From the May 2008 issue of Boomer Market Advisor • Subscribe!

May 1, 2008

Understanding critical retirement trade-offs

Most advisors already know the risks facing boomer retirees. They know timing (at what age to retire) and affordability (costs during retirement) are obvious decision factors for their clients when creating retirement income plans. But few boomer investors, and a subset of advisors, actually consider five important trade-offs.

1. Age of retirement is the first tradeoff. Working even one additional year can dramatically improve a boomer's chances for a successful retirement. Delaying Social Security payments, maintaining employer-subsidized healthcare coverage and contributing to retirement accounts instead of withdrawing from them can be added together to put retirees in a better position to meet their retirement objectives.

2. A second tradeoff is retirement lifestyle, or expenses in retirement. Reducing discretionary expenses, particularly in the early years of retirement, can reduce the likelihood that a retiree will outlive his or her assets.

3. Planning to leave a bequest means that a retiree chooses not to use those assets to fund their retirement expenses, making a clear tradeoff between a bequest goal and their retirement lifestyle goals.

4. While the right asset allocation during retirement remains controversial, it is generally accepted that some equity exposure is necessary to keep pace with inflation. Many planning tools utilize Monte Carlo simulation to illustrate the range of outcomes and the effect of asset allocation on retirement success.

5. While the first four variables that affect a client's plan are fairly straightforward, the probability of success is often missed. Monte Carlo can give a probability that the plan will succeed, but there is no definitive number that a client must reach to be comfortable. Some clients will be comfortable with a 70 percent chance of success, since they are willing to take the risk in order to build wealth for an important legacy goal. Other clients will only be comfortable with near-certainty. Achieving a higher probability of success can mean that clients will need to adjust the other four key retirement tradeoffs.

To illustrate the interplay of the five tradeoffs, it is essential to look at hypothetical scenarios that could meet the needs of a specific boomer couple. For example, Mr. and Mrs. Anderson are 55 and 52, respectively. Mr. Anderson is an aggressive investor who wants to know if he can retire at 63, while Mrs. Anderson would like to retire at 60 and prefers to invest conservatively. Their holdings total $1.67 million, invested in a balanced allocation of 67 percent equity, 30 percent fixed income and 3 percent cash. They do not wish to change their asset allocation. Their ideal retirement lifestyle requires $14,000 per month and they would like to leave $500,000 to their children. Like most investors, Mr. and Mrs. Anderson would like to be very confident that they will not outlive their assets, and have decided on a target of 90 percent probability of success.

Using an automated tool specifically designed to optimize, implement, and monitor individual retirement income programs we created three alternatives that could work for the Andersons, each with different choices for the five key tradeoffs.

Each scenario allows the Andersons to achieve three out of the five goals. In the first alternative, they can achieve their probability of success, retirement age and legacy goals by reducing monthly expenses in retirement by $2,000. In the second alternative, if they work another two years they can achieve the remainder of their goals. In alternative three, they can retire when they would like with the retirement lifestyle they desire, if they are willing to eliminate their legacy goal and reduce their probability of success by 17 percent to 75 percent.

While any of the three scenarios could work for the Andersons, they will need help from their advisor to select the right combination of tradeoffs for them. It is difficult and time-consuming to look at multiple scenarios without the right tools, but it also essential to illustrate the tangible impact of each of the five key tradeoffs.

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