Turning Your 401(k) Into a Cash Machine: Avoid being shy of funds when retiring

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If someone handed you a lump of clay, could you turn it into something that wouldn’t be mistaken for a preschooler’s best effort on an off day? Could you do any better if you sat in front of a blank canvas with oil paints and skinny brushes? Unless you are artistically gifted, chances are the most appropriate place to display your art would be on a wall behind the furnace.

No one expects those of us with paint-by-number abilities to create masterpieces. But when we hit the age at which the actors and actresses in Centrum Silver commercials start looking foxy, we are suddenly supposed to become financial geniuses. Once you’ve retired, you’re expected to be able to transform a lump sum of money—typically what you’ve managed to save through a 401(k) or some other workplace retirement plan, along with any individual retirement accounts—into an efficient cash machine that throws off just enough income to keep the bills paid.

Say what?

It sounds ridiculous to expect someone with shaky financial skills to pull this off. Yet the expectations are even greater now that pensions are following the same path as passenger pigeons and other extinct critters. Increasingly, the only monthly income that Americans can depend on is their modest Social Security check. The rest is up to them.

Actually, the challenges are even more daunting. Research suggests that you essentially should withdraw no more than 4 percent of your nest egg a year if you want to ensure it lasts 30 years. There are ways, however, to make this feat seem less intimidating. First, you can consult a financial planner, which I’d recommend for just about anybody approaching this milestone. You can also rely on two other strategies to hedge against outliving your portfolio:

• Stick with cheap mutual funds.
• Consider diverting part of your nest egg into an immediate annuity. (Don’t confuse immediate annuities with deferred variable annuities, which are often shamefully peddled to people who are old enough for senior discounts.)

Expensive investments can be as sneaky as termites, because you won’t necessarily know there’s a problem with the costs until your foot goes through the floorboards. If you use low-cost index funds, however, you can avoid this hidden portfolio predator.

Here’s an illustration of what I’m talking about. Let’s suppose you retire with $250,000, which will generate a return of 6 percent a year for three decades, and you limit your annual withdrawals to 4 percent. You invest in cheap index funds, which pass along a dirt-cheap investment charge of 0.3 percent a year on your assets. At the end of 30 years, your hypothetical nest egg would have ballooned to $378,401. And that’s after withdrawing funds totaling $365,992.

In contrast, let’s imagine that you stuck with expensive mutual funds that gouged you with an annual investment charge of 2.3 percent. The withdrawal rate and fund performance, however, remained the same. Thirty years later, you’d have $209,272 left. Even worse, your withdrawals would only total $273,074 because your nest egg shrank faster, thanks to the bloated fees.

An immediate annuity can stretch your nest egg, even if you live as long as the dwindling number of Confederate widows. When you deposit a portion of your retirement portfolio into an immediate annuity, you transfer the responsibility for making sure the money doesn’t vanish to an insurance company. One of these annuities provides an owner with a monthly check that’s guaranteed to last one or two lifetimes, even if the initial investment eventually is depleted. The monthly amount depends upon such factors as a person’s age, gender and the amount invested. The older the customer, the more generous the check. The payouts will be smaller if the annuity covers two lives, say yours and your spouse’s. The check amount will also depend upon whether you choose a fixed or a variable immediate annuity.

With the fixed variety, you are guaranteed a set rate of return for your investment. The amount of each check never changes. This can be reassuring for someone who retires without a monthly pension check, but it can also be unnerving if inflation starts shaking down retirees. Imagine how much your check will buy if the price of a gallon of gas reaches $15 and a box of Cheerios costs $18. With a variable immediate annuity, inflation isn’t the bogeyman. A stock market meltdown is. A variable immediate annuity typically invests at least part of the money in stocks. Consequently, the payments fluctuate. That’s fine when the stock market is partying, but it can be rough when a hangover sets in over Wall Street. While the payments will vary with a variable immediate annuity, your account balance won’t change.

A study by TIAA-CREF, which operates the nation’s largest private pension system, suggests that the chance of outliving your portfolio drops, and in some cases quite significantly, with a fixed immediate annuity. The study’s results indicate that conservative investors, who are leery of loading up on stocks in their golden years, could particularly benefit from an immediate annuity. The study, for instance, reported that a conservative portfolio (50 percent bonds, 30 percent cash and 20 percent stocks) faced a 67 percent chance of being depleted within a 30-year period if a 4.5 percent withdrawal rate was used. But if 50 percent of the portfolio was annuitized, the risk dropped to less than 19 percent.

If you’re interested in a fixed immediate annuity, you may not want to dump a ton of money into it all at once. With interest rates so anemic, you may wish to spread the money out across multiple annuities with different insurers over a period of time. Look for low-cost immediate annuities with highly rated insurance companies. Be sure to comparison shop.      

Lynn O’Shaughnessy is the author of The Retirement Bible and The Investing Bible. She can be reached at lynnoshaughnessy@cox.net