MONEY 401(k)s

This Nobel Economist Nails What’s Really Wrong with Your 401(k)

Robert Merton, a Nobel laureate and finance professor at the Massachusetts Institute of Technology
MIT professor Robert Merton John Hanna—AP

Retirement plans are doing it all wrong, says Robert Merton. He ought to know. His hedge fund nearly brought the down the global economy.

In the 30-plus years since 401(k) plans were first introduced, they’ve faced criticism for everything from the risks employees face to the fees they pay to poor investing options. Now Robert Merton, a Nobel Prize-winning economist, says 401(k)s are headed for a crisis.

If anyone should know about a potential crisis, it’s Merton. Along with his fellow Nobel laureate Myron Scholes, Merton co-founded and sat on the board of Long-Term Capital Management, a hedge fund that was managed based on complex computer models. Under the leadership of co-founder John Meriwether, LTCM’s massive failure nearly brought down the global economy in 1998.

Now Merton is saying that 401(k)s are headed for trouble, but for very different reasons. In particular, he argued at a recent Pensions & Investments conference, 401(k)s take exactly the wrong approach to retirement investing by emphasizing account balances and investment returns, thereby encouraging savers to amass the largest portfolio possible, which pushes them to take too much risk. That’s an approach he calls “la-la land.”

Instead of focusing on wealth creation, 401(k)s should emphasize the level of income employees can expect to receive in retirement, Merton says. By knowing whether they are on track to that goal, workers will make better saving and investment choices.

One of the best ways to be assured of steady future income is to invest in an inflation-adjusted annuity, Merton says. But current 401(k) regulations do not allow deferred annuities as an investment option. Merton argued in a recent Harvard Business Review article that this barrier should be changed.

Meanwhile, workers are encouraged to invest in Treasury bills for safety, which they appear to deliver — if you look at year-by-year returns. But if you consider the income that T-bills would provide in retirement, as measured by the amount of deferred annuity income they would purchase, they are nearly as risky as the stock market. “The seeds of the coming pension crisis lie in the fact that investment decisions are being made with a misguided view of risk,” Merton writes.

Even so, he isn’t recommending that investors hold only deferred annuities to achieve their income goals. Instead, he suggests investing in a mix of stocks as well as bonds and deferred annuities. Over time, that asset allocation should shift based on the likelihood of achieving the investor’s income goal. At retirement, the worker would have enough money to buy an annuity that would provide the target salary replacement amount. But the choice would be left up to the employee. Still, Merton clearly has an opinion about what option is best, as a recent MarketWatch article noted. “When we take a risk, it’s generally for a good reason. You wouldn’t normally put yourself in harm’s way for no reason,” Merton writes.

Problem is, figuring out the right portfolio strategy, and when to make those shifts, is a tough challenge for the average investor. And not so coincidentally, Merton has a solution, which is to rely on professsional investment managers to handle this for you. An MIT professor, Merton is also the “resident scientist” at Dimensional Fund Advisors, which offers a 401(k) plan that focuses on producing a reliable income stream. (For more on DFA’s approach, see “The End of Investing.”)

The DFA connection aside, Merton’s insights are well worth considering. Along with Scholes, he won the Nobel in 1997 for a landmark options-pricing theory, called the Black-Scholes model, that is still widely used. (Economist Fisher Black passed away before the Nobel was awarded.) And in his call for 401(k) reforms, Merton has plenty of company. A growing number of academics and 401(k) providers advocate an income approach. So does the U.S. Labor Department, which intends to require plan providers to present investors with statements showing their projected income in retirement. Some investment groups already do.

Even if your 401(k) plan doesn’t offer income projections, you can get find calculators online that will give you estimates. Just remember, they are only projections, and if you don’t keep checking your assumptions, models can steer you astray. Just ask Robert Merton.

Update 7/1: The U.S. Treasury today approved the option of deferred annuities in retirement plans.

Related story: The New 401(k) Income Option That Kicks In When You’re Old

 

MONEY Social Security

As Social Security Cuts Take Effect, The Most Vulnerable Are Left to Cope

Cuts to Social Security have closed offices in some of the areas where they're needed most.

Until earlier this year, there was a Social Security field office in Gadsden County, Florida, in the state’s panhandle. It’s the kind of place where seniors need to get in-person help with their benefits rather than pick up a phone or go online.

“Our poverty rate is nearly double the state average, and we trail the state averages in education,” said Brenda Holt, a county commissioner. “Most of the people here don’t have computers, let alone reliable Internet access.”

Holt testified Wednesday before the U.S. Senate Special Committee on Aging, which is investigating the impact of budget cutting at the Social Security Administration over the past five years. Sixty-four field offices and more than 500 temporary mobile offices, known as contact stations, have been closed. And the SSA is reducing or eliminating a variety of in-person services that it once provided in its offices.

The SSA also has been developing a long-range strategy for delivering services. A draft document states that it will rely on the Internet and “self-service delivery”—and provide in-person services in “very limited circumstances, such as for complex transactions and to meet the needs of vulnerable populations.”

Gadsden County meets any criteria you could pick for vulnerability. But the field office in Quincy, the county seat, was closed with just a few weeks’ notice in March, Holt said. The nearest office is 30 miles away in Tallahassee—reachable only by car or a crowded shuttle bus that runs once a day in each direction.

The Senate committee’s investigation found SSA’s process for office consolidation wanting for clear criteria, transparency and community feedback. Only after persistent objections by local officials did the SSA offer to set up a videoconferencing station in a local library that connects seniors to representatives in its Tallahassee office.

“It’s deeply frustrated and angered our community,” said Holt. “Many of our residents live in a financial environment where they make choices between medications and food to feed their families. Problems with Social Security benefits can have a catastrophic effect on families.”

The SSA’s workload is rising as baby boomers retire; the number of claims in fiscal 2013 was 27 percent higher than in 2007. Yet the agency has 11,000 fewer workers than it did three years ago, and hiring freezes have led to uneven staffing in offices.

The SSA has received less than its budget request in 14 of the last 16 years. In fiscal 2012, it operated with 88% of the amount requested ($11.4 billion). The budget was restored somewhat in fiscal 2014 to $11.7 billion. And President Barack Obama’s 2015 budget request is $12 billion.

But service still suffers. The National Council of Social Security Management Associations reports that field office wait time is 30% longer than in 2012, and wait times and busy rates on the agency’s toll-free 800 number have doubled.

The SSA’s plan to save $70 million a year by replacing annual paper benefit statements with electronic access also has been a misstep, at least in the short run. Paper statements were suspended in 2011, but just 6 percent of all workers have signed up for online access, in some cases because of a lack of computer access or literacy but also because of sign-up difficulties related to the website’s complex anti-fraud systems.

In April the agency backtracked, announcing it will resume mailings of paper statements this September at five-year intervals to workers who have not signed up to view their statements online. (You can create an online account here.)

Wednesday’s hearing shed much-needed light on the customer service squeeze at SSA, though it would have been good to hear legislators acknowledge that Congress had no business cutting the SSA budget in the first place. The agency is funded by the same dedicated stream (payroll taxes) that funds benefits, and its administrative costs are low, 1.4% of all outlays. The SSA is funded by Americans’ tax dollars and exists to provide customer service to all Americans.

Nancy Berryhill, the SSA’s deputy commissioner for operations, did her best at the hearing to defend the agency’s efforts to cope. “It’s my job to balance service across nation—these are difficult times.”

Still, she conceded that there’s room for improvement. “We need to get more input from the community,” she said, speaking about the events in Gadsden County. “Adding the video service made a difference after the fact, but we need to be more thoughtful in the future.”

MONEY Social Security

When to Take Social Security? Your 401(k) Plan May Know Best

New claiming tools can help you make the right choice. Adding them to your 401(k) withdrawal strategy may be a game-changer.

Deciding when to file for Social Security is no simple task, and most Americans don’t handle it well. But increasingly, help is available from an unexpected source: your employer.

The nation’s largest independent investment advisory firm is rolling out a service today that walks 401(k) plan participants through their Social Security claiming options, with the aim of helping them maximize benefits. Financial Engines, which works with company retirement plans, will show participants how to integrate their Social Security income plan with drawdown from retirement savings. The service includes an online tool and optional one-on-one guidance from advisers.

This isn’t the first service of its type, but Financial Engines’ large presence in workplace plans means the service will be available immediately to 9 million 401(k) savers. Meanwhile, a more limited free version of the Social Security claiming tool—lacking integration and one-on-one advice—is available on the company’s website.

Integrating robust Social Security planning tools into 401(k) plans is a positive development. Social Security is the most important retirement benefit for most Americans, but most of us leave big dollars on the table in lifetime income by failing to pick the optimal filing strategy.

“Coordinating 401(k) savings with Social Security is a big part of the retirement planning puzzle,” says Brooks Herman, head of data and research at BrightScope, which ranks and analyzes 401(k) plans. “More companies will be moving into this space—there’s a real need for robust tools.”

Timing is the key issue in Social Security claiming decisions. Benefits are calculated using a formula called the primary insurance amount, or PIA. Claimants who wait to start Social Security until their full retirement age (currently 66) receive 100% of PIA; taking benefits at 62, the first year of eligibility, gets them 75% of PIA. By waiting until age 70 (the maximum year for delayed filing credits), they’ll receive 132% of the PIA. And those benefits are enhanced by an annual cost-of-living adjustment, which is added in for years of delayed filing.

Filing later means higher annual income for life, which can be a great hedge against the risk of running out of money in old age. Couples can boost their combined benefits further by executing a file-and-suspend strategy.

“It’s a screamingly good deal,” says Christopher Jones, Financial Engines’ chief investment officer. “There’s a 6% to 8% increase in payout for every year you defer up to age 70—that’s a real rate of return guaranteed by the federal government. Very few investments out there can match it.”

Yet 40% of Americans file at age 62, and another 40% file sometime before their full retirement age, according to Social Security Administration data. Filing early isn’t always the wrong move; it can make sense if you’re in poor health and don’t expect to live long, or if you simply need the money. But studies have shown that early claiming is most often tied to incorrect expectations about longevity and misunderstandings about the risk that Social Security will run out of money and not be able to pay benefits.

The public already has access to some solid Social Security claiming decision tools. AARP, T. Rowe Price and the Social Security Administration offer free tools, and SocialSecuritySolutions.com can help you out for a small fee. But the workplace is where the rubber most often hits the road when it comes to retirement planning.

GuidedChoice, which competes with Financial Engines in the 401(k) advisory market, already has a Social Security optimization feature coupled with one-on-one advice. Morningstar, another player in the field, doesn’t offer Social Security optimization yet but plans to add it, a spokeswoman says.

Financial Engines’ offering begins with a projection of likely nest egg size at retirement, followed by an illustration of how savings can be converted to income-oriented investments that generate income to meet living expenses while waiting for Social Security to begin—and how the strategy results in higher lifetime income.

The illustration aims to help people get over a key psychological hurdle, Jones says. “Retirees are reluctant to spend all of their savings, or even a large fraction up front,” he says. “They see their accumulated balances as a safety net, so they’re reluctant to spend that down too quickly.”

So, how much is it worth to optimize your benefits? Financial Engines has been testing its new service over the past three months with a few large corporate clients; the median amount of additional benefits found for a typical married couple over the course of their retirement has been well over $100,000.

A screamingly good deal, indeed.

MONEY Social Security

Are You Leaving Thousands of Social Security Dollars On The Table?

Choosing the right claiming strategy can add $100,000 or more to your lifetime retirement income.

Deciding when to take your Social Security benefits is one of the most important retirement moves you can make—and it’s one that a lot of Americans get wrong. The good news is that new tools and services are being launched that can help you avoid these costly missteps. The latest entry: Social Security Income Planner, was unveiled today by 401(k) advice provider Financial Engines.

Unlike some of the tools out there, the Financial Engines calculator is easy to use and free. After sifting through thousands of claiming strategies, the calculator presents you with the best filing choice for you and your family, at least according to Financial Engine’s algorithms. It can also include your assets (and your spouse’s portfolio) as part of the retirement income analysis.

There’s a lot at stake. Some 40% retirees rely on Social Security for the majority of their income. Even wealthier retirees receive about one-third of their income from the program.

“Social Security is incredibly complex and most people miss out on tens of thousands of dollars in benefits by claiming too soon or not coordinating with their spouse,” says Christopher Jones, chief investment officer at Financial Engines. A single person could be passing up as much as $100,000 over a lifetime by claiming Social Security early, while a married couple could lose $250,000 in lifetime income, says Jones.

Take a married couple: Jane, age 57 and Ian, 59. He earns $65,000 a year, while she earns $35,000. He wants to retire at 65 and she at 63. If they both take Social Security at those ages, he will get $24,500 a year, and she will get $12,600, giving them a combined income of $37,100 annually. That adds up to lifetime benefits of $872,300, based on Financial Engines’ estimates.

A different claiming strategy would give this couple an additional $131,700 more in lifetime income from Social Security, bringing their total lifetime benefits to $1 million, according to Financial Engines. Jane still files for Social Security at 63, while Ian delays taking his Social Security until age 70, which is when you get the maximum benefit. But at age 66, which is his full retirement age, Ian files a restricted application to claim a spousal benefit based on Jane’s income, which gives him $8,100 a year, which gives them a total $20,700 a year in income. Then he switches to his own benefit at age 70, boosting their payout from Social Security to $45,300 a year.

But many people don’t understand these options. Three out of four people say they are confident about their ability to make a good Social Security decision, according to a Financial Engines survey. But when those surveyed were asked basic questions about the way Social Security worked, 73% got most of the answers wrong.

When you get beyond the basics, it’s hard not to be confused. There are more than 8,000 claiming strategies for married couples, says Jones. You can file for Social Security as early as age 62 and many people do—40% start benefits at age 62, while 60% do so by 65. Fact is, every year you wait to take Social Security, your income increases 6% to 8% a year until you reach age 70.

The additional income you receive by delaying can make a big difference in your retirement security. If you had annual benefits of $18,900 at age 62, you would get $27,216 by waiting till age 67 and $33,264 a year by holding out till 70. As a recent Nationwide survey found, nearly 25% of those who claimed Social Security early regretted that decision. “Your chief risk today comes not from dying too soon but from living too long and running out of money,” says Ron Keleman a financial planner in Salem, Oregon.

Your family may also regret your decision. Married women tend to outlive their husbands, yet men often take the retirement benefit that looks best now, even if it reduces their spouse’s future income after they pass away. And if you have children, your decision would also affect their survivor benefits.

Thinking about your claiming options before you file for Social Security benefits can help not only you but your family as well. Start by checking your estimated benefits at Social Security, then try a online tool. In addition to the Financial Engines calculator, others include those at T. Rowe Price, AARP, Social Security Solutions ($50 fee). Or consider working with a financial adviser.

MONEY Ask the Expert

Should I Buy a Deferred Income Annuity—and When?

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Robert A. Di Ieso, Jr.

Q: I’m interested in buying a deferred income annuity to supplement my income in my later retirement years. What is the best age to buy one? – Jeremy, Austin, Texas

A: As worries about running out of money in retirement grow, so has interest in deferred income annuities. Also known as longevity insurance, sales of these products hit $2.2 billion last year, double the amount in 2012, which was the first year of significant sales, according to Beacon Research and the Insured Retirement Institute.

Deferred income annuities are popular because they give you a hedge against outliving your money. They work like this: You give a lump-sum payment to an insurance company and in return, you get a guaranteed stream of income for life. In that way, deferred annuities are similar to immediate annuities. But with immediate annuities, the income kicks in right away. With deferred annuities, as the name suggests, the benefit payments don’t start until much later, perhaps 10 or 20 years down the road. Because the payments take place so far in the future, you can buy a bigger benefit with a deferred annuity compared to an immediate annuity.

Say you are a 65-year-old man today, and you deposit $50,000 into a longevity annuity that doesn’t start making payments for 15 years. You would get payments of about $1,300 a month starting at age 80. That’s another $15,000 a year in income. The longer you wait for the payments to kick in, the more you’ll get. In that same example, if you wait till age 85 for the payment to start, your monthly income jumps to $2,475. By contrast, a 65-year-old man who invests $50,000 in an immediate annuity today would get monthly payments of about $280 a month.

Of course, the downside is that if you don’t make it to 85 or whatever age you select for payments to start, you get nothing. You also need to consider that the benefits are not inflation-adjusted, so their purchasing power will have declined.

As for when to purchase the annuity, the younger you are, the better the deal. If you make the $50,000 purchase at age 55, instead of 65, with benefits that kick in at age 85, you will get 50% more income—$3,800 a month.

But first, you need to decide whether this move makes sense for you. That depends on your other sources of guaranteed income. If you already have a pension that covers most of your essential costs, you probably don’t need one. And the longer you can delay taking Social Security, which increases each year until age 70 and is adjusted annually for inflation, the less attractive it is to lock up money in an annuity. “Social Security is the best annuity income you can buy today,” says David Blanchett, director of retirement research at Morningstar Investment Management.

Beyond protection against outliving your money, however, deferred income annuities can give you peace of mind by reducing the stress of making your money last till you’re 100. “Longevity annuities remove a lot of uncertainty and that’s very valuable to retirees,” says Blanchett.

MONEY Social Security

How to Get Social Security In a Lump Sum (Without Taking Any Lumps)

You can get a big one-time payment from Social Security. But you will give up other benefits, so proceed carefully.

When you think of Social Security benefits, you probably imagine a regular stream of income. What you may not realize is that two kinds of claiming strategies can get you a big lump-sum benefit—one that may be worth more than $100,000 to higher-income retirees.

It’s a tempting notion. However, some people should resist the glitter of even this much money lest they wind up leaving even more benefits dollars on the table. Here’s a quick look at the pros and cons of these strategies:

In the first scenario, you can claim a retroactive payment from Social Security if you have reached full retirement age (FRA) and did not file for benefits at that time. (FRA is 66 for people born between 1943 and 1954, rising in two-month increments to 67 for those born in 1960 and later.) The maximum retroactive lump-sum payment is six months’ of benefits.

Say you were going to defer benefits past your FRA at age 66, then you had to change your mind at 66 and six months. You could then claim a lump-sum payment equal to those six months of benefits. If you decided at age 66 and four months that you wanted to file retroactively, you’d get only four months’ worth of benefits in your lump sum—rules prohibit you from claiming benefits that pre-date your FRA. (For some retroactive claims involving people with disabilities and their family members, the lump-sum payment will extend to 12 months of benefits.)

This brings us to the second claiming opportunity: a lump-sum reinstatement of benefits. It involves more money but it could cost you more too. Again, this option is only available to people who’ve reached their FRAs. Let’s say your FRA is 66, and you decided to defer filing until you turn 70, when you can claim maximum benefits. By delaying, your benefit increases 8% each year (plus any cost-of-living adjustments) until you turn 70. That means your benefits at 70 would be 32% higher than at 66 after inflation.

To get this higher benefit you could simply do nothing at age 66, and your benefits would begin rising each month due to the delayed retirement credits.

A more flexible approach is to tell the agency that you want to “file and suspend” your benefits. This way, your benefits will still rise each month until you begin taking them. But it creates a nice insurance policy for you. At any time after turning 66 and before your benefits begin automatically at 70, you can ask Social Security to issue you a lump-sum payment for all the benefits you would have received had you begun taking them at age 66.

Without the file-and-suspend in place, if you had an emergency that required you to start benefits, you could not get all the foregone payments reinstated. The best you could do is file retroactively and get a maximum of six months benefits.

While this might be a great insurance policy, there are three downsides to keep in mind.

1. If you ask for a lump-sum payment, you lose all the delayed retirement credits you’ve accrued. That’s because Social Security calculates your benefits from age 66 and will give you a lump sum based on that monthly rate (plus any cost-of-living increases). Your monthly benefit thereafter will be based on a start date of age 66. If your FRA benefit was, say, $1,000 a month, it would have risen to $1,320 in real terms by age 70. You will have forfeited that extra $320 each month.

2. If you ask Social Security to file and suspend your benefit, it will prohibit you from ever being able to collect spousal benefits while deferring your own retirement benefit. To enable such spousal benefits, you must file what’s called a “restricted application.” Unfortunately, you can’t do both.

3. If you wave good-bye to that maximum $1,320 monthly benefit, so will your survivors. Their benefits are tied to yours, so when you do anything to reduce your benefit, it can have a life-long impact on your family.

For this reason, filing and suspending benefits is only a guaranteed slam-dunk for single people with no spouses or children—they don’t need to care about benefits for surviving family members. For married persons and single persons with former spouses and children, a file-and-suspend strategy to preserve access to a lump-sum payment is a tricky decision. Consider talking to a financial adviser before making this move.

Philip Moeller is an expert on retirement, aging and health. He is an award-winning business journalist and a research fellow at the Sloan Center on Aging & Work at Boston College. Reach him at moeller.philip@gmail.com or @PhilMoeller on Twitter.

MONEY retirement income

Need Retirement Income? Here’s the Hottest Thing Out There

gold nest eggs
Joe Belanger / Alamy—Alamy

Sales of fixed annuities are surging as income-strapped retirees seek ways to rescue their retirement plans.

Annuity sales are exploding higher as retirees look to lock up guaranteed lifetime income in an environment where fewer folks leaving the workplace have a traditional pension. In a sign of wise planning, easy-to-understand basic income annuities are among the fastest growing of these insurance products.

In all, net annuity sales reached $56.1 billion in the first quarter—up 13% from a year earlier, based on data reported by Beacon Research and Morningstar. Variable annuities, often seen more as a tax-smart investing supplement for the wealthy than a vehicle for lifetime income, account for most of the market. These annuities, which essentially let you invest in mutual funds with some insurance guarantees, saw first-quarter net sales of $33.5 billion—down slightly from a year ago. (For more on the cost and potential risks of variable annuities, click here and here.)

Meanwhile, net sales of fixed annuities, which offer more certain returns, surged to levels last seen in the rush to safety at the height of the Great Recession—totaling $22.6 billion for the quarter. Fixed annuities come in simple and complex varieties—those indexed to the stock market can be confusing and laden with fees. But the subset known as income annuities—the most basic and straightforward of the lot—grew at a 50% clip versus 44% for the index variety.

Basic income annuities, also known as immediate annuities, remain a tiny portion of the overall $2.6 trillion annuity market. Yet they are what most investors think of when they ponder buying an income stream. With an immediate annuity you plunk down cash and begin receiving pre-set guaranteed income over a period of, say, 10 or 20 years, or life. Rates have been relatively low, as they are for most fixed-income investments. Recently a 65-year-old man investing $100,000 could get a lifetime payout of 6.6%, according to ImmediateAnnuities.com.

Another type of fixed annuity, called a deferred income annuity or longevity annuity, lets you put down a lump sum in return for income that starts years later —think of it as a form of insurance for old age. Though less well known, longevity annuities are increasingly popular, with sales reaching $620 million in the first quarter, up 57%, according to LIMRA, an insurance marketing research group. You can find other types of annuities designed lock up income, but the amount of the payout is often a moving figure and the fee structure can be difficult to understand.

Lifetime income has emerged as perhaps the biggest retirement challenge of our age. The gradual shift from defined benefit plans to defined contribution plans over the past 30 years has begun to leave each new class of retirees without the predictable, monthly stream of cash needed to cover basic expenses. The push is on to help these retirees convert their 401(k) and IRA savings to a guaranteed income stream. But innovation is not coming fast, and traditionally many investors have been reluctant to tie up their money in fixed annuities. So the quarterly sales trends are heartening. They suggest that individuals are acting to shore up a critical aspect of their retirement plan.

MONEY retirement income

To Invest for Retirement Safely, Know When to Get Out of Stocks

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Bill Bernstein Joe Pugliese

Investment adviser William Bernstein says there's no point in taking unnecessary risks. When you near retirement, shift your portfolio to safe assets.

A former neurologist turned investment adviser turned writer, William Bernstein has won respect for his ability to distill complex topics into accessible ideas. After launching a journal at his website, EfficientFrontier.com, he began writing numerous books, including “The Four Pillars of Investing” and “If You Can: How Millennials Can Get Rich Slowly.” (“If You Can,” normally $0.99 on Kindle, is free to MONEY.com readers on June 16.) His latest, “Rational Expectations: Asset Allocation for Investing Adults,” is written for advanced investors. But Bernstein, who manages money from his office in Portland, Oregon, is happy to break down the basics.

Q. Retirement investors have traditionally aimed to build the biggest nest egg possible by age 65. You recommend a different approach: figuring out how much you’ll need to spend in retirement, then choosing investments that will deliver that income. Why is this strategy a better one than the famous rule of withdrawing 4% of your portfolio?

There’s really nothing wrong with the 4% rule. But given the lower expected portfolio returns ahead, starting out with a 3.5% withdrawal, or even 3.0%, might be more appropriate.

It also makes a big difference whether you start out withdrawing 4% of your nest egg and increasing that amount by inflation annually, or withdrawing 4% of whatever you’ve got in your portfolio each year. The 4%-of-current-portfolio-value strategy may mean lower income in some years. But it is a lot safer than automatically increasing the initial withdrawal amount with inflation.

I also think that it makes sense to divide your portfolio into two separate buckets. The first one should be designed to safely meet your living expenses, above and beyond your Social Security and pension checks. In the second portfolio you can take investing risk in stocks. This approach is certainly a more psychologically sound way of doing things. Investing is first and foremost a game of psychology and discipline. If you lose that game, you’re toast.

Q. What are the best investments for a safe portfolio?

There are two ways to do it: a TIPS (Treasury Inflation-Protected Securities) bond ladder or by buying an inflation-adjusted immediate annuity. Neither is perfect. You might outlive your TIPS ladder, and/or your insurer could go bankrupt. But they are among the most reliable sources of income right now.

One other income source to consider: Social Security. Unless both you and your spouse have a low life expectancy, the best version of an inflation-adjusted annuity out there is bought by spending down your nest egg before age 70 so you can defer Social Security until then. That way, you, or your spouse, will receive the maximum benefit.

Q. Fixed-income returns are hard to live on these days.

Yes, the yields on both TIPS and annuities are low. The good news is that those yields are the result of central bank policy, and that policy has caused the value of a balanced portfolio of stocks and bonds to grow larger than it would have in a normal economic cycle—so you have more money to buy those annuities and TIPS. That said, there’s nothing wrong with delaying those purchases for now and sticking with short-term bonds or intermediate bonds.

Q. How much do people need to save to ensure success?

Your target should be to save 25 years of residual living expenses, which is the amount that isn’t covered by Social Security and a pension, if you get one. Say you need $70,000 to live on, and your Social Security and pension amount to $30,000. You’ll have to come up with $40,000 to pay your remaining expenses. To produce that income, you’ll need a safe portfolio of $1 million, assuming a 4% withdrawal rate.

Q. Given today’s high market valuations, should older investors move money out of stocks now for safety? How about Millennial or Gen X investors?

Younger investors should hold the largest stock allocations, since they have time to recover from market downturns—and a bear market would give them the opportunity to buy at bargain prices. Millennials should try to save 15% of their income, as I recommend in my book, “If You Can.”

But if you’re in or near retirement, it all depends on how close you are to having the right-sized safe portfolio and how much stock you hold. If you don’t have enough in safe assets, then your stock allocation should be well below 50% of your portfolio. If you have more than that in stocks, bad market returns at the start of your retirement, combined with withdrawals, could wipe you out within a decade. If you have enough saved in safe assets, then everything else can be invested in stocks.

If you’re somewhere in between, it’s tricky. You need to make the transition between the aggressive portfolio of your early years and the conservative portfolio of your later years, when stocks are potentially toxic. You should start lightening up on stocks and building up your safe assets five to 10 years before retirement. And if you haven’t saved enough, think about working another couple of years—if you can.

MONEY Social Security

Surprise! Even Wealthy Retirees Live On Social Security and Pensions

Older Americans with six-figure portfolios rely on old-fashioned programs for half their income.

Where do affluent retirees get their income? Portfolios invested in stocks and bonds, you might think—but you’d be wrong. Turns out many are living mainly on Social Security and good old pensions.

That’s the surprising finding of new research from a surprising source: Vanguard, a leading provider of retirement saving products like individual retirement accounts and 401(k)s. Vanguard studied the income sources and wealth holdings of more than 2,600 older households (ages 60-79) with at least $100,000 in retirement savings. The respondents’ median income was $69,500, with median financial assets of $395,000. (The value of housing was excluded.)

The researchers were looking for answers to a mysterious question about the behavior of wealthier retirement account owners: Why do few of them draw down their savings? They found that nearly half the aggregate wealth of these households comes from the two mothers of all guaranteed income programs, Social Security (28%) and traditional defined-benefit pensions (20%).

The median annual income for these households is $22,000 from Social Security, with an additional $20,000 from pensions. Tax-deferred retirement accounts came in third among those who have them, at $13,000 (11%).

“Only a small number of the people who have 401(k)s and IRAs are really relying on them as a regular source of income,” said Steve Utkus, director of the Vanguard Center for Retirement Research. “There’s a lot more income from pensions than we expected,” he adds.

That last finding may seem surprising, given all the publicity about shrinkage of defined-benefit pensions. Although most state and local government workers still have pensions, only a third of private-sector workers hold a traditional pension, down from 88% in 1975, according to the National Institute on Retirement Security. And NIRS data points to a continued slide in the years ahead.

“Will this look different 10 years from now—will we have less pension income and more from retirement savings accounts? I think so,” Utkus says.

Another interesting finding: 29% of affluent retirees get some income from work, with a median income of $24,600. And the rate of labor force participation was even higher—40%— among households more reliant on retirement accounts.

“That’s only going to jump dramatically over the next few years,” Utkus says. “All the surveys show there’s a real demand for work as a structure to life. People say they can use the money, or they want to work to get social interaction.”

The findings are all the more striking because the big buzz in the retirement industry these days is about how to generate income from nest eggs. That includes creation of income-oriented portfolios, systematic drawdown plans and annuity products that act as do-it-yourself pensions.

Yet few retirement account holders actually are tapping them for income. The Investment Company Institute reports that just 3.5% of all participants in 401(k) plans took withdrawals in 2013. That figure includes current workers as well as retirees; the numbers are higher when IRAs are included, since those accounts include many rollovers from workplace plans by retired workers. With that wider lens, 20% of younger retired households (ages 60-69) take withdrawals, according to a study for the National Bureau of Economic Research and the Social Security Administration’s Retirement Research Consortium.

The income annuity market has been especially slow to take off. One option is an immediate annuity, where you make a single payment at the point of retirement or later to an insurance company and start getting a monthly check; the other is a deferred annuity, which lets you pay premiums over time entitling them to future regular income in retirement.

Deferred annuity sales doubled in 2013, to about $2 billion, according to LIMRA, the insurance industry research and consulting group. But that’s still a drop in the bucket of the broader retirement products market. And the Vanguard survey found that just 5% of investors surveyed held annuity contracts.

“The theme of translating retirement balances into income streams is emerging very slowly,” Utkus says.

The Vanguard study also underscores the importance of smart Social Security claiming decisions, especially delayed filing. “There’s been a sea change over the past year,” Utkus says, with more people recognizing that delayed filing is one of the best ways to boost guaranteed income in retirement. Vanguard is “actively discussing” adding Social Security advice to the services it offers investors, he says.

 

 

MONEY Portfolios

Alex, I’ll Take “How to Invest Like a Jeopardy Champ” for $1000

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Host of Jeopardy! Alex Trebek and contestant Arthur Chu. courtesy of Jeopardy

Controversial Jeopardy champion Arthur Chu talks with MONEY about risk-taking, his long-term goals, and why he isn't in the market for a shiny convertible.

Earlier this year, Arthur Chu won a staggering 11 games on Jeopardy, nearly $300,000 in prize money, and the unofficial title of “Jeopardy Villain.”

Chu upset some gameshow purists with his counter-intuitive tactics. For instance, he relied on game theory to outmatch his opponents. Chu would often skip around from category to category and select the most valuable answers first. Fans who were used to contestants staying in one category, and starting with the least valuable answers, chafed at his approach. (Although Chu is hardly Jeopardy’s first unconventional player.)

A few months after his epic run, Chu had to figure out what to do with his winnings, and how to adjust to life with a lot more money in the bank.

The 30-year-old voice-over artist and actor lives in Broadview Heights, Ohio, and recently spoke with MONEY.

(The interview has been edited.)

Viewers seemed to view you as a risky player, but you’ve maintained that your strategy was risk-averse. How so?

For some reason, probably because Jeopardy consistently refers to its points as “dollars,” people don’t get the most fundamental rule of how Jeopardy works — the points you earn in the game are NOT dollars. They only turn into money if you win the game, if after Final Jeopardy you’re in first place. If you aren’t in first place, all your points disappear, your total is completely erased and you either get the 2nd-place $2,000 or 3rd-place $1,000 consolation prize and go home.

The expected value of winning the game versus losing is immense. Not one single dollar in your stack is worth anything if you lose. And yet people do irrational stuff all the time like make bets that ensure they’ll still “have something” if they lose the bet, even though if you lose the game “having something” and “having $0″ are completely equivalent — you get the same consolation prize either way.

So imagine if you had some bizarre contract where if your investment portfolio hit a certain value by a certain time limit, you get to keep the money. But if it’s below that value all the money is taken away. Do you see how this would be different from normal investing? How “low-risk” moves would actually be very high-risk moves — the “safer” your portfolio is, the higher the risk that you won’t hit your target and win the game, and all your money will vanish?

Speaking of risk, how do you view risk in your own portfolio?

When all I had was a small amount of savings I was invested conservatively to make sure that our total funds wouldn’t dip too low in case we needed them — specifically the Vanguard LifeStrategy Conservative Growth Fund (VSCGX).

Now that I have a much bigger stack I’m sitting on and the capacity to absorb more downside risk I have it all invested aggressively in Vanguard’s Target Date 2050 Retirement Fund (VFIFX.) I’m trying to keep everything as automated as possible so that managing money can be one less drain on my thoughts and energy among all the other stuff I have to do.

What’s your long-term investing strategy? Do you own actively managed funds?

As long as I’ve been into investing I’ve been an indexer. I’ve absorbed the gospel of A Random Walk Down Wall Street, I follow the Bogleheads forum, I’m invested in Vanguard, all of that stuff.

I’ve yet to see a compelling, rational argument that says you come out ahead with active investing — at least not without a lot more research and a lot more savvy that I really want to put into it. (You have to be able, as a non-financial professional yourself, to identify the managers you trust to give you above-market returns — and not just above-market returns but returns that are enough above market to justify the cut they take. I’ve yet to see a reliable method for doing this.)

What goals will your winnings allow you to achieve?

It’s not really buying stuff that matters most to me — the single thing I value most that’s most irreplaceable is my time. A nine-to-five job, while it comes with a lot of perks and a lot of security, takes the lion’s share of the hours in the day away from me and puts them toward something I’d rather not be doing. To be able to live a life basically like the one I have now but to have that time freed up — that’s worth more than any car or any cruise.

What does all of this money buy you?

The main thing it buys is a feeling of peace. I have no intention of quitting my job in the near future but just knowing that you don’t need a job is profoundly freeing.

Knowing that I could buy almost anything I wanted if I really wanted to is profoundly freeing — and, paradoxically, having this knowledge means I no longer think about things I want but can’t have nearly as much. When the thing that you’d be trading off for the lust-inspiring luxury is tangible — when I know that I’d be trading, say, six months of not having to work for a shiny new convertible — it puts things in perspective and helps push away the need to lust over such things.

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