Accurately measuring whether stocks are over- or under-valued is hard enough. Yet even if that problem were solved, others would remain. An indicator that predicts a big change in stock prices over the near term is likely to have a wild margin of error. Longer term, the error-rate may decline, leading to a safer, more confident prediction, but the price-change will also fade to a smaller size. Is there any way to have it all: calculate a credible benefit, capture it safely, and bank it soon?

Earlier posts on this topic proposed how best to measure whether stocks are over- or under-valued. To recap, three ideas are key.

• According to solid academic studies, Shiller's ten-year CAPE is a good starting point. Andrew Ang's Asset Management (chapter 8, section 5.2 ) explains CAPE's uniquely reliable, if somewhat modest, power as a predictor
• The standard measurement of CAPE can be improved by computing it over a longer period than ten years with a method that gradually reduces the weight of older data, and by applying logarithms to ensure that high and low readings are judged evenly.
• Some credence should be given to the possibility that CAPE has its own long-term trend. Predictions can be improve by filtering out this trend, at least partially.

"Corrected CAPE" is the term used here to designate a metric that applies all these ideas. To learn more, follow the links above.

As of early 2016, the corrected CAPE is rather high, approximately +0.4. A corrected CAPE this much above a neutral value of zero implies over-valued stocks, hence a risk that future returns from stocks will be less than normal. Given this reading, how much weakness in stock prices might one expect? Is a swift decline likely, or an extended period of lackluster gains, or what? The answer, it turns out, depends on whether the goal is to predict changes for next year, the next decade, or even farther into the future.

In the chart above, the CAPE Effect is a multiplier that tells how much to adjust the future returns of U.S. stocks, given a value of the corrected CAPE. The blue dots are actual data points from a comprehensive study covering the period from 1896 through 2015. The red line is a statistically fitted model used in our calculators.*

Given corrected CAPE's early 2016 value of +0.4, a one-year forecast is an effect of roughly 0.4 * 0.14 = 0.056 on a log scale. The spreadsheet function EXP(0.056) converts back to a percentage, 5.8%, which is the predicted reduction in real (inflation-adjusted) stock-returns over the next year, because of the current over-valuation. For the 1896-2015 period of the study, compound real returns were about 6.6% per year, so the year-ahead prediction is a return of 6.6% - 5.8%, or a meager 0.8% better than inflation, including reinvested dividends. With economists currently predicting an inflation rate of about 2%, the nominal return would be 2.8%. That's less than the historical return of ten-year Treasury bonds.

​If U.S. stocks were held longer, for the next 20 years, the chart predicts the effect would still be negative but less drastic, roughly half as large. The compound, inflation-adjusted return would be reduced about 2.6%. Instead of enjoying average real returns of 6.6% annually for two decades, one's portfolio of U.S. stocks would grow 6.5% - 2.6% = 4.0% per year, above inflation. That's not shabby. It's better than bonds, but below average for the long-term performance of stocks.

​What the chart says, in short, is that buying stocks today is like paying a premium price for a house when real-estate is hot. Even after holding the investment for many years, one's annualized profits may be tepid.

There's a problem, however, in making decisions like these. The next chart shows why. It presents the same data points (the blue dots), bracketed by their margins of error.** Statistically, most of the historical data falls between the upper and lower margins of error (the orange lines). A big gap between the lines implies great uncertainty; a narrow gap means the prediction is more trustworthy.

For stock investments held one year, the margin of error is extreme. While the average one-year effect might be alluring, actual one-year results have often been very different, in both directions. Evidently, a short-term forecast is both big and wild. It's like predicting tomorrow's weather to be a 90% chance of rain, maybe a steady downpour, maybe a brief drizzle.

At the other extreme, for a holding period of 30 to 40 years, the prediction is much more precise, thanks to a tiny margin of error. It's a safe forecast, but the effect has become small. Now the weather forecast is for a certainty of rain this season, totaling 5 to 6 inches, but there's no telling which days will be wet.

The ideal case would be to find the points on the chart where the range of uncertainty excludes a zero effect, which appears to happen after about three or four years, yet the effect-size remains large enough to matter, which seems possible up to the mid-twenties.

Our calculators quantify these ideas by giving a weight to the corrected CAPE.*** As the margin of error decreases, the weight goes up. At the same time, as the effect-size declines, the weight goes down. The statistical model finds an optimal way to calculate the weights, and, it so happens, the weight steadily increases from one to 24 years, then very gradually declines.  

For a concrete example, start with the chart below. It shows how our calculators simulate the portfolio of a hypothetical investor who matches this description:

• She has moderate preferences. Her goal is a compromise between maximizing gains and minimizing losses, and she is somewhat able to tolerate ups and downs in her investments.
• She plans to start spending her savings in two years, when she will retire. Given her health status and current age, she expects to continue spending for a total of 25 years.
• If she had children, she might add another five or ten years of spending, to allow her heirs to spend-down any residual savings after she dies. But she has no children and prefers to maximize her retirement budget by spending all her investments. Her home equity provides a safety net.

The calculator's statistical model, shown by the red line, sets the investor's exposure to stocks, given her preferences and the time remaining until invested funds will be spent.^ The blue bars are slices or portions of her portfolio, one for each year of anticipated spending.

Because this particular investor's preferences are moderate, the calculator assigns 65% as her maximum exposure to stocks, for investments held 20 years or longer. Anything not invested in stocks goes to bonds, at durations that depend on how soon the funds will be spent.

More than half the portfolio will be held 12 years or longer, and is therefor invested near the maximum level of 65% stocks and 35% bonds. The other half is invested with increasing caution, depending on proximity to the retirement date. As the investor ages and begins to spend her savings, the blue bars will, in effect, march to the left in the chart while staying under the model's red line, thus causing her portfolio to become more conservative over time. Right now, with retirement still two years away and many years of longevity on the horizon, her investments are, overall, about 60% in stocks.

That's without any adjustment for stocks being over- or under-valued. The next chart shows how much this investor's profile would have changed, when adjusted by the corrected CAPE, had the current date been any year between 1920 and 2015. Over those 96 years, 80% of the data fell between the lines shown as High CAPE and Low CAPE (10% were even higher, 10% even lower).

​As it happens, the corrected CAPE in early 2016 is approaching the value marked by the blue line, where High CAPE means that stocks are over-valued. In times like these, the hypothetical investor's profile gets shifted to the blue line, where the maximum invested in stocks is adjusted down to about 50%. On the other hand, if today's corrected CAPE were like the green line in the chart, with stocks a real bargain (Low CAPE), then more than 75% would be invested in stocks to be held for a decade or more. Notice, however, what happens for near-term holdings that will be spent in two or three years. Here, the calculator makes hardly any adjustment for CAPE.

If the holding period were extended well beyond 30 years, the adjustment would diminish somewhat because the effect of CAPE would very gradually fade. But it would not vanish completely in any normal lifetime. To give a specific example, if you had bought stocks near the top of the dot-com bubble in late 1999, when over-valuation of stocks peaked, your returns, even if you held the stocks for many decades, would likely be poorer than if you had purchased at a more normal price.

One final note is important. Some time in the next decade or two, stocks could take a tumble. If they do, the corrected CAPE may fall to a level that recommends a higher-than-normal exposure to stocks. If you adjust your stock allocation periodically, perhaps every quarter or year, according to the calculator's then-current recommendations, the result will be to move some of your holdings in and out of stocks as they become cheap or expensive, taking into account your evolving plans to spend your savings. In that sense, today's relatively expensive stocks are not a permanent penalty for your portfolio. They are a reason for caution that will last only until more optimism is warranted.

* The data for the study were monthly prices of the S&P 500, or a reasonable surrogate, and corresponding estimates of consumer inflation, from 1871 to 2015, as compiled by Robert Shiller. The period from 1871 to 1895 was used to initialize the values of the corrected CAPE. The plotted points in the chart are slopes from regressing LN(r) on LN(c), where r is the annualized real return on stocks, with dividends reinvested, and LN(c) is the corrected CAPE as described in an earlier post. The fitted line is a power function of the form s = -b * POWER( m, y ) where s is the slope; b and m are fitted constants; and y is the holding period in years.

** Statistically, the margin of error is the standard error of the least-squares estimated slope, on a natural-log scale.

*** The weight is k * s / e, where s is the slope; e, the standard error of the slope; and k, a fitted constant. All are on a natural-log scale. The weight is fitted to optimize the natural-log of the annualized real return.

^ The calculator's model for stock-allocations is an exponential function of the form:
p = q + u * ( 1 - EXP( - (y-1)/v) ),
where p is the portion allocated to stocks; q is a minimum allocation when there is one year left before spending starts; q + u is the upper limit or asymptote of the stock allocation; y is the holding period or "slice"; and v is a factor that controls the rate of rising from the minimum to the asymptote. As described here, this model worked better than other growth functions as a method of optimizing returns.

​

Earlier posts in this series reviewed possible explanations for what economists call "the annuity puzzle." The gist of the puzzle is that classical economic theory says retirees should buy more annuities than, in fact, they do. This series of posts can't claim to fully solve the puzzle. Instead, the more modest aim here is to use research by economists to help current and future retirees make good decisions about annuities.

A decision to buy or avoid an annuity is likely to be better made if it's properly framed. Being well framed means that the choice is stated in a way that counteracts common biases that could otherwise lead to a poor decision. That's the conclusion of a 2008 study published by Jeffrey R. Brown, J. R. Kling, S. Mullainathan, and M. V. Wrobel.

In the study, the authors surveyed 1,342 participants and asked them to evaluate decisions made by hypothetical retirees. The retirees were said to have "made permanent decisions on how to spend a portion of their money in retirement ... each person has some savings and can spend $1,000 each month from social security." Participants were told about the decisions that two such retirees had made and were asked which of the two had made a better choice.

For example, in one comparison, "Mr. Red" made a decision that allowed him to "spend $650 each month for as long as he lives in addition to social security. When he dies, there will be no more payments." He was compared to "Mr. Gray [who] invests $100,000 in an account which earns a 4% interest rate. He can withdraw some or all of the invested money at any time. When he dies, he may leave any remaining money to charity." Given this choice, most participants said Mr. Gray had made the better decision.

However, in another comparison, Mr. Red was the same, but Mr. Gray was described differently. He was able to "choose an amount to spend each month in addition to social security. How long his money lasts depends on how much he spends. If he spends only $400 per month, he has money for as long as he lives. When he dies, he may leave the remainder to charity. If he spends $650 per month, he has money only until age 85. He can spend down faster or slower than each of these options." In this case, most participants said Mr. Red had made the better decision.

Although described differently, these two cases were mathematically equivalent. In both of them, Mr. Red had a lifetime annuity, and Mr. Gray had a savings account earning 4% interest. When the savings account was characterized as in investment (the first case) it was favored over an annuity. However, when the savings account was characterized in terms of the spending pattern it would foster (the second case), it was disfavored.

The study was well designed in a manner that systematically compared a simple lifetime annuity to several other options, including interest-bearing investments and more complex annuities like the ones insurance companies may pitch to skeptical buyers. In every case, the simple lifetime annuity was logically and mathematically the better choice, but it was favored by the participants only when framed in language that clearly stated how each option would affect the retiree's budget and lifelong spending.

Thus, looking at budgets and spending led to better decisions than looking at investment factors such as interest rates and earnings. Focusing on budgets and spending counteracted people's tendencies, described in the previous post in this series, to over-simplify and to miscalculate risks.

Summing up, two points stand out from the various studies reviewed in this series of posts:

1. Consider your future health costs (for the reasons described in the first post). If you have excellent health insurance, such as a strong Medigap policy and long-term care insurance, then a simple annuity may be a reasonable way to smooth and stabilize your retirement income. If not, then you may be wise to set aside a reserve fund before purchasing an annuity.
2. Lay out your retirement income and budget without an annuity. Then consider whether purchasing an annuity might improve your lifetime spending. Do this instead of focusing on interest rates, investment returns, or payback periods.

Of course, other factors will also come into play, including your desire to leave bequests to your heirs or charity and your shared income with a spouse or partner, if you have one. For a step-by-step method that incorporates all these considerations, along with specifics regarding the best types of annuities, see our article on annuities for retirees.

Classical economic theory says that retirees should prefer annuities over investing in stocks and bonds. But they don't. Why? An earlier post reviewed one explanation, citing a study that said classical theory overlooks how health shocks reduce lifespans and impose burdensome costs. This post reviews other studies offering a second explanation. It examines how retirees think when deciding whether to buy an annuity.

In 2014, Jeffrey R. Brown, A. Kapteyn, E.  F.  P. Luttmer, and O. S. Mitchell, published a study that examined decisions to buy steady, lifelong annuity payments or to take a one-time, lump-sum payment. They noted that much of the research about such decisions "assumes a rational and fully informed individual who knows ... mortality rates, market returns, inflation, future expenditures, and income, and who can use this knowledge to optimally choose the mix of financial products to smooth" one's future budget over many years. That's a tall order, even for the brightest among us. Most of us may compensate, according to the study, by over-simplifying the decision.

To conduct the study, Brown and his colleagues generated realistic but hypothetical choices between annuities and lump-sum payments, and presented the choices to 2,112 individuals. The data indicated that most participants in the study used "simple heuristics rather than full optimization." The tendency to simplify the decision was strongest for those who had low scores on financial literacy and numerical ability, and those with less education.

A very common method of simplification, even among the more shrewd participants, was to buy an annuity or to trade one for a lump sum only when it was "an exceptionally good deal." While it might seem rational to insist on a good deal, the typical price-points in the study were extreme. On average, the participants were willing to buy an annuity only if the price was marked down by about 75% from the amount they would accept when trading an annuity for a lump sum. That's like offering to buy a new home for $60,000 but, as the owner of the same house, refusing to accept any offer below $250,000. A modest difference between the offer and list prices might make sense, but at values this extreme, a rational sale at fair value won't happen. In short, annuity buyers may have expectations that preclude reasonably priced transactions.

Another recent study offers a systematic explanation of the decision process that may guide annuity buyers. Under review for possible publication in an academic journal, the study is by Daniel Gottleib. Using a mathematical model from behavioral economics called Prospect Theory, the study analyzed consumers' decisions to buy or avoid either an annuity or life insurance. Logically, annuities and life insurance are complementary. One pays if you die; the other, if you live. As Gottleib argues, a theory that explains why retirees buy fewer or smaller annuities than is optimal (which they do) may also explain why the same retirees buy more life insurance than is reasonable (which they also do).

Setting aside the sophisticated math of Prospect Theory, one of its core ideas, as Gottleib explains, is that "individuals are risk averse over gains and risk seeking over losses." This means that decisions are based on miscalculation of the true risks. Here are some plain-language examples:

• Consumers (retirees and younger individuals alike) avoid taking losses. If, for example, they own a stock listed below what they paid for it, they avoid selling the stock at a loss and instead hold onto it, hoping that the price may recover. In doing so, they risk an even greater loss. For an annuity, the irrevocable decision to buy one may seem like a loss, if the buyer worries about dying before receiving enough payments to recoup the original cost. Just as the owner of a losing stock will hold onto it at risk, potential annuity-buyers hold onto their cash at the risk of depleting it, should they live longer than expected.
• Consumers are also over-eager to take gains. Stock-owners who have a modest gain, for example, may be inclined to sell pre-emptively and not let their profits run. They are averse to the risk that modest gains might vanish. Similarly, one who has held an annuity long enough to receive payments equal to the original purchase price may be reluctant to buy more annuities, even when doing so might be optimal. Logically, for example, it might be wise to increase an annuity if inflation has eroded the value of the original payments or if the buyer's good health has boosted the odds of a very long life. But such wisdom is atypical for retirees.

Gottleib's study offers the cold logic of Prospect Theory to explain decisions like these and similar ones regarding life insurance, including consumers' proclivity to under-purchase life insurance when young and over-purchase it when old. A point in favor of Gottleib's analysis is, thus, the breadth of decisions it covers.

The foregoing studies imply that when thinking about annuities, we are prone to over-simplify complex decisions and to miscalculate the true risks. Are there ways to counteract these misguided tendencies? Other research suggests that there are, and that better informed choices may be possible. That's the subject of Part 3 in this series.

For step-by-step methods to evaluate whether an annuity would be right for you, including methods to find a good insurance company that sells annuities, read our article on annuities for retirees.

Since a ground-breaking study by Menachem Yaari in 1965, economists have called it "the annuity puzzle." Classical economic theory says that retirees should, in a perfectly rational world, prefer annuities over investments such as stocks and bonds.* But they don't. In fact, very few retirees hold annuities. Why? Is the theory wrong? Or are retirees making bad decisions?

There's been plenty of research on the topic since 1965, with no definitive resolution. Some recent studies tackle the problem from very different perspectives. While not written as advice to retirees, the studies do, as I read them, offer useful insights that can sharpen one's thinking about annuities. In this post, I'll explain the core idea from one study. In subsequent posts, I'll discuss additional studies and review what the new research may imply about whether and when a retiree may sensibly consider an annuity.

The first paper, published in the November 2015 issue of American Economic Review, is by Felix Reichling and Kent Smetters. It aims to resolve the annuity puzzle by examining "​health shocks that simultaneously affect longevity and increase uninsured health costs." Setting aside the elegant mathematics used in the paper, the core idea is quite plausible.

To illustrate the idea, suppose you had purchased a lifetime annuity at age 65. It has paid you a steady stream of income for a few years, just as promised. When you bought the annuity, you had good information about your health. You knew that people with similar health had only a small chance of dying right away and maybe a 50% chance of dying in their 70's. But now, at age 72, you've gotten what Reichling and Smetters call a "health shock." While on vacation in a tropical paradise, you contracted a local disease that nearly did you in. You survived, after a long stay in the hospital, and your future health, alas, now looks bleak. To put a number on it, your chance of dying in your 70's is approaching 90%.

Making matters worse, you had no Medigap coverage, and you needed care from some pricey specialists. Consequently, you've withdrawn much more than planned from your retirement savings. Your personal wealth is much diminished.

The core idea articulated by Reichling and Smetters, supported by mathematics and by data, is that when both these events occur, a health shock that increases the risk of dying plus costs not easily covered by insurance or savings, then annuities become less attractive than holding bonds or other safe investments. Should you live in a world where the combination of such events is plausible, you would, according to Reichling and Smetters, be rational to avoid annuities.

Nonetheless, in the Reichling-Smetters model, annuities continue to make sense if only one of the unhappy events occurs. Thus, in certain scenarios, annuities may still be attractive. Here are two such scenarios:

• You've already had a bad health shock. For you, the next shock would be if your health improves, or a medical miracle arrives in the nick of time, and you live longer than the few years you thought you had left. Or, as a less extreme case, your health may be weaker than average because of a chronic condition. Think about it. Wouldn't an annuity be helpful, just in case you find yourself greeting the sunrise far beyond what you pessimistically expect? That's essentially what Reichling and Smetters argue.
• Your savings and insurance are ample. You can afford to buy an annuity so generous that no health shock would devastate your finances. It might wreck your health, but you would remain financially secure. Alternatively, you may be so shrewd about health insurance and long-term care that you have sufficient coverage for all conceivable costs. Then, whether or not you ever suffer a health shock that actually triggers your insurance benefits, an annuity would be a sensible way to guarantee and stabilize your future income.

Let's revisit your hypothetical self, at age 65, before you took that disastrous vacation. If you were thinking like Reichling and Smetters, you would do one of two things, maybe both.

First, you would set aside some of your retirement savings as a reserve fund for uninsured medical costs. Or you would increase your insurance coverage for medical expenses and long-term care. Doing so would make you less vulnerable to the double-whammy of a health shock that reduces your longevity combined with uncovered costs that degrade your financial viability. To get started, read our article on reserve funds for retirees, and use our Retiree Reserves calculator.

Second, you would buy annuities only to the extent that, after setting aside some reserves or increasing your insurance, you still have ample savings. You would have to review your personal circumstances, perhaps in consultation with a financial professional who receives no compensation for selling annuities or possibly with sophisticated software like ESPlanner.

Aiming to set a benchmark, Reichling and Smetters presented a chart (their Figure 7) indicating that for a healthy 65-year-old, at least $500,000 in savings would be necessary before buying any annuity. With $1,000,000 in savings, the chart says that annuitizing half or more might be defensible. Smetters offered similar advice when interviewed by the New York Times. Given the level of savings available to most retirees, this advice would rule out annuities for a substantial majority.

You should, of course, make your own decisions and consult your own adviser. As one way to get a second opinion, Part 2 in this series reviews another recent study that took a different perspective. It examined the decision process that retirees may be using, perhaps unwisely, when they avoid annuities. You can also find a step-by-step process for evaluating annuities and insurance companies in our article on annuities for retirees, which was recently updated to incorporate ideas from this series of posts.

* To make the economic theory accessible, I am necessarily glossing over some technical details. For example, the classical model assumes that annuity buyers have no "bequest motive." They do not intend to set aside some assets to be inherited by a spouse, child, or charitable organization. To dig into the technical details on your own, you might start here and then consult the home page of Prof. Smetters.

Disclaimer: Historical data cannot guarantee future results. Although a mixture of bonds, stocks, and other investments may be safer than investing exclusively in one class of assets, diversification cannot guarantee a positive return. Losses are always possible with any investment strategy. Nothing here is intended as an endorsement, offer, or solicitation for any particular investment, security, firm, or type of insurance. You are responsible for your own investment decisions. Please read our full disclosures and Fiduciary Oath.

The best and most popular news-posts at able2pay.com are being updated and moved. To see what's available, click on Retirement or on the Goals, Investing, or Portfolios menus at the top of this page. Included under Portfolios is an article on Basic Portfolios that amplifies the post immediately below.

Do you want  guidance on funds to buy in your 401(k), 403(b) or IRA, college-savings, or investment account? Here's an easy method from able2pay.com.

• Answer two questions to set targets for stocks and bonds, suitable for your goals and preferences.
• Allocate to three basic funds, which any firm will offer.

Step 1. Set a target percentage for stock funds.
When do you expect to spend most or all of the investments in this account?

• All in the next year or two: Set final target = 0% and stop (skip the next question).
• Most or all within five years: Set preliminary target = 30% and continue.
• Six or more years from now: Set preliminary target = 60% and continue.

What is more important to you, maximizing gains or minimizing losses?

• Maximize gains: Add 15% to your target.
• Minimize losses: Subtract 15% from your target.
• Do both: Keep your preliminary target (no change).

You now have a target of 0%, 15%, 30%, 45%, 60% or 75%. This is the amount you will allocate to stock funds. The rest will go to bond funds. (If you want more finely tuned values, you can get them with our Best-Invest calculator.)

Step 2. Allocate to suitable stock and bond funds.
Use your target to find the matching row in the table below. Then use the percentages in your row to invest in the funds shown by the column headings. Most 401(k), 403(b), IRA, college-savings, and investment accounts will offer these funds or equivalents. Below the table are descriptions that will help you find the right ones for your account.

• U.S. Stocks: Use an index fund that invests in the total U.S. stock market. If not available, use an index fund of large-cap U.S. stocks or the S&P 500. Avoid anything that's not indexed or that's more specific.
• International Stocks: Use an index fund that invests in all non-U.S. stock markets. If not available, use an index fund of EAFE stocks (developed countries outside the U.S.). Avoid anything that's not indexed or that's more specific.
• Intermediate Bonds: Use a bond fund that invests primarily in a broad mix of U.S. treasury and corporate bonds. Avoid funds with a limited focus on TIPS or on inflation-linked, international, high-yield, or short-term bonds. In a 401(k), 403(b), or IRA account, you should also avoid municipal bonds.
• Short-Term Bonds: Use a fund of U.S. treasury bonds with maturities less than five years. If not available, use instead a short-term bond index fund or a money-market fund.

Optional Step for IRA and Taxable Accounts
The following options are good improvements for an IRA or taxable account, but are unlikely to be available for your 401(k), 403(b), or college-savings plan:

• Invest at Betterment, and simply use the target from Step 1. Betterment's automated service will invest in a well-designed set of U.S. and international stocks and bonds.
• Invest  at Vanguard, using the alternate table below and these funds: Global Minimum Volatility; either Mid-Cap Value Index or Strategic Equity; Intermediate-Term Bond Index; and Short-Term Treasury.
• Invest in a low-fee brokerage account such as Fidelity or TD Ameritrade, using the alternate table below and these Exchange-Traded Funds (ETFs): iShares MSCI All-Country World Minimum Volatility (ACWV), Vanguard Mid-Cap Value (VOE) or equivalent; Vanguard Intermediate-Term Bond (BIV) or equivalent; Vanguard Short-Term Government Bond (VGSH) or equivalent.

To learn more about global low-volatility stocks, mid-to-small value-stocks, and Betterment's portfolio, see the article Diversify! on the Portfolios menu.

This post was part of a series which is now located on the Retirement tab. The series covers:

• The finances of Rachel, a hypothetical retiree, and the decisions she had to make.
• Key goals for any retiree.
• How to estimate a retirement budget.
• Home equity as a retirement asset. 
• A reserve fund during retirement, mostly for medical expenses.
• Annuities that do (or don't) make sense for retirees.
• Managing income and payouts from your retirement savings.

Some economists argue that during retirement, you should be "dis-saving," by which they mean spending down your assets, not holding reserves or saving for the future. They might also argue that "mental accounting" is irrational. From the standpoint of objective financial analysis, they would say your decisions can go awry if you mentally set aside certain funds to be spent only for certain purposes. Money is fungible, they point out. It can be used for any purpose, so spend it where you need to, constrained only by a goal to maintain a stable standard of living.

While in principle one might agree with these notions, in practice most of us do otherwise. We feel safer if something is set aside to cover the unexpected. Whether it's called a reserve fund, an emergency fund, or a sheltered account, it's a safety cushion whose purpose is as much psychological (for peace of mind) as financial (for budget planning).

Because the fund's objective is to pay for the unexpected, it is really a form of self-insurance. During your working years, a reserve fund mainly offers protection against losing your job. Thus, it's unemployment insurance that you devise for yourself and your family. During retirement, the main risk of unplanned expenses is for health care not covered by Medicare or other insurance. To a lesser extent, there may also be risks of occasional large expenses for a home you own, if not covered by your home-owner's insurance.

To plan a reserve fund for your retirement, ask yourself three questions:

• What potential expenses should you self-insure with a reserve fund?
• What amount should you reserve to cover those expenses for your unique circumstances?
• Where should you hold and invest your reserve fund?

For worked examples that illustrate how to answer these questions, click here to go to the full article.

The Social Security Administration (SSA) began making annual cost-of-living adjustments (COLA) in 1975. They compute the COLA value in the early fall from three recent months of data on the Consumer Price Index (CPI).

Should those three months happen to witness a large but temporary gain or drop in consumer prices, the SSA COLA would affect payments for a full year, starting in January, as if the temporary event had been long-lasting. In 1986, for example, the prices of oil and gas were plunging when the COLA was computed. In 1987, although energy prices stabilized and inflation quickly returned to its previous level, retirees were stuck for the full year with SSA benefits set at a lower level because of the earlier, temporary downdraft. Of course, it can work the other way, too. A temporary uptick in the CPI when the COLA is computed can give retirees a nice benefits for 12 sweet months the next year.

There are better alternatives. But they are not the ones most often cited by commentators, which were covered in the first post in this series. Have a look at the chart below. It shows the SSA COLAs since 1975 (green dots), the full CPI-U index (blue line), and two alternatives for computing COLAs.*

Before considering the alternatives, compare the SSA COLA to the actual CPI-U. In 1980 and 2006, the SSA COLA was well above the CPI-U level, giving a nice boost to retiree's budgets the following year. In 1986 and 2010, both the SSA COLA and the CPI-U were low, but the CPI-U bounced back the following year to a normal level of inflation. Yet retirees had to budget for the previous year's low COLA of 1% or less.

The SSA COLA and CPI-U both vary from year-to-year to a visibly greater extent than the two alternatives, shown by the yellow and red lines on the chart. What are these alternatives, and what makes them different?

• Core is a measure that's been computed for decades as an alternative to the full CPI-U. It uses the same data, but leaves out Food and Energy. If domestic gas, home heating oil, or imported food should rise of fall temporarily, the full CPI-U will follow along, but the "core" inflation index won't. Wait a minute! Don't retirees have gas stoves, drive cars or take buses that use gasoline, and buy foods that may have volatile prices? Of course they do. That's why the CPI-E index ("E" is for "elderly") includes Food and Energy, in portions calibrated to the spending habits of older households. But because it includes them, the CPI-E has the same flaw evident in the chart for the SSA COLA. Any index the includes Energy is prone to the boom-and-bust cycle of the gas and oil business. Possibly, some Foods have the same failing, especially if they are imported and subject to foreign currency rates. Omitting Food and Energy from an inflation index simply removes troublesome volatility.
• Trimmed is another measure derived from the CPI-U. Like the Core index, it omits certain items from the calculation. Of the 40-plus items in the CPI-U, the "trimmed" index omits the 3 or 4 that showed the highest inflation in a given month, and the 3 or 4 that had the lowest inflation. If gasoline prices surged or collapsed in a given month, they are omitted. The same goes for utility bills or medical services or food away from home or any other component of CPI-U. The method is agnostic, however, about what to drop. Unlike the core inflation index, which always drops the same items, the trimmed index zeroes in on the current offenders, whatever they may be.

Both the core index and the trimmed index are available from the Federal Reserve Bank, going back 30 years or more. More recently, some have advocated a related index, the median CPI, which simply finds the component of the CPI that's right in the middle in a given month, at a level of inflation that exceeds half the components and is itself exceeded by the other half. 

To see how the core and trimmed indexes are better, consider the statistics in the chart below. It shows that over the 33 years since 1983, when both indexes were available, they had long-run averages similar to those of CPI-U and SSA COLA. Thus, neither the core index nor the trimmed index would have given a retiree more or less over the long run, than would have been generated by the full CPI-U or the standard SSA COLA. If the trimmed or core index gave more in a particular year, they tended to give correspondingly less in another year. The compound rate of the core index was virtually identical to the SSA COLA, while the trimmed index was about 0.1% higher. The median or middle rate over the 33-year span was virtually the same for the trimmed rate as for the SSA COLA.

Look next at the standard deviation, a measure of volatility. The trimmed and core indexes had less volatility than the SSA COLA and the CPI-U. This is statistical evidence of the pattern visible in the historical chart, where the path over time was smoother for the trimmed and core indexes.

The smoothness of the two alternative measures is important for another reason. It makes the trend of cost-of-living adjustments more predictable for retirees. This year's COLA is more like next year's inflation. In the historical chart, the 0% SSA COLAs in 2009, 2010, and 2015 would have been small but non-zero values, had the trimmed or core index been used. Conversely, the spike to nearly 6% for the SSA COLA in 2008 would have been a more normal value between 2% and 4% with the other two indexes.

The final chart, shown above, provides statistical evidence that the two indexes were more predictable. Both the CPI-U and SSA COLA were utterly unable to predict next year's inflation. Their correlation was virtually zero, both with their own value in the following year, and with the future value of the full CPI-U. In contrast, the core and trimmed indexes in a given year were highly correlated with their own value the following year (r > 0.7). They were even somewhat correlated with next year's CPI-U (r > 0.3).

As noted in the first post in this series, it doesn't help retirees to ask SSA to compute an index that simply weights all the normal components differently, whether in a way that matches the spending patterns of older individuals (CPI-E) or by a method that focuses on supposedly necessary but volatile expenses. What really matters to retirees is to have a method that offers reassurance on questions like these:

• Will I be able to live within my budget next year?
• Will my COLA this year be like it was last year?
• Over my retirement years, will my SSA benefits truly keep up with inflation?

Because an index that removes volatile components is both predictable in the near-term and aligned with inflation in the long-run, it is superior in addressing these concerns. This is the direction SSA should take in revising their COLA calculations.

* For CPI-U and Core inflation, the plotted value is a compounded annual rate of change. First, for a given month, the non-seasonally-adjusted value is divided by the same value a year ago. This value is then compounded for the months of July, August, and September, to approximate the three-month method used for SSA COLA. For Trimmed inflation, the plotted value is compounded in September over the preceding 12-month period, using the seasonally adjusted monthly values of the 16% Trimmed Mean CPI as calculated by the Federal Reserve Bank of Cleveland. In effect, all three measures are doubly smoothed. The CPI-U and Core measures first smooth out seasonal effects by comparing the non-adjusted, current month to a year ago, then smooth again by compounding over three months. The Trimmed value first smooths out seasonality by averaging the seasonal adjustments on each expense category within a given month, then smooths over the full year by compounding 12 months of rates. Although the methods are somewhat different, the Core and Trimmed values end up having very similar volatility.

Data sources: FRED for CPI-U, Core CPI-U Less Food and Energy, and 16% Trimmed Mean CPI. Social Security Administration for its annual COLA values.

To get a rough budget, you'll need to estimate your overall expenses, your sources of income, and how long you need your income to last. The method outlined here is meant to be a first step, an approximation. It will help you judge whether your income may enable you to reach your main goals. It won't answer every question, down to the last dollar. But it's a good start.

Here's an overview of the method, step-by-step. It has five "round numbers" that are close enough for a rough budget.

1. Find Life+6, your life expectancy plus an extra cushion of six years.
2. Use tax returns and account statements from last year, plus the inflation rate for the past 12 months, to estimate your annual expenses this year. This number is what you actually spent last year, including tax payments, but excluding income you saved, all adjusted for current inflation.
3. Find your stable income from Social Security, pensions, income annuities, and reliable work, also adjusted for current inflation. Life+6 plays a part in calculating this number.
4. If your stable income won't cover your annual expenses, find your spending balance. This is the amount available to extract from your spending account. As detailed in Enable Your Accounts, a spending account is a temporary reserve where you manage one or two years of living expenses.
5. If your annual expenses are still not met, calculate the safe payout you can take from your retirement accounts and taxable savings. With Life+6, there's a simple, reasonable way to do this calculation. (Our Safe-Payout calculator does it for you, and offers other options, as well.)

Should you be over 70 years and 6 months of age, and required by the IRS to take minimum distributions from your retirement accounts, these would go to your spending account in step 4, if needed, and next to your safe payout or taxable savings in step 5.

For worked examples of each step, click here to read the full article.

On October 15, the Social Security Administration (SSA) announced that there would be no cost-of-living adjustment (COLA) in 2016. Retirees, their dependents, and people on disability will receive the same monthly benefits in 2016 as they did in 2015. Some commentators have responded that real inflation for retirees and the disabled was greater than SSA estimated, and there should have been an increase in benefits. Who's right?

The answer hinges on how inflation is calculated. Let's consider these options:

• CPI-U is the Consumer Price Index for All Urban Consumers. First introduced in 1978, it is estimated to cover the expenses of 80% of American households.
• CPI-W is the Consumer Price Index for Urban Wage Earners and Clerical Workers. Based on the original inflation index developed by the U.S. government in 1918, it is estimated to cover 32% of American households.
• CPI-E is the Consumer Price Index - Elderly. An unpublished, experimental value, it estimates the spending of households whose "reference person" (or their spouse) is 62 years of age or older, regardless of whether they are employed or retired. It covers about 24% of U.S. households.
• CPI for Basic Necessities. Also an unpublished, experimental value, this index covers the costs of food-at-home, shelter, apparel, energy, and medical care. It applies to the same 80% of households as CPI-U, but eliminates categories such as eating out, entertainment, and other expenses considered to be non-essential.

The SSA uses CPI-W, which estimates inflation for wage-earners, even though SSA's beneficiaries are, to a large extent, not wage-earners. CPI-W actually decreased from 2014-2015, but SSA's rules prevented them from decreasing benefits. Thus the benefits were held flat.

CPI-U, one might argue, is a broader measure that includes non-wage earners, and might therefore be a better measure of inflation for retirees and those receiving disability benefits. But CPI-U also fell slightly from late 2014 to late 2015. Here, too, SSA's rules would have required the benefits to remain unchanged.

CPI-E would seem appropriate for retirees, but not necessarily for Social Security recipients younger than 62, such as widows, those on disability, and dependent children. An old, possibly outdated comparison of CPI-E and CPI-W found that CPI-E was about 0.3% higher than CPI-W, mainly because of higher expense for health care among the elderly. Applying 0.3% as an adjustment to SSA's calculations, the inflation rate would have been just under zero (-0.01%). Furthermore, in more recent data for the period 2002-2015, CPI-E has averaged the same as CPI-W. Either way, with newer or older data, CPI-E would not generate an increase in SSA benefits this year.

Finally, CPI for Basic Necessities would seem appropriate for retirees whose goal is to guarantee a "floor" budget for essentials, while allowing a flexible "ceiling" budget for discretionary items. Comparison of this index against CPI-W for the past 30 years indicates that CPI-W under-estimates inflation in basic necessities by about 0.26% per year. However, even after adjusting for the 30-year difference, the current inflation rate would still be less than zero. And it remains zero when CPI for Basic Necessities is compared for September 2015 versus September 2014.

The bottom line? No matter which measure of inflation you prefer, all of them estimate a slight decline in consumer prices for retirees, between late 2014 and 2015. Thus the decision is whether to cut benefits or leave them flat. Viewed in that light, SSA's announcement of no COLA may be more palatable.

​The real concern? If overall inflation is not a valid concern, what is? I suspect two legitimate issues may be on people's minds.

• First, if you don't drive a car, then your personal inflation rate is probably higher than average, perhaps between 1% and 2%, because you are not getting the full advantage of declining gas prices. You may be seeing only a small decline in utility bills or some modest savings on airfares or other transportation.
• Second, you may be concerned about the predictability of your budget. For example, looking ahead to housing and health care costs next year, you may expect them to rise. If they do, this year's 0% COLA means you will have to bear the additional costs for 12 months, until SSA calculates the next COLA in October 2016.

​Addressing these concerns, the follow-up post in this series examines other ways to calculate inflation for retirees, and recommends how to make cost-of-living adjustments more stable and predictable.

An annuity that gives you guaranteed payments, for the rest of your life, may seem attractive. But it likely comes with fees and restrictions that may be hard to decipher. Furthermore, the net benefit to you may be less than you think, and more expensive than other options. Still, for some, certain annuities make sense. The key questions are:

• What's an annuity, and do you need one?
• How can you find the best annuities from the best companies?
• What annuities should be avoided, because better alternatives are available?

For answers, click here to read our article on annuities, which is located on the Retirement tab. Or, for detailed examples based on our research, continue reading the post below.

Here are some examples of Single-Premium Immediate Annuities (SPIAs) and other options. They are based on actual quotes and real products, for a hypothetical married couple in their late 60's, seeking to invest $100,000 from an existing retirement account, with 100% benefits to be paid as long as either spouse lives. Although the quotes and products are genuine, I've made the companies anonymous because they may not operate in the state where you live, your age and other variables may differ, and the companies may impose contractual stipulations that depart from the quotes and website-data available to me. These examples should not be construed as recommendations to buy any particular security or insurance product. Rather, they are intended to illustrate how you might examine and evaluate annuity options applicable in your circumstances.

• SPIA-3%. This immediate income annuity raises its payments by 3% each year. The first year's payment is $4544, a 4.54% rate on the $100,000 deposit. With a COMDEX rank of 96, the insurer is among the top 30.
• SPIA-CPI. Also an immediate income annuity, this one increases its payments by the same percentage as the previous year's increase in the Consumer Price Index. Its first year payment is $4349, or 4.34%. The insurance company's COMDEX rank is 90, which puts it solidly in the top 100.
• Rider. This variable annuity is a partnership between a well established, highly regarded investment firm and an insurance company with a COMDEX rank of 92 (the top 60). Underlying the annuity is a mutual fund invested 60% in domestic and international stocks, and 40% in domestic and international bonds. The mutual fund, if purchased by itself, would have fees under 0.2%. Purchased as a variable annuity, it has additional fees of 0.29%. A guaranteed income rider adds 1.2% more. The total fees are pro-rated as 0.127% deducted automatically every month. In year one, for a $100,000 purchase, the annuity pays you $4500 (4.5%). Net, every month that year, the insurer deducts $501.67 from your account, paying $375.00 to you and $126.67 to itself. These values may change, depending on the performance of the mutual fund. It's possible for the annuity fees to increase while the payments to you remain flat. On the other hand, a legal rider to the annuity contract guarantees that payments to you will never decrease, and stipulates a formula by which they will increase if the underlying investments rise above their value at the time of purchase.
• Self-CPI. This option is not an annuity. It's a direct investment in the same mutual fund that underlies the Rider option. But the fees are lower, under $16 monthly, because none of the annuity fees apply, and the fund is held in an IRA account with no employer-related fees. It's a self-managed plan, where the investor uses the "collared inflation" method described here and implemented in our retirement income calculator. This method starts with an initial payment of $4020 (4.02%) because of the age of the hypothetical couple. It increases the payment each year by the smaller of (a) 6.7% or (b) last year's change in the Consumer Price Index. The limit of 6.7% is a "collar" which, historically, has been necessary to protect against depleting the fund in the worst case of 40+ years in retirement with inflation initially at extreme levels.

I was able to obtain market data since 1972 for the domestic stock, international stock, and domestic bond indices underlying the Rider and Self-CPI options (but not for the international bond index, which was added to the mutual fund only very recently). This data was used to simulate what would have happened if an investor had begun each of the options above under three scenarios:

• From January 1972 to December 2014, a 43-year retirement with wide variation in markets and inflation.
• A 21-year retirement starting in 1973, when stocks crashed then rose, and inflation started very high.
• A 21-year retirement starting in 1994, when stocks and bonds both rose and fell, but inflation was low.

The simulations are necessarily conjectures. The annuities being simulated were not available to be purchased during these time-periods, and had they been, their prices, interest rates, and contractual terms might have been different from what is sold today. Thus, the analyses reported below must be viewed as suppositions about what might happen if today's annuity products were to experience future markets for stocks, bonds, and interest rates resembling markets of the past.

First, the good news. All four options provided payments every year for 43 years. Even better, the Self-CPI option had a residual value of $209,650, adjusted for inflation, in 2014. Yes, you read that right. With the money left in 2014, the investor's heirs would have had twice the buying power of the couple's original $100,00 investment in 1972. The annuities, as annuities, had no residual value. Instead, any profits went to the insurers.

However, because 43 years is a long time, because inflation was high in the 1970's, and because the period included multiple large swings in the values of stocks and bonds, the four options paid out very different amounts from year to year. The chart below shows how they differed, over time. It's important to note that in the chart, all values are inflation-adjusted to show constant buying power, pegged to January 1972.

Viewed in terms of buying power, the SPIA-CPI option was the clear winner. When adjusting for last year's inflation, it sometimes lost a bit of buying power if current-year inflation was high. But over the long term, it guaranteed constant income, in real, inflation-adjusted dollars. 

The SPIA-3% option underestimated the high inflation of the 1970's and never caught up. Had this annuity been purchased with a 4% annual increase instead of 3%, the initial payment would have been a bit smaller, but the decline during high inflation would have been more limited. Eventually the initial buying power would have been nearly restored, as the compound rate of inflation for the entire 43-year period was 4.14%.

The Self-CPI option, because of its 6.7% cap on annual increases, fell behind inflation in the 1970's, but leveled out from 1980 onward. In effect, this method made a trade-off. It kept a large bequest as a result of cautious withdrawals.

The Rider option, when adjusted for inflation, fell short on its promise that payments would never decrease. Yes, in nominal dollars, the same amount was paid every year throughout the 1970's, but within a decade, inflation cut the buying power of those dollars in half. When huge bull markets in stocks and bonds began in 1982, the Rider option swiftly recovered, only to lose ground again after the dot-com bubble burst in 2000. Of all four options, this one had the least consistent payouts, adjusted for inflation.

The foregoing analysis comes with a big caveat. It's for a very long retirement in a unique historical period. Your experience in retirement will almost certainly be different. Consider, then, two other examples, both 21 years in length, one from January 1973 to December 1993; the other, from January 1994 to December 2014.

During these two periods, the underlying mutual fund of the Rider and Self-CPI options had compound, inflation-adjusted returns a bit higher than 5% per year. In this respect, the stock and bond markets were, overall, about average during both periods, despite some dramatic swings along the way.

At 21 years, both periods were also average in another sense. They fit the joint life-expectancy of a couple in their late 60's.

A key difference, however, is that in the first period, 1973-1993, inflation was abnormally high (6.05%), while in the second, 1994-2014, inflation was much lower (2.30%). Because of inflation, the SPIA-CPI option did the best job of maintaining payments at constant buying power in the 1973-1993 period; the other methods lost about 25%, falling close to $3000, inflation-adjusted. In the low-inflation period from 1994 to 2014, however, all the options preserved buying power, and the SPIA-3% and Rider payments actually bettered inflation. The chart below displays the average payments, after adjusting for inflation.

As shown in the next chart, only SPIA-CPI generated annual increases that kept pace with the 6% rate of inflation in the first period, while all the options matched or beat the tame 2.3% rate of inflation in the second period.

Finally, as with the 43-year analysis, the Self-CPI option was unique in preserving a bequest. Adjusted for inflation to reflect constant buying power, Self-CPI preserved principal approximately equal to the initial investment, in both 21-year periods: $90,756 at the end of 1972-1993, and $144,631 at the end of 1994-2014. The three annuities, by design, left nothing.

The examples presented here are for selected options and time periods. As such, they cannot be taken as guarantees of future performance or as definitive recommendations of certain products. Your results may differ, and will, as with any investment, entail a risk of loss. With those important cautions in mind, consider the following key insights from these examples:

• If one's goal were to guarantee constant buying power, SPIA-CPI would have been the best of the options examined above. A SPIA with a 4% or 5% annual increase might have performed comparably for periods of high inflation, but would have been more than necessary under normal levels of inflation.
• If one's goals were to preserve constant buying power and also leave a bequest, Self-CPI would have been the best of the options studied here. However, it would require active management by the investor (or by a paid adviser), which sets it apart from the annuity options.

When my father retired, he was fortunate to have inherited assets from my mother, who had died too young several years earlier, and from his own father. I remember my father saying his goal was to live on the interest and leave the principal for my three siblings and me. There was no way he could have known that the next decade would bring constant inflation and poor markets. A frugal spender who had no formal knowledge of finance or economics, he was happy, I suspect, to see the dollars in his account hold firm over the years, unaware that adjusted for inflation, they were worth much less than when his retirement began. I'm not complaining. He richly deserved every penny he spent, and then some.

Looking back on my father's experience and thinking ahead to my own retirement, I would reframe his twin goals of living on interest and preserving principal. Instead, for any retiree, I see the objectives as a triplet:

• Covering expenses. As noted earlier in this series, insured income from Social Security, possibly supplemented by a lifetime, inflation-adjusted annuity, may partially achieve this goal. The rest would come from managed investments.
• Holding emergency reserves. Unless one's retirement accounts are very large, some portion should be managed separately for unplanned expenses such as uninsured medical costs, accidental damage to property, or dependents' unforeseen needs.
• Leaving a bequest. For those lucky enough to have assets exceeding their own needs for normal expenses and emergency reserves, the remaining funds may be managed as future gifts, donations, or inheritances.

Historical data on U.S. stock and bond markets implies that one method of money-management may work best for emergency reserves. This post covers that method. For living expenses and bequests, a different method may be better, so those goals are covered separately, in the post on finance strategies.

Previously, I described a set of historical data on U.S. stock and bond markets since 1924, with which I studied the experience of hypothetical investors, all of whom retired at age 65 and lived to 95. The analysis had 62 cohorts, each starting in January of a year between 1924 and 1985, and ending 30 years later in December of a year between 1974 and 2015. For these cohorts, I considered three methods of managing retirement funds.

• Flat Percentage. Annually, a fixed percentage is withdrawn from a retirement account, while the remainder is left to grow over time. Variants of this method turn out to work best for managing emergency reserves. The method is similar to how universities and foundations typically manage their endowments.
• Required Minimum Distributions (RMD) . As dictated by the Internal Revenue Service, retirees at 70.5 years and older must withdraw a portion of their traditional IRA, 401(k), 403(b) or 457 accounts annually and pay taxes on the amount withdrawn. Each year, the mandatory portion increases, because the tax-collectors want their due. Consequently, the RMD method works poorly for emergency reserves and bequests. By design, it depletes the accounts of those who live long lives. It won't preserve a surplus for unexpected needs or posterity. Furthermore, if reserves or gifts are held in Roth or taxable accounts, as may be advantageous, then withdrawals are not obligatory, and the RMD method is irrelevant.
• Inflated 4%. This method withdraws 4% of an account's initial value at the start of retirement, then increases the withdrawn dollars each year by the same percentage as the previous year's inflation in consumer prices, or, less commonly, decreases it by the amount of deflation. It's really a variant of the flat-percentage method, but one that risks depletion of the account if inflation runs high for many years. For this reason, it's a non-starter for all except very short retirements.*

With flat-percentage as the method of choice, I ran simulated retirements for the 62 cohorts from 1924-1953 to 1985-2014, across withdrawal rates that ranged from 0% to 5% annually.

I first looked at a portfolio with 35% in U.S. stocks, 50% in 10-year U.S. treasury bonds, and 15% in 2-year U.S. treasury notes. Allocating 35% to stocks was a compromise between capturing the long-term, inflation-beating power of stocks and earning the shorter-term, stable return of bonds. In my previously reported study of inflation, a 35% allocation was a good choice for funds likely to be spent five to six years in the future, which seems reasonable as a planning target for retirement reserves. Coincidentally, the retirement income funds offered by most investment firms allocate 30% or 40% to stocks. Perhaps they should be renamed "retirement reserve funds" and relegated to the emergency-reserve portion of one's portfolio.

The chart below summarizes the simulated outcomes at the end of a 30-year retirement, for withdrawal rates ranging from 0% to 5% annually. The blue line labeled "35% Steady" shows the amount remaining after 30 years, for the middle cohort, using the 35% allocation to stocks and steady withdrawals every year. Half the cohorts did better than the blue line; half did worse. For example, at Flat0%, where nothing was ever withdrawn, the middle cohort's reserve fund had nearly tripled in buying power after 30 years. Even for Flat3%, where each year the retiree spent 3% of the reserves, the middle cohort kept 100% of its original buying power. Nice!

For comparison, I ran simulations for two additional portfolios as depicted in the chart. One, called "20% Steady" and shown by the red line, had a more conservative allocation: 20% stocks, 60% 10-year bonds, and 20% 2-year bonds. Because of the lower allocation to stocks, the returns tended to be a bit lower. Even so, after 30 years of withdrawing 3% annually, the middle cohort had virtually all its original buying power.

The final portfolio, shown by the green line labeled "35% Cautious," was the best of all. It had exactly the same allocations to stocks and bonds as the 35% Steady portfolio, but the method of withdrawal was modified. If, in the previous year, the portfolio had fallen in value, then no withdrawal was taken. However, if the previous year had positive returns, then 1% to 5% was withdrawn, as depicted in the chart. This method simplifies more elaborate strategies that many endowments use to moderate their withdrawals depending on the results of prior years. It's also what your instincts might guide you to do. After a down year, you might find yourself taking no discretionary withdrawals, while waiting for your funds to recover. That's exactly how the "35% Cautious" simulation worked, with favorable results. 

Because of normal, non-discretionary expenses, you might not be able to delay withdrawals from the rest of your retirement assets after a bad year. But non-emergency withdrawals from your reserve fund are truly discretionary. They allow you to redirect surplus funds to a vacation, to charitable donations, or to your fund for future bequests. When markets are falling, you can skip them.

If an emergency requires you to spend your reserves, it matters little what they might hypothetically earn after 30 years. You need them now. What matters, from this perspective, is the least amount you can expect to be available at any point during your retirement, not the cumulative total at the end. Accordingly, my simulations calculated the low-point for each payout method, over all 62 portfolios and all 30-year periods. For a given method, that's the lowest of 62 times 30 or 1860 outcomes. It's truly a worst-case metric, one that's lower than the other 99.95% of the method's historical results. The next chart shows this metric for each simulation.

As one example, for the 35% Steady portfolio and 2% withdrawals every year, the most dismal cohort sank to about 65% of its original buying power at one point during its 30-years of retirement. One might think that a more conservative portfolio, with less allocated to stocks, would be less volatile and thus suffer less depletion. Not so! Comparing the red and blue lines in the chart, it's clear that the more conservative 20% portfolio actually sank to lower lows than the 35% portfolio. How could this be? The reason, in brief, is that during periods of high inflation, the interest rate on bonds has often been less than the current inflation rate. A heavier allocation to bonds, if it lasts long enough during such times, will reduce inflation-adjusted returns.

The best strategy for limiting losses, across all the simulations, turned out to be the same as the one that was best for promoting gains. It was the 35% Cautious method.

This analysis has several implications for retirees.

• The retirement income funds offered by many investment firms, with about 30% to 40% allocated to stocks, may be a good match for funds you set aside as emergency reserves during retirement. This does not mean you should put all your assets in such funds, just the portion necessary for emergencies.
• If the future is like the past, then in most years you may be able to spend a modest percentage of your reserve fund, without losing any of its purchasing power, long-term. About 1% to 3% may be prudent.
• Your instinctive tendency to scale back spending after a bad year may be wise, at least for discretionary withdrawals from your reserve fund.

To learn more about reserve funds for retirees, read this related article.

* Endowments sometimes use cost-increases or inflation as part of their strategy for determining withdrawals. However, to curtail the risk of depletion, they add "collars" that prevent the withdrawn amount from growing faster than a certain rate compared to previous years. Should you be inclined to try such methods, you can find a very simple, very effective version in the post on finance strategies, or more elaborate versions here for Yale University and here for three other institutions.

Although a mixture of bonds, stocks, and guaranteed benefits may be safer than investing exclusively in one class of assets, diversification cannot guarantee a positive return. Losses are always possible with any investment strategy. Nothing here is intended as an endorsement, offer, or solicitation for any particular investment, security, or type of insurance.

Do you see your Social Security benefits as a retirement account? Your view, perhaps, is that you made deposits into a personal account with payroll taxes, and, when the time comes, you will withdraw from that account. Actually, Social Security was devised not as a government-sponsored retirement account, but as a form of insurance for retirees, the disabled and their children, and widows and widowers. Payroll taxes are premiums that are paid into a pooled fund, and payments to retirees and other qualified individuals are benefits to insure them against lost income. 

Viewed as insurance, Social Security benefits should be postponed to the latest possible age, because doing so maximizes the amount of the benefit. By waiting longer to collect your benefit, you get more insurance against loss of income later in life. You might need it if you live longer than expected or have large unplanned expenses. One excellent source of information is the website, Maximize My Social Security. For a modest fee, it provides a sophisticated online calculator to compute your best option for collecting benefits.

As detailed in other posts in this series, it is difficult to use stock and bond investments to construct a retirement portfolio that will last a lifetime and reliably protect against inflation. Social Security benefits address this difficulty because they are both adjusted for inflation and paid until you depart. There's a flip-side, of course. You can't bequeath your Social Security benefits to an heir (although a spouse, former spouse, or child may be entitled to benefits of their own, because of their relationship to you). Your stock and bond investments, however, can be bequeathed to a charity or a person, if any assets remain in your estate. Because of their complimentary nature, you need both Social Security and some investments. The following list spells out the reasons, based on the payout risks likely to be of concern to a retiree:

Inflation: Will it erodes your income?

• Social Security: Guaranteed protection.
• Investments: Some protection, depending on your investment strategy, but no guarantee. Read this post for details.

Payout Volatility: Can you rely on sufficient income every year?

• Social Security: Guaranteed delivery of the same inflation-adjusted amount, every month.
• Investments: Likelihood of higher payouts some years, lower ones other years.

Longevity: Will your income sources last as long as you do?

• Social Security: Guaranteed to last your lifetime.
• Investments: May last your lifetime if you adopt a good strategy, but failure is possible.

Emergency: What if you are struck by a costly event or illness?

• Social Security: No help here. Your benefits won't increase if you suddenly need more.
• Investments: If you are wise with your strategy, you can set aside some retirement savings as a reserve or contingency fund.

Bequest: Will you be able to leave an inheritance to your heirs or charity?

• Social Security: No help here. You have guaranteed benefits to you, not to your heirs. There's no account balance that would go to your estate.
• Investments: Again, it depends on your strategy. It's possible, as other posts in this series explain, to follow a plan that has a high probability of leaving something for your estate, provided you avoid emergency payouts.

If you have both Social Security benefits and retirement investments, do you also need an annuity? For many retirees, an annuity of any kind may add little value. 

To see why, consider a typical retiree. Her actual Social Security benefits might cover 40% or more of her pre-retirement income (see, for example, a classic study by Munnell and Soto). This figure would rise if she maximized her Social Security benefits, because the actual practice, as noted in the reported studies, is that most retirees minimize their annual benefits by taking them too soon. As it happens, 46% is about how much of a typical household income is paid for housing and food expenses, according to the most recent survey by the U.S. Department of Labor. Your circumstances may differ. Still, to a good approximation, Social Security benefits may suffice to pay for your most critical expenses.

Thus, your income from investments, although it may vary from year to year, may only need to cover about 60% of your budget. If your investment income were to fall by, say, 30% in a given year, that's really 30% of 60%, or 18% of your total income. The key question is whether your budget can sustain a drop of 18% or so. If you have a reserve fund or can reduce some optional expenses or have ample investments, the answer may be yes. If not, you may want to consider annuitizing some (not all) of your investments, thereby raising your guaranteed income to a higher percentage than the 40% or so that Social Security might cover. 

Should you chose to buy an annuity, it would be sensible to get one that resembles Social Security benefits. As explained in a related article, the best annuity is fixed (not a variable annuity); it pays for your lifetime (not for a limited period); and it's inflation-adjusted.

While your individual circumstances must guide your decision, you might, as a rule of thumb, consider your options very carefully before locking up more than two-thirds of your budget in the total of Social Security plus guaranteed annuities. Certainly, if your retirement investments are more than adequate to cover your income needs beyond what Social Security insures, then converting those investments to annuities would have little value. Other posts in this series provide some guidance on making such decisions.

Disclaimer​: Although a mixture of bonds, stocks, and guaranteed benefits may be safer than investing exclusively in one class of assets, diversification cannot guarantee a positive return. Losses are always possible with any investment strategy. Nothing here is intended as an endorsement, offer, or solicitation for any particular investment, security, or type of insurance.

The core ideas for a retail strategy are to use an all-in-one fund from your investment firm, and to withdraw from the fund by a simple method that requires the bare minimum of calculations.

Most investment firms offer an all-in-one fund intended for retirement income. It is typically where a target-date fund will land as it glides to your retirement date. These funds tend to be conservative, with 30% or 40% invested in stocks and the rest in various bonds. For a lengthy period of withdrawals, such as the 30-to-40 years that many retirees may experience, retirement-income funds may be too conservative. If you use our retirement calculator, for example, you will get recommendations for a higher allocation to stocks, given a spending period of, say, 30 years, starting in the current year. To cover a range of options, I ran a study with two simulated all-in-one portfolios:*

• 35% U.S. stocks (S&P 500), 50% 10-Year U.S. Treasury Bonds, 15% 2-Year U.S. Treasury Notes
• 65% U.S. stocks (S&P 500), 20% 10-Year U.S. Treasury Bonds, 15% 2-Year U.S. Treasury Notes

With funds available today, you could create similar portfolios with our Best-Invest calculator or our article on Basic Portfolios.

To take withdrawals from the simulated all-in-one portfolios, I studied three tractable methods:

• Flat 5%. In December, an amount corresponding to 5% of the portfolio's value was calculated. That amount was then withdrawn in January, to be deposited in a bank savings account and spent over the next 12 months.
• 4%-or-RMD. Instead of a flat 5%, the amount withdrawn was the larger of (a) 4% of the portfolio's December value, or (b) the Required Minimum Distribution (RMD) for a traditional IRA, 401(k), or other retirement account, as defined by the Internal Revenue Service. Investment firms often provide RMD calculators. Before age 70, RMD is not defined for a retiree; after age 72, it exceeds 4% and increases each year.
• Inflated 4%. This method is well-known and much-debated. In the first January, 4% of the portfolio's December value is withdrawn and saved to cover current-year expenses. The next year (and every year thereafter), the annual dollar amount of the withdrawal is increased by the previous 12-month percentage increase of the Consumer Price Index (in the same manner done for inflation-indexed Social Security benefits). In my study, if the previous 12-month period experienced deflation, the withdrawal was decreased correspondingly, to keep the payout aligned with consumer prices. This did happen occasionally in the historical data.

For the two portfolios and three methods of withdrawal, I generated results for every 30-year period from 1924-1953 through 1985-2014. That's a total of 2 X 3 X 61 = 366 simulated retirements. For the RMD method, I set the retiree's age at 65 in the first year of the period. For the other methods, age didn't matter.

To understand the advantages and disadvantages of each method, consider the payout risks likely to be of concern to retirees:

1. Inflation. Each annual withdrawal was adjusted for inflation, pegged to the purchasing power of dollars in the first year. As one example, for the 30-year period 1938-1967, which included a stiff round of inflation in the 1940's, here's how the three methods fared, using the 35% portfolio:

• Flat 5% was the worst of the three for 1938 retirees. Over the 30 annual payouts, the median (middle) withdrawal had a value of $63 compared to $100 in the initial year. Had you been able to buy 10 meals at $10 apiece in the first year, then over the rest of the period you typically could afford to buy only 6 meals. Some years, the number was even lower; others, a bit higher, but never more than $106.
• 4%-or-RMD afforded good protection against inflation for 1938 retirees, although with some variation year-to-year. The median (middle) value was $101. In the worst year, it was $70 (sorry, only 7 meals); in the best, $135 (splurge on three more veggie burgers or whatnot!).
• Inflated 4% provided exactly the rock-solid consistency it is designed to offer. Every year, the purchasing power remained steady at $100.

What about periods that started in other years, not just 1938? The charts above and below show the median (middle) real (inflation-adjusted) buying power, across all the time periods studied. The first chart is for the 35% portfolio; the second one, 65%. The message of the charts is that for consistency in matching inflation, the Inflated 4% method is best. It always provided a $100 payout, every year, in every time-period, for both the 35% portfolio and the 65% portfolio. However, on average, the 4%-or-RMD method, although quite variable, was even better. The middle (median) value overall for 4%-or-RMD was $114 in the 35% portfolio, and $141 in the 65% portfolio. Finally, the Flat 5% method was fine overall in the 65% portfolio, with a median of $104, but not in the 35% portfolio, where the median was $78.

Perhaps the main implication is a warning. To protect against inflation, don't use the combination of a conservative portfolio and a flat-percentage rate of withdrawal.

2. Payout Volatility. If a method of withdrawal generates consistent payouts over the years, budgeting is easy. If not, it may be hard to plan your spending. One way to gauge this risk is to look at the spread from the highest to the lowest payout, over a given 30-year period. As a baseline, I used a $100 a payout in year one, and for direct comparison, I pegged all values to year-one dollars. The results were as intimated above. Payout volatility, as measured by the average gap between the highest and lowest payouts in a 30-year period, was ...

• Lowest, literally zero, for the Inflated 4% method.
  
• Middle, and rather high at $71, for the Flat 5% method.
• Worst, and very high at $145, for the 4%-or-RMD method. Note, however, that much of this volatility was on the upside. On average, over all 30 periods, the minimum payout was $84 and the maximum was $229.

Conclusion: For consistent payouts, the Inflated 4% method is much superior.

3. Longevity. Will you outlive your portfolio? Or will it pay its last dollar before you take your last breath? In the study reported here, this risk can be judged by looking at two indicators:

• Did the payout ever fall to zero, within the 30-year period?
• After 30 years, what percent of the portfolio remained unspent? For this question, I adjusted the final portfolio value for inflation, to express it in constant, first-year dollars.

The answers are in the charts above (for the 35% portfolio) and below (for 65%).  Just when you thought the Inflated 4% method was looking good, here comes its ugly side. In the chart above, for 1937 retirees, this method depleted a 35% portfolio after 27 years. It nearly did the same for 1939 and 1940 retirees in the 35% portfolio, and twice again in the late 1960's for the 65% portfolio. Among the three methods, it was by far the most erratic. In comparison, the 4%-or-RMD method did the best job of spending down the portfolio consistently for 30 years and retaining a modest cushion for a longer life-span, while never coming close to depletion. As shown in the two charts, it held a value after 30 years that was between 40% and 100% of the original portfolio.

Bottom line: 4%-or-RMD is best for longevity, neither leaving too much unspent nor falling to zero.

4. Emergency. Which of the methods and portfolios provides the best backstop for unplanned expenses, such as a medical emergency or loss of expected income from a spouse or partner? The best metric for this risk is the minimum value to which a portfolio falls at any point in the 30-year period. The higher the minimum, the greater is the cushion for emergencies. By this criterion, the Inflated 4% method is ruled out altogether, as it allowed the portfolio to fall to zero (or very close) in several of the time-periods. The best method was Flat 5%, where the overall minimum was 40%. The 4%-or-RMD method was not far behind, at 32%. 

For any given method, there was not much difference between the minimums for the 35% and 65% portfolios.

The conclusion in this case is another warning: To guard against emergency expenses, don't use the Inflated 4% method.

5. Bequest. If your goal is to leave an inheritance for children or charities, what method best limits the risk of falling short? To quantify the risk, two measurements are needed. One is the minimum portfolio value; if it goes to zero, there's no bequest. This rules out the Inflated 4% method. The other is the average ending value; it should be as high as possible. By this measure, Flat 5% scored higher (89%) than 4%-or-RMD (64%).

Bottom line: To leave a bequest, don't use the inflated 4% method, and view Flat 5% and 4%-or-RMD as you first and second choices, in that order.

Among the methods examined in this study, using all-in-one funds, none of the alternatives was best on all the risks. Each had some weaknesses. The Inflated 4% method was unique, however, in having some risks one might consider to be fatal. Its poor showing on longevity and emergency preparedness would make it ill-advised for many investors and retirees. Happily, as explained in the post on finance strategies, a modified version of the Inflated 4% method can overcome its limitations. For any of the methods, the key may be to adopt a combined strategy, managing some portion of assets with one method and the remainder with a different method. For example, one might establish one account for emergency preparedness and bequests, to be managed in one way, and handle retirement withdrawals in a separate account, by a different method. To learn more, read the related article on Retirement Income, or try our Safe-Payout calculator, or use the links at the beginning of this post.

Disclaimer​: Historical data cannot guarantee future results; your results may differ. Although a mixture of bonds and stocks may be safer than investing exclusively in one class of assets, diversification cannot guarantee a positive return. Losses are always possible with any investment strategy. Nothing here is intended as an endorsement, offer, or solicitation for any particular investment, security, or type of insurance.

* Monthly data for stocks and 10-Year treasures came from Shiller. For 2-year treasuries, I did a regression analysis on 10-year treasuries, 2-year treasuries, and 3-month T-bills for the years 1976 to 2014, using data from the St. Louis Federal Reserve (FRED) database. The analysis generated an equation that predicted 2-year treasury interest rates as a function of 10-year treasury rates and 3-month T-bill rates. The regression model explained 99% of the variance in 2-year treasure rates for 1976-2014. I then applied that model retrospectively to historical 10-year treasury and T-bill rates, going back to 1920. A similar model used 10-year treasury rates alone to estimate what 2-year rates would have been from 1871 to 1919. This model, while less precise, nonetheless explained over 90% of the variance for 1976-2014

If you read the legal prospectus for one of your investments, you'll find an obligatory listing of risks. It is likely to include items such as stock-market risk, currency risk, interest-rate risk, and many more. In truth, these alleged risks are really potential reasons that your investment may fluctuate in value, maybe to your detriment (or maybe not), maybe by a large amount (or maybe not by much). These are not really the risks you care about.

What truly matters are the following five risks:

• Inflation. Will the prices you pay for housing, food, transportation, and health care grow so fast that your quality of life erodes? Over time, will you become unable to afford your basic needs? Fortunately, inflation is extremely low right now, but no one knows where it will be in the future. Had you been in the unlucky cohorts that retired in the late 1930's or 1960's, the extended inflation of the following decades would have significantly impaired your standard of living.
• Payout Volatility. No, not the volatility of the markets, the bubbles and crashes that are reported in the news. The volatility of genuine concern is whether the amount of your payout has enough stability for you to sensibly plan your budget. It matters not a whit that the stock market crashes, if your payout strategy guarantees a consistent spendable income. On the other hand, it may matter a lot if your payout plan is overly sensitive to market gyrations, causing your income to change significantly from one year to the next.
• Longevity. You don't want to outlive your income. If you expect to live to be 85 or 90, but medical advances enable you to live well past 100, your investments may run dry. On the other hand, if you pass on much sooner than expected, you may leave money unspent that, had you known better, you would have allocated to more time on sunny beaches or in museums or with family members dispersed across the country. Ideally, if you knew exactly how much life remained for you to enjoy, you would spend accordingly. But none of us know that, so we need a payout strategy that intelligently copes with the uncertainty.
• Emergency. Even the best-laid plan can be overpowered by an unforeseen emergency. It may be a severe economic downturn, like the one in 2008, which has long-lasting negative consequences for your ability to earn income. Perhaps it's high, uninsured medical expenses for you or a dependent. Maybe it's a divorce that came from nowhere and sent your wealth to a place of no return. The point is that a payout plan will normally have a cushion of some sort, to soften the pains of the unexpected.
• Bequest. Do you have an idea how much of your wealth will remain after you are gone, and who will get it? Maybe you want to leave something to your favorite charity, or to your children. Or, maybe you want to spend it all and leave a bequest of exactly zero. The risk is that the bequest you eventually leave may differ radically from the one you intend. For many, this risk may carry less weight than the risks of inflation, payout volatility, longevity, and emergency readiness. However, even if it carries less weight, it shouldn't be ignored.

Consciously or by default, you will adopt a strategy to manage your payouts. You might take the advice of a financial planner, or use a software program for guidance, or passively accept the dividends that your investments deliver. Whether you have given it lots of thought or none at all, you will have a strategy. Here's the rub. It may or may not be one that's optimal for your objectives.

As this series unfolds, we'll look at several strategies. Generally, each strategy has both strengths and weaknesses. It will manage some risks better than others. One strategy may completely control certain risks and totally ignore others. Another strategy may address all the risks to some degree, but require extra diligence and effort from you. None of them is without at least some caveats.

Therefore, before you study any of the strategies, think about the risks that matter most to you. If you are 90, wealthy, and in declining health, perhaps longevity risk is less important than ensuring a bequest. If you are 60, working at a job you like, and behind schedule in saving for retirement, your top concerns might be inflation, longevity, and perhaps emergency preparedness. Decide what risks are foremost in your personal priorities, and read about the strategies with your priorities firmly in mind.

You may find one strategy that perfectly meets your needs. More likely, a combination that allocates your investments to two or three strategies may prove best.

Each post in the series examined one of the following strategies:

• The retail strategy. In this case, by default, a retail investor allows a target-date mutual fund to devolve into a retirement income fund, typically with 30% to 40% invested in stocks, and the rest in bonds. Income may be taken from this fund in various ways, perhaps using Required Minimum Distributions.
• The insurance strategy. Social security benefits and annuities from an insurance company are examples of this method, which is very strong on some risks and very weak on others.
• The endowment strategy. A payout fund from Vanguard is an excellent example here. The goal is to manage payouts the way an endowment fund for a foundation or university would manage their assets. One version of this strategy works nicely for a reserve fund.
• The finance strategy. A product from Betterment is an automated implementation of this approach, and the Bogleheads forum has an approximate version done as a downloadable spreadsheet. At the core of this approach are concepts from what economists call the time-value of money, coupled with attention to life-expectancy and portfolio composition. Happily, really simple, effective variants of this method are available in our safe-payout calculator.
• The smooth consumption strategy. With sophisticated models from economic research, coupled with online databases and algorithms, this strategy aims to manage all the risks, while generating an affordable, life-long spending plan. ESPlanner has the necessary software, which is not for the faint of heart. But a basic version is free, easy to learn, and offers great insights for your retirement plan.

If you have a 401(k) or 403(b) account from a former employer, should you move it somewhere else? After reviewing the factors outlined here, you will be able to make an informed decision. Should you decide to move the account, you would be wise to consider two options:

• Transfer to an IRA account at a good firm. See our review of the best firms.
• Transfer to the retirement plan of your current employer. If the plan has low fees or it meets other criteria explained below, this may be worth considering.

Probably the most important question to ask yourself about transferring your 401(k) or 403(b) is whether it will help you manage your money. Are you paying attention to your retirement accounts? How much time are you willing to invest to keep track of them? Would it be helpful to consolidate in fewer accounts? Thinking about these questions, you may decide it would be easiest, and smartest, to have the minimum number of accounts:

• A 401(k) or 403(b) account with your current employer.
• An IRA account that aggregates all the 401(k) or 403(b) funds from previous employers. It might also include some direct contributions that you make.

But before you rush off to do that rollover, consider a few more questions.

How do the fees of your old 401(k) or 403(b) compare to the fees at the firm where you might move your investments? Finding the fees of a 401(k) or 403(b) plan can be difficult. There are step-by-step instructions here. If it turns out that an account from a former employer meets our benchmark level of 0.4% ($4 per $1000 per year), you may want to consider keeping your investments there. If not, read on.

You'll need to find out out whether you would face any termination fees. The main types are:

• Surrender charges on an annuity. If you have an annuity in your 401(k) or 403(b) plan, it may charge an extra fee for terminating the annuity contract. Read the prospectus, or talk to your vendor, or try the 403bCompare site for your vendor's fees. Normally, the only way to eliminate these charges is to wait longer.
  
• Back-end loads on a mutual fund. This type of fee is charged when you sell a fund. The fund is normally listed as "Class B" if it carries a back-end load. Verify the fee with your vendor's representative, because these fees are sometimes waived. If a back-end load applies, you cannot escape the payment. You will have to pay now, during a rollover, or later, when you retire. It may be less now than in the future, so a back-end load is actually a reason to rollover, not a deterrent.
• Frequent trading fees. If you purchased a fund within the previous 30 to 90 days, your vendor may charge a fee (maybe 2%) when you sell the fund. Check the fund prospectus or ask your vendor's representative. If fees apply, you will have to wait a few weeks until they are no longer charged.

In a traditional IRA account, you must begin taking withdrawals in the year you reach 70.5 years of age. However, in some 403(b) and 401(k) plans, you may not have to take withdrawals from your current employer's vendor until you stop working for that employer. For past employers, as for a traditional IRA, you have to take withdrawals in the year when your age hits 70.5 years. Then there's a Roth IRA, where you never face mandatory withdrawals until you die (and then your heirs have to spend it). And did you know about the special case for pre-1987 contributions to a 403(b), which don't have to be withdrawn until you are 75? Confused? Consult the IRS for details ... or focus on the following key points concerning a rollover:

• If you plan to work past age 70 and your employer won't require withdrawals, you may want to consider transferring 401(k) or 403(b) accounts from previous employers into the one for your current employer.
• If you will be working past age 70 and your current tax rate is low, you may want to consider transferring some or all of your old 401(k) or 403(b) accounts to a Roth IRA. Be careful. You will have to pay some taxes on the amount transferred, so check with your tax adviser before doing this.

Before you start, please note! Do a trustee-to-trustee transfer, not a rollover. In a rollover, you liquidate the old account, get a check, deposit it in your bank account, then send a check to your new vendor. The IRS lets you do this tax-free only once every 12 months. Do it twice in 12 months, and you'll owe taxes. Also, if the process takes too long, you may owe taxes. In a trustee-to-trustee transfer, your old vendor sends a check to your new vendor. There's no IRS limit on annual frequency and no tax liability.

Able to Pay LLC is not a tax adviser. You should consult the IRS or your tax adviser about tax consequences. None of the information here should be taken as advice or solicitation to buy a particular fund, security, product, annuity, or type of insurance. You are responsible for your investment decisions, and should read the prospectus and disclosures for a security before investing. Investments have risks; you may lose money. Please read our full disclosures and our Fiduciary Oath.

Can you contribute more to your employer's 403(b) or 401(k)? And if you can, should you? Or would it be better to sink those extra dollars into an IRA? Making the right decision can have a big impact on your eventual retirement income. If your employer's plan has high fees, you can do a lot better by putting those dollars to work in an IRA at an investment firm that has low fees. 

How much better? Suppose your employer's plan charges an extra 1% in fees each year (as many do), causing your pre-fee returns of 6% to get reduced to 5%. Over 10 years, if you contributed your dollars every year to a low-fee IRA, instead of your employer's plan, they would grow to a total that's nearly 5% bigger. And over 20 years, your dollars would grow 11% more.*

If that sounds enticing, here's how to proceed. First, you need to know your target, the number of dollars you need to save each year to meet your retirement goal. Advisers often recommend 10-15% of your pre-tax income. Or you can use our retirement calculator to get a more precise estimate. Next, subtract the all the following types of contributions that go to your 401(k) or 403(b):

• What your employer contributes, if they do.
• What your employer requires you to contribute, if you have mandatory contributions.
• The total of your contribution plus the employer's match, if the plan includes an employer-match.

Finally, at this point in the calculation, if you have not met your target, consider contributing to a Roth IRA or a tax-deductible traditional IRA, at one of the best firms. In most cases, the Roth option will be the better choice. And last, if you still haven't met your target, make some additional voluntary contributions to your employer's 401(k) or 403(b). There are some additional details you will have to consider, regarding IRS regulations, so read on, buckle up your seat-belt, and ride through the complete 10-step process. And consult your tax-adviser, to be sure you've got the details right for your situation.

None of the information here should be taken as advice or solicitation to buy a particular fund, security, product, annuity, or type of insurance. You are responsible for your investment decisions, and should read the prospectus and disclosures for a security before investing. Investments have risks; you may lose money.  Able to Pay LLC is not a tax advisor. Please consult your tax advisor, and read our full disclosures and Fiduciary Oath.

* Since you invested more each year, your savings have been growing, on average, for about 10 of the 20 years - some longer, some shorter - so the cumulative gain is about half of 1% per year, plus some compound interest.
** If you are not covered by an employer's 401(k) or 403(b) plan, but your spouse is, your spouse should be reading this, not you. Be aware that for you, there's a different wrinkle. You can't claim a tax-deductible contribution to an IRA if your modified AGI is over $181,000, either on a joint return or an individual return.