From the April 2005 issue of Investment Advisor • Subscribe!

Retirees Looking for Income They Can't Outlive

Building a retirement nest egg is one thing. Turning it into an income is another

Just one in five pre-retirees have an idea of how to turn retirement savings into an income stream. Just one in five pre-retirees have an idea of how to turn retirement savings into an income stream.

After spending years accumulating enough money for retirement, baby boomers are now grappling with their next step: turning that money into an income stream that will guarantee a comfortable retirement.

A recent study by Prudential Retirement found that regardless of a person's level of investing savvy or the amount of money they've saved, "people are pretty confused on how to convert a lump sum" of retirement money into an income, says Scott Sleyster, executive VP of Prudential Retirement's full-service retirement business. Those nearing retirement, the study found, are desperately seeking help in managing the "payout phase" of retirement. But their biggest obstacle "is a lack of education or not having someone to talk to that they can trust," Sleyster says.

This is the fourth year that Prudential Retirement, a division of Prudential Financial Inc., has conducted its Workplace Report on Retirement Planning. In the latest study, which focused on pre-retirees age 55 to 64, 83% of those polled said that it was "very important" to generate an income during their retirement years, but only 20% said they know how to do so. When asked if they've considered using an income annuity to create a retirement paycheck, the study found that fewer than half of the participants, 44%, even knew about the option, and only 9% said they would use it. The study also found that a large percentage of pre-retirees are still focused on accumulating assets or achieving better returns when they should be figuring out how to generate income.

Pre-retirees have two major concerns, Sleyster says, losing the balance they've accumulated, and converting their money into income. Later this year, Prudential Retirement plans to release to plan sponsors a separate account product that will "give people a guaranteed return of principal but allow them to keep some equity upside," he says. Retirees fail to garner optimal returns because they often become too conservative and "move completely into an intermediate bond fund or 100% into stable value," Sleyster says.

Sleyster says plan sponsors are more focused than ever on addressing "the challenges the baby boom generation faces," and are "thinking a lot more about having the best investment lineup and open architecture." Many "larger [defined contribution] plans often opt for separate accounts."

Prudential is also developing a deferred annuity--or income annuity--which will be available to plan sponsors as well as retail clients of advisors. The deferred annuity will allow retirees to convert a portion of their 401(k) balance into an income stream to supplement Social Security. "We're trying to remind people that if they're going to annuitize, they may not want to do it all in one bite; they may want to do it in thirds or fifths," Sleyster says. "We're designing a product where people, as they are approaching retirement, could lock in their interest rate in advance by buying a deferred annuity." At least the way it stands now, Social Security is really the only income that retirees can't outlive. "Most financial planners will tell you that it makes sense to take some portion of your IRAs or savings or DC balance and supplement Social Security so that 50% to 60% of your replacement ratio is guaranteed and you can't outlive it."

Wilmington Trust is also helping retirees generate an income by combining a single-premium immediate annuity from a AAA-rated insurance company with a life insurance policy from another AAA-rated insurer. Joseph Godfrey, managing director and national markets insurance specialist at Wilmington Trust FSB in New York City, says if structured properly, meshing these two products cannot only double a person's income stream, it can also increase the money they leave to their heirs. "Nobody has ever really put these two [insurance products] together before," Godfrey says. But the results "almost seem too good to be true when you see the numbers."

It's important to note that with this type of strategy, a person should be at least 65 or 70 years old "because the annuity payments aren't strong enough to make it worthwhile if you're younger," Godfrey says. "An annuity payment is a combination of principal and interest with the payment guaranteed for as long as the person lives, so the older you are the larger the amount that is coming back as principal."

Let's take, for instance, an 80-year-old male who's looking to generate more income and leave more money to his children and grandchildren. He's currently worth $10 million and has $1 million invested in a municipal bond that is giving him an annual income of $35,000. Godfrey says if that client invested his $1 million in an immediate annuity instead his income would be $130,217 per year, based on last year's annuity rate, which paid $10,851 per month. Since part of that income is considered a return of principal, it's not taxable. Godfrey notes that then you have to calculate how much is taxable and apply the tax rate to it. In this case, $40,000 is taxable and about $90,000 is considered return on principal. If the man was in the top tax bracket between federal and state, say 40%, his tax would be $10,001, so his after-tax income would be $122,016 versus the $35,000 income generated from the muni bond. If the man died one day after entering into the annuity contract, however, his family would inherit nothing.

But if the man had stayed invested in the muni bond, his family would get about $400,000 after paying about $600,000 in estate taxes and legal fees. Now the man "wants to hedge that risk of dying too soon, so he buys an $800,000 life insurance policy," Godfrey says. "Assuming he's in the second-best non-smoker category rates, not the best risk, the premium for an $800,000 guaranteed universal life contract is $49,080." Subtract that amount from the $122,016, and the lifetime income amount is $71,136 versus $35,000. "We've doubled his spendable income, and when he dies, his grandkids and kids would inherit the $800,000 because what he did was use the $49,000 premium and put it as a tax-free gift into an irrevocable life insurance trust."

Godfrey warns, however, that when combining these two products, it's important to complete the insurance underwriting before purchasing the annuity. "We always get the doctor's report (which can be the longest part of the underwriting process) and shop it to various carriers to get the most attractive offer," he says. "Then you have the best life insurance rate so you can go and find the best annuity rate." If the advisor fails to have the life insurance policy in place before buying the annuity and the client dies, "the person who arranged the transaction is going to have a huge malpractice claim on their hands" because the annuity payments stop at a person's death.

An advisor must also use two different insurance carriers when combining the life insurance with the immediate annuity. If not, the IRS will say there is no transfer of risk because the same company is on both sides of the transaction.

Godfrey says during the two years that he's been combining an immediate annuity with life insurance, he has had his share of clients shy away from it because they thought it was just too good to be true. "It's a new concept, so people want to make sure it works," he says. It may come in handy the next time that a client who is nearing retirement, or is already there, asks you how they can get a bigger paycheck.

Washington Bureau Chief Melanie Waddell can be reached by e-mail at mwaddell@investmentadvisor.com.

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