still have options if you have enough funds left. The easiest step is to cut out luxury expenditures and decrease what you need to live on. Significant cost cutting can often be accomplished without compromising your basic lifestyle. There are also some options for increasing your monthly income without returning to work.
One option to consider would be purchasing an annuity with part of the remaining funds. This effectively transfers the risk of outliving your investments to the insurance company. The insurance company can usually give you a bigger monthly payout than would be suggested by the safe withdrawal rate, since many retirees do not live 30 years into retirement.
Another option for retirees who own a home is to enter into a reverse mortgage loan. Essentially, this allows you to receive monthly income by accessing the equity you have built up in your home. This can be a viable option because a reverse mortgage loan does not require the loan to be repaid until the house is no longer used as your primary residence. The idea is that once a retiree passes away, then the house can be sold to repay the loan. However, this can be a risky option. If real estate values decline significantly and the home ceases to be used as the primary residence, then there might be a significant debt to repay out of pocket.
Running Out of Money
As funds dwindle, a retiree's options begin to look much worse. Many retirees may not be able to go back to work due to failing health or lack of skills. They may have to cut expenses to the bare minimum and rely on social security benefits. In March 2010 the average monthly benefit from social security was only $1,067--not much to get by on. If neither one of those options are possible, there are few choices but to rely on welfare or support from family members.
The Bottom Line
Proper planning for retirement is paramount. Outliving your retirement savings is a nightmare, but with solid financial planning you should be able to minimize the chances of it happening to you. [rc]
2010 Forbes.com LLC™
Illustrative photo by courtesy: newamerica.net