He believes that it is more important to estimate retirement income than knowing how much to save for retirement. He maintains that it is indeed critical for you to define—and redefine—your exact retirement income needs.
In his recent article, “The Crisis in Retirement Planning,” published in the July-August 2014 edition of the Harvard Business Review, Merton outlines a retirement-focused framework that divides income needs into three categories.
1. Minimum guaranteed retirement income
When creating a retirement income plan, you first want to identify your baseline income needs. How much income is absolutely necessary — mandatory — for you and your household? How much income MUST you have to cover your necessities?
For these mandatory expenses, you want to guarantee adequate income. 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.
Income that falls under this category includes government benefits such as 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, if a 60-year-old male purchases a $150,000 annuity today with 3% inflation protection and opts to start receiving payouts in 5 years, he would get $744 a month for the rest of his life, according to NewRetirement’s Lifetime Annuity Calculator.
However, annuities can be inflexible investments and don’t allow for liquidity if someone’s financial circumstances change and they need to access more of their assets, according to Merton.
2. Create conservatively flexible income streams
The next category of retirement expenses are those 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 that is typically based on an individual’s life expectancy when he or she retires.
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 UST [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.”
3. Strategize to achieve desired additional income
Finally, you want to identify the nice to have expenses and plan for these accordingly.
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 DC [defined contribution] accumulations in risky assets that hold out the possibility of earning sufficient returns to permit achieving the desired higher retirement income.”
Achieving all three categories of income takes careful planning, and for many, the use of a certified financial planner may be helpful.