(Money Magazine) -- Question: My mother-in-law, who's in her early 60s, was recently widowed. She now has Social Security and approximately $300,000 from a life insurance policy to live on. She's not comfortable taking on much, if any, risk but she does need to generate income from the life insurance proceeds. Any recommendations for how she should invest this money? --Chris, Atlanta, Georgia
Answer: Before you and your mother-in-law can even begin to think about investments, you first need to address two fundamental questions.
The first is how much income does your mother-in-law require to maintain an acceptable lifestyle for the rest of her life? If she's in her early 60s, she could easily live another 30 years, if not longer, depending on her health and genes.
The second question is, how much of that income can she reasonably expect to withdraw from the $300,000 in life insurance proceeds?
Three hundred thousand bucks is a lot of moolah. But there's a limit to how much lifetime income you can get from it -- probably much less than most people think.
Start with a pencil, paper pad and a calculator by going over her current outlays and then making reasonable assumptions about the future, such as how much different expenses might rise (such as health care) and which might decline or even disappear (paying off a mortgage other loan, perhaps).
Or, to make the process easier and try out different scenarios, you can do it electronically. For example, Fidelity's Retirement Income Planner tool contains an interactive budgeting worksheet that allows you to enter figures in 49 different expense items and even allows you to plug in different inflation estimates for different expenses.
The point of this exercise isn't to project future expenses down to the penny. No matter how hard you try, you can't be that accurate. Rather, the idea is to get a sense of how much income your mother-in-law needs to live a secure and comfortable retirement.
Once you have a reasonable figure for the income she requires, you can deduct whatever she receives from Social Security from that amount. You will then know how much she'll need to draw from her $300,000 nest egg.
But here's where things can get tricky. The amount she needs from her $300,000 based on the retirement lifestyle she'd like to live could very well exceed the amount of income she can realistically expect to draw from her three hundred thousand over a period of 30 or more years.
Which brings us back to that second question: How much income can your mother-in-law reasonably draw from $300,000, without running through it too early?
There's no hard-and-fast answer. Generally, if your mother-in-law wants a high level of assurance that her money will last, she should probably figure on withdrawing no more than 4% to 5% of her three hundred grand initially, or $12,000 to $15,000. She would then adjust that amount for inflation each year so that rising prices don't erode her purchasing power later in life.
The way she invests can affect how much income she can draw and how long that nest egg will last.
If she invests extremely cautiously, say by keeping virtually all her stash in money-market funds and CDs, she should probably count on income at the lower end of the range above. That's because "safe" investments tend to offer the lowest returns (like 1% to 2% annually in the case of savings and short-term CDs lately). So if your mother-in-law goes this route, she'll indeed avoid the risk of her nest egg getting scrambled by upheavals in the stock market. But she may be paying for that security with a lower level of lifetime income.
If, on the other hand, your mother-in-law invests a portion of her three hundred large in stocks and bonds, she has a higher probability of coming in at the upper end of that income range.
But notice I said "higher probability." Even though a diversified portfolio of stocks and bonds is more likely to generate higher returns, such a portfolio also has a much higher potential for suffering short-term losses. And if those losses are steep enough and occur early in retirement, they can be very difficult to bounce back from. So difficult, in fact, that it's possible her money could run out quickly and your mother-in-law could end up with less income than she would get from a less volatile portfolio.
All of which is to say that while your mother-in-law says she isn't comfortable taking "much, if any" risk, she can't eliminate risk entirely. If she invests too cautiously, she faces the risk of not having enough income to fund the lifestyle she wants. If she invests too aggressively, she faces the risk of a devastating setback that might drain her savings too soon.
What you really want to help her do is balance those risks in a way that's acceptable to her.
One way to do that is to go to T. Rowe Price's Retirement Income Calculator and plug in different types of portfolios. That will give you an idea of how much income different mixes of stocks, bonds and cash might generate.
Your mother-in-law has another very valuable tool for protecting against the risk of running through her money too soon -- namely, the option of scaling back the amount of income she takes from her nest egg.
So however you and she decide to invest her $300,000, it's important that you both track its value periodically. You can do that by re-running the numbers annually on the calculator I mentioned.
If you feel that this sort of number crunching is beyond what you and your mother-in-law are up to on your own, you can always consuslt an adviser. Just make sure you're dealing with someone who's looking at the big picture and not just trying to sell her one investment or another.
Speaking of investments, one that you and your mother-in-law might consider is an immediate annuity, which is a vehicle that guarantees a certain level of lifetime income regardless of the market's ups and downs. It wouldn't be appropriate for her to put all, or likely even most, of her money in such an annuity. But combining an immediate annuity with other investments is a good way to generate reliable lifetime income that can keep pace with inflation while also lowering the odds that you'll outlive your savings.
Ultimately, your mother-in-law will have to decide what to do with that $300,000. But to the extent you can help her sort through the issues I've outlined, she'll have a much better shot at investing her money in a way that works best for her.
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