No Pension? No Problem. Here Are 3 Steps to Replicate a Retirement Paycheck

Your actual income would be substantially higher. You would still have $500,000 remaining in your investment portfolio after buying the annuity. You don’t have to take required minimum distributions from your tax-deferred accounts until age 72, but if you need the money earlier, the government publishes RMDs for younger ages. Under the government’s coming RMD table, a 70-year-old would take out 3.44%. That amounts to $17,200 from a $500,000 portfolio. As long as you take out the RMD every year, your draws may decline in a down market but you’ll never run out of money as long as you live.

How would such a synthetic pension perform over long periods of time?

Social Security rises with inflation but the annuity doesn’t, so your inflation-adjusted income will slowly deteriorate over time. This is OK, according to David Blanchett, Morningstar’s head of retirement research, because spending drops for most people in their 80s and 90s. They travel less, go out to dinner less, buy new vehicles less often. Most private pensions weren’t inflation-adjusted either, so your parents weren’t any better off in this regard. And because you have maximized your Social Security payment, the biggest chunk of your income is protected from rising prices.

In an average stock market, you’d still have about 80% of the spending power at age 100 that you had at 65, Blanchett calculates based on a Monte Carlo computer simulation he ran that investigated 5,000 different outcomes. In a great market, you’d have more than 110% of spending power; and in a rotten market, you’d have about 65%. So even in that rotten market, the worst 5% of outcomes, you’d probably still be OK because 100-year-olds tend to spend a lot less money.

Blanchett calls the synthetic pension approach “probably the best strategy for the average American.” He adds, “You can’t beat the payout in Social Security.”

Indeed, maximizing Social Security is key to creating the best possible synthetic pension. Social Security rises by 8% for each year you delay taking it past your full retirement age. And yet for years, half or more of Americans would begin taking Social Security at the minimum age of 62 and accept a much smaller monthly check.

In an era of low yields, maximizing Social Security becomes more attractive. Americans are figuring that out. In a recent year, only 31% of women and 27% of men began taking Social Security at 62.

The synthetic pension requires you to buy annuities to cover other essential expenses after maximizing Social Security. To keep things simple, any remaining money in your deferred-savings account would be placed in a 60% stocks/40% bonds mutual fund like the Vanguard Balanced Fund. Such a fund will capture most of the market upside, yet still fall substantially less in a crash because bond prices typically rise when stocks prices tumble.