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July 18, 2021
Figuring out how much income you need during retirement and formulating a retirement income plan is the most important aspect of financial planning. Don’t believe me? Well, the theory is advanced by Robert C. Merton, recipient of the 1997 Alfred Nobel Memorial Prize in Economic Sciences and Distinguished Professor of Finance at the MIT Sloan School of Management. (Hear him on The NewRetirement Podcast here.)
Merton believes that the most important aspect of retirement planning is to estimate your retirement income and insure that it is adequate to cover your spending. He rejects the focus on net worth and savings formulas without first understanding spending needs and how to turn assets into income. As he said on the podcast, “Overwhelmingly, I’m trying to make the case that the thing that matters for retirement is the amount of income you get and not how big your pot is. Those are very different.”
In his article, “The Crisis in Retirement Planning,” published in the Harvard Business Review, Merton outlines a retirement-focused framework that divides income needs into three categories. He also defines how to invest money for each category.
Here is how he recommends you approach creation of a retirement income plan
When creating a retirement income plan, you first want to identify your baseline income needs. How much income is absolutely necessary for you and your household? How much income MUST you have to cover your necessities?
Not sure? The NewRetirement Planner can help you figure out this number. The budgeter enables you to set discretionary and mandatory spending levels in over 70 different categories and vary this projected spending over time. The system also helps you project your healthcare and housing expenses.
To cover your mandatory expenses (housing, food, healthcare, and everything else you deem necessary), you want to guarantee adequate income — for life.
“It’s important for people to start figuring out what income they will have that is inflation-protected and guaranteed for the rest of someone’s life. This will help protect a retiree from longevity risk, interest rate fluctuations, and inflation,” writes Merton.
Retirement income that is guaranteed for life includes Social Security along with defined-benefit pensions. But there are other ways to achieve more income in this category.
“To increase the amount of guaranteed income above and beyond those benefits, the pensioner would have to buy an inflation-protected life annuity from a highly rated insurance company,” says Merton.
Lifetime income annuities offer guaranteed payments for the rest of someone’s life. For example, let’s say a 60-year-old male purchases a $150,000 annuity today with 3% inflation protection. If he were to opt to start receiving payouts in 5 years, he would get around $700 a month for the rest of his life. (Try your own calculation with NewRetirement’s Lifetime Annuity Calculator.)
However, annuities can be inflexible investments and don’t allow for liquidity. Nor are they the most efficient investment — you aren’t going to get rich “investing” in an annuity. In fact, they are technically an insurance product.
This is why you would only want to put money into an annuity to cover the most necessary expenses. Having your needs covered can provide peace of mind.
The next step in creating a retirement income plan is to look at a second category of retirement expenses — money to cover costs that are not strictly mandatory but that you would really like to afford.
“People who are uncomfortable with annuitizing their entire retirement portfolio should consider trading off some — but not all — of their guaranteed future income for alternatives offering more flexibility,” Merton advises.
A portfolio of U.S. Treasury Inflation-Protected Securities (TIPS) can serve as a “more flexible but still relatively safe” alternative to annuities, he says. TIPs offer a periodic payout of inflation-protected income for a fixed period of time, called a “maturity.”
Portfolio interest income from the securities is combined with principal at each bond’s maturity to create income payments, resulting in no remaining capital once the payout period ends.
“There are two advantages to this type of conservative additional income relative to guaranteed income,” says Merton. “Because the savings can be held in liquid [U.S. Treasury] assets, they are available in whole or in part to the participant at any time, for medical emergencies or other lump sum expenditures.”
Finally, you want to identify the nice to have expenses (again, the Budgeter in the NewRetirement Planner can help you with this). Invest funds for discretionary expenses in accordance with your values and risk tolerance.
“People with defined-contribution retirement plans will typically find that their targeted mix of guaranteed and conservative incomes, in combination with personal assets such as their house, bank accounts, and savings, is enough to meet their retirement goals,” says Merton.
These individuals may be comfortable allocating all of their defined contribution accumulation for investments in financial products such as annuities and bond funds for additional guaranteed and conservative incomes.
“But some participants may find that their anticipated total income and assets will not be enough to finance the level of retirement income they desire,” he writes. “In that case they may wish to accept lower income now (that is, increase savings) or invest a portion of their [defined contribution] accumulations in risky assets that hold out the possibility of earning sufficient returns to permit achieving the desired higher retirement income.”
Merton posits that understanding retirement income is a more approachable and meaningful way to think about retirement planning.
He gave 2 examples in the podcast to illustrate his point:
Merton said, “If I can visit you in your hometown and I said, ‘Hey, this is a nice town. I’d like to move here.’ Then, I looked at how you’re living and I said, ‘Well, I like the way you’re living. What would it take for me to live in your town like you?’ I doubt you’d say to me, ‘You need $3,637,550 in the bank.'”
“I think you’d say, ‘Well, if you want to live like me here, you have to be earning about so much a year, right?’ That’s how people would say. ‘You got to earn about that amount, you can live like me.’”
Merton gives another example of why thinking about income is easier than a pot of money. He said, “I’ll give you another example, social security around the world. When you retire, what do they give you? What do they tell you they have? Do they tell you, you have a pot of money accumulated? No. They tell you, they will pay you so much per month for the rest of your life, and they will adjust it for inflation, right? Once again, an income concept.”
So, in summary, you want to first figure out your retirement spending in three categories:
And then, create a plan for accumulating and investing your assets for those categories.
Achieving all three categories of income takes careful planning. The NewRetirement Planner can help you define how much you will need and when. And, you can plan for different types of income streams to meet your various spending needs.
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