Chances are,the money that financed your grandparents’ retirement came from three sources: the government, the company they worked for and their savings. You’re probably not going to be so lucky. “We used to talk about the three-legged stool of retirement,” says Harold Evensky, a financial adviser in Coral Gables, Florida. “The first leg was your pension, the second Social Security, and the third your own resources. Now it’s looking like a two-legged stool—and with all the uncertainty about Social Security, we’re moving toward one-legged. So the responsibility for saving is on you.”
Also on you: making that money last for decades. It’s a challenge, but by saving aggressively and investing intelligently, you can generate a safe, steady income stream in retirement—even without help from your employer. Here’s where to put a chunk of your money to create your very own self-funded pension.
In basic terms, an immediate annuityis an investment that allows you to turn a lump sum of money into a guaranteed series of payments that start right away and last until you die. For example, a 65-year-old woman could put down $1 million to buy an annuity today that would guarantee her a payment of $5,726 a month for the rest of her life. Annuities are sold through insurance companies. These products can be confusing, but in the simplest example, if the woman buys that annuity and dies five years later, the insurer pockets the rest of the money; if she lives to 105, the insurer is on the hook for all those years.
Why is investing in an immediate annuity better than just leaving the money in the bank or the stock market? For one thing, with an annuity, you never outlive your money. For another, annuities can be a low-risk way to generate a pretty good rate of return. If you put the money into a savings account, you won’t take much risk, but you also won’t earn much interest. If you put the money into the stock market, your money could grow—but you could also lose a big chunk if there’s another crash. Your gamble with an annuity is that you will live a long time. An annuity is not a good bet for someone in poor health or with a family history of early death. But for someone who believes she’ll live for many more years, it could make sense.
One challenge many retirees face is keeping up with the cost of living. Of help here are U.S. Series I Savings Bonds, or I Bonds, which are structured to stay in step with inflation. The interest rate on an I Bond is really the sum of two rates: one that is fixed for the 30-year life of the bond and another that mirrors the inflation rate. Twice a year, this inflation component adjusts up or down. The I Bonds are exempt from state income taxes; federal income taxes are deferred until the bond is cashed in. You can purchase I Bonds by opening an account at treasurydirect.gov. If you believe inflation is on the rise (for the record, I do), then these are a good bet. But there is a hitch: Individual investors can buy only $10,000 worth of bonds every year.
I have this fantasy that if I live a long time, I’ll be like my grandfather, who wasn’t sick a day in his 98-year life until the night he went to sleep and stayed there. But my grandfather’s experience is atypical; the reality is that most people who live to be extremely old will have to spend a lot of money on health care. Fidelity Investments estimates that a 65-year-old couple who retired in 2010 will need a quarter--million dollars to pay for medical expenses not covered by Medicare—and that figure doesn’t include nursing home fees.
If your family is long lived, you may want to consider insuring against such costs by purchasing longevity insurance. This is essentially an -income-producing annuity whose payments don’t begin until you’re fairly old. “Typically, you buy between ages 50 and 60, and payment starts at 75 to 80,” says Evensky. For example, a 65-year-old woman could turn a $1 million lump-sum payment today into a monthly paycheck of $23,902 beginning at 80. The return is so much higher than the return from an immediate annuity because the insurance company is betting many of us won’t live to see that first check!
One important note: When you buy longevity insurance or any annuity, always look for an insurer with a top-tier credit rating (A or better) from AM Best (ambest.com/ratings) or Standard & Poor’s (standardandpoors.com/ratings/en/us). After all, says Evensky, “this is a company you’re counting on to be around for another 30-plus years.”
What if you (or your aging parents) are running out of money? If you own a home, you might consider taking out a reverse mortgage. This allows people age 62 or older to turn their home equity into a lump-sum payment or a pensionlike income stream that lasts as long as they live in the home. FYI: If housing values fall significantly, the loss is swallowed by the lender; it takes the hit, not you.
Historically, some experts have not recommended reverse mortgages because they’ve been so pricey. But that changed last year, thanks to a new push on a program from the Federal Housing Administration. The program, called the Home Equity Conversion Mortgage Saver, greatly reduces the typical $15,000 to $20,000 in transaction fees and 1.25 percent in annual insurance on the loan; some lenders are waiving one or both. AARP has great information on this: Go to aarp.org, then type “reverse mortgage” into the search box.
Reverse mortgages have gotten attractive enough that even experts are keeping the option open for themselves. “My wife and I think we have enough in our accounts to cover us for the rest of our lives,” says Zvi Bodie, a finance professor at Boston University. “But if it came down to running out of money and the choice was to move in with our kids or borrow out the equity in our home, I would choose the latter.” And so would I.