This Is How Retirees Live on $1 Million Dollars
For most, the word "millionaire," a term coined in the 18th century, calls to mind images of lavish wealth and extravagant lifestyles. Simply having this much money once represented a ticket to life on easy street. As of 2016, thanks to inflation, cost-of-living increases and lifestyle changes, retiring on $1 million isn't as carefree. It now requires smart budgeting to ensure this nest egg lasts for a retiree's remaining years.
Though it does not provide for the sumptuous lifestyle of years past, having $1 million for retirement is still a blessing. Many retirees have nothing or next to nothing in liquid assets and have to rely on Social Security benefits to pay the bills each month (seeWhat is the size of the average retirement nest egg?) . This is a big reason why the poverty rate for Americans 65 and over is frighteningly high. A retiree with exactly $1 million may not be spending much time at the Breakers on Palm Beach, or the Plaza Hotel in New York, but invested smartly, this sum should ensure he can live in a typical U.S. big city, such as Chicago, Los Angeles or Houston, without worrying about poverty or inability to pay the bills.
Let's take a closer look at two of the key strategies shrewd retirees employ to stretch $1 million throughout the retirement years. One technique is to purchase an immediate annuity, which converts the retiree's lump sum into a guaranteed monthly paycheck for the remainder of his or her life. Another is to invest the money in a standard portfolio, typically one diversified with mutual fund, stock and bond investments, then withdraw a fixed percentage of that portfolio each year to pay living expenses.
For retirees who worry about running out of money at some point, an immediate annuity offers perhaps the single most attractive feature of any retirement product: a fixed-income stream that is guaranteed for life – whether the purchaser dies the day after buying the annuity or lives to 120.
Immediate annuities are sold by life insurance companies. They are not classified as investments but as contracts by which the retiree places a lump sum into the annuity, which draws interest. The annuity's principal and interest balance are amortized with a series of fixed, regular payments to the retiree. A couple of factors determine the amounts of these payments. One is prevailing interest rates; when interest rates are high, annuities pay more. The other factor is the retiree's life expectancy. The longer he or she is expected to live, the lower the monthly payments. For this reason, women, who generally outlive men, receive smaller annuity checks on the same balance.
At 2016 interest rates, an immediate annuity purchased for $1 million by a 65-year-old man paid between $5,400 and $5,700 per month, while the same annuity pays a 65-year-old woman between $5,000 and $5,500 per month.
While life expectancy is used to calculate benefit amounts, the checks do not stop coming once that age is reached and the annuity balance is amortized. Rather, the retiree receives checks for as long as he or she lives. An annuity is essentially insurance against outliving one's money, with the
insurance company assuming the risk of the individual living too long. A retiree who prioritizes peace of mind in this regard, knowing that his parents and grandparents all lived to 100, should consider an annuity.
Annuities feature two distinct disadvantages: tax treatment and illiquidity. While most investment income earned over a long period is taxed at long-term capital gains rates, annuities are taxed at ordinary income rates. The difference between the two depends on the investor's tax bracket; it might be immaterial, but it might also be significant. For a high-income earner, the top ordinary tax rate, as of 2016, is 39.6%. Long-term capital gains, by contrast, are never taxed at more than 20%.
The other problem with annuities is that owners are effectively limited to their monthly checks. They cannot withdraw a large chunk from the annuity, such as for an emergency or a major purchase, without incurring penalties. It comes down to priorities. If having income for life is a bigger priority to a retiree than having access to his or her money in full, an annuity might be the best option. Otherwise, retirees should look elsewhere – or at least not invest all or most of their retirement funds in an annuity.
Another strategy to make $1 million last through retirement is to place the money in a diversified portfolio and withdraw a set percentage per year, indexing that amount to inflation. Many retirees who use this strategy follow the 4% rule. They withdraw 4% the first year, or $40,000, and they live on this amount. The second year, they take out the same 4% plus the rate of inflation for that year. If inflation were 2%, the second year's withdrawal would 102% of $40,000, or $40,800. The third year follows the same pattern, and so forth, with the retiree always taking out 4% plus the accumulated inflation rate. Projecting forward the interest rates and inflation environment of 2016, a retiree can easily make $1 million last more than 30 years using this strategy.What's the Best Retirement Drawdown Strategy for You?can help you choose the best rate.
The main downside to the traditional portfolio strategy is, unfortunately, no method exists to project with certainty future market returns or inflation rates. The years following the Great Recession have been excellent for stocks and mutual funds, and equally good as far as low inflation is concerned. However, a protracted bear market or a period of unusually high inflation – the 1970s featured both – causes a retiree's $1 million to evaporate much more quickly if it is invested using the strategy outlined above.
The Bottom Line
Investing $1 million in a traditional portfolio and taking yearly withdrawals gives a retiree more flexibility with money than purchasing an annuity does. The returns from mutual funds, historically, have been stronger than annuity returns. And in a low interest rate environment, such as the current one, annuities are going to have less generous payout rates than in times when interest rates are higher. On the other hand, an annuity offers a retiree one feature a traditional portfolio does not– an iron-clad guarantee he will never outlive his money.