It's a dynamic and distinct discipline, yet retirement income planning continues to mystify many financial advisors, who are relying on classic investment advice to solve issues that require new thinking.
As Fran?ois Gadenne, executive director of the Retirement Income Industry Association, frames it: "The difficulty with the retirement income issue is that we're like the plumber showing up for an electrical job. One job deals with the flow of water, the other the flow of electrons. I think we all know that if you take plumbing tools, especially if they're wet, to an electrical job, you're not going to like the results."
The analogy pinpoints the crux of the challenge facing the retirement income planning community today: How does the forward-thinking advisor prepare clients for retirement when so many of yesterday's rules no longer apply?
"Retirement income planning is not just accumulation planning in reverse. It requires different tools, techniques and skills," according to Howard Schneider, president of the consulting firm Practical Perspectives and co-author of the 110-page report,The Continued Evolution of Retirement Income Delivery: An Analysis of Leading Practices in Advisor Support.
Far more than investment management, Schneider says, retirement income planning involves a broader focus, a more pervasive risk and a different mindset. "Investment management is not the be-all, end-all in terms of helping someone prepare for retirement," he adds. "The reality is that once you're in retirement, almost every decision you make -- whether it's financial or not -- has a financial impact. The state of your health, where you're going to live, whether you work part-time -- all those things have a financial implication in retirement. And it all circles back to this: Do you have enough resources to get it done?"
Disappearing pensions, the threat to Social Security, and the increase in life spans have been talking points in the retirement income planning debate for years. No news there. But the damage inflicted by the recession to investor wealth has served as an ugly reality check that has elevated the conversation to another level, according to Gregory Salsbury, executive vice president of Jackson National Life Distributors and author of Retirementology: Rethinking the American Dream in a New Economy.
"Retirewent," Salsbury calls it. "Investors have seen the black swan. They have been fundamentally and emotionally changed by what's unfolded the last two years. Lots has changed: expectations, legacy planning, how much to gift, how much to contribute charitably. Guarantees are no longer nice to have, they are a must-have. An advisor's best effort is no longer good enough. I don't want a pretty good chance of having enough retirement income for the rest of my life. I want a guarantee," says Salsbury. "The best advisors aren't going to go back to standard asset accumulation and planning strategies. They simply can't."
What are the major issues facing advisors in the retirement income planning space today? Here's our checklist, with expert commentary from some of the industry's top thinkers.
Given this era of global financial turmoil, to what extent should advisors rethink retirement risk management?
While volatility in the capital markets has always been on the table, it's something investors haven't paid much attention to in recent years -- until now.
"It's how you feel when you actually lose a big chunk of your portfolio that folks are having to sit up and confront," according to Olivia S. Mitchell, a professor of insurance and risk management at the Wharton School at University of Pennsylvania and executive director of its Pension Research Council. "In the current era, people are much more conscious of downside risk."
Also in play: inflation risk, longevity risk and what Mitchell calls "political" risk. "How can we possibly make good decisions about our retirement nest eggs if we don't know what we have to pay in taxes 10, 15 and 20 years from now? The whole area of retirement risk management has so many more challenges today," adds Mitchell.
A self-described inflation hawk, Mitchell is a fan of Treasury Inflation-Protected Securities. She says advisors should also give payout annuities and income insurance a hard look.
To adapt to the new climate, she suggests advisors do two things: 1) Get very clear on how much a client is willing and able to lose and use that as guidance in constructing a portfolio. 2) Make sure the client understands that he or she could live to be 100. "Presumably, it's not going to get any cheaper," Mitchell says. "So then you have to think very carefully about how you are going to husband your resources so that you can support yourself at that point."
What is the difference between the accumulation toolbox and the retirement income toolbox?
One of the key differentiators is that in the accumulation phase, the advisor sells expectations, according to Gadenne. In retirement income, the advisor is tasked with providing reliable outcomes: a floor.
"The first thing you've got to ask yourself is: Are you operating at the right context level? Retirement is not an individual client event, it's a household event," Gadenne says. "While accumulation-level work can sometimes involve the entire household, this is not necessary nor is it prevalent. For retirement income work, the household is the place to start. This seemingly small semantic difference matters because it is one of the many reflections of the shift in the mentality of the investor from the traditional 'make me rich' to 'pay me a smooth monthly income' business proposition."
Other differences: 1) In accumulation, the focus is on assets under management. In retirement income planning, it's the ratio of annual consumption divided by financial capital. 2) In accumulation, the advisor works primarily with financial assets. Later, that expands to include human and social capital. 3) The objective in accumulation is to expose assets to the upside, depending on the client's risk profile. Not so in retirement income planning. First, the advisor builds a floor, then exposes to the upside. 4) In accumulation, the advisor practices asset allocation among risky assets. In retirement income, assets are allocated using risk management techniques that include diversification, risk pooling, risk transfer and retirement-focused risk-free assets.
How do you get the client on board?
Advisors need to have unprecedented and straight-talking conversations with clients about everything from prudent spending habits to realistic expectations about what their battered portfolios can buy going forward, according to Salsbury.
"A lot of what is changing is psychological as well as fiscal. We've got to become more aware of the biases and barriers which cause us to make bad financial decisions. We have got to include the psychological with the fiscal elements of retirement planning," he says. "The best financial planning advice in the world is irrelevant if the client won't follow it."
In a focus group Salsbury conducted recently, a wife said that she and her husband had completely remodeled their 5,000-square-foot home, spending hundreds of thousands of dollars that they did not get back when the property sold. The husband, squirming, replied: "What's that got to do with retirement?"
"Americans have divorced their other spending from retirement. It's connected. That's what investors have to wake up to," Salsbury added. "Advisors need to help them get there."
How do you know if your client is right for an annuity?
Three types of clients are appropriate for annuities, according to Moshe Milevsky, professor at York University in Toronto and executive director of the IFID Centre at the Fields Institute. "Sometimes all three personalities are wrapped into one. Understand which is the personality that's dominant," he says. "The type of annuity you're going to recommend is very different based on what the personality is." The line-up:
- The client who needs tax-sheltered growth. This person has a substantial income, a high tax bracket, is concerned about the phase-out of tax credits and is worried about paying a 10 to 35 percent tax on income. "This is someone you're going to steer toward a low-cost, tax-sheltered annuity," Milevsky says. "It's all about investment and tax deferral."
- The client who doesn't have a pension. This is someone who isn't necessarily very wealthy and is close to retirement. What you're after: an annuity with pension-like features such as guaranteed lifetime income for both spouses and downside protection.
- The client who is extremely worried about the stock market. This person is naturally risk-averse and has suffered losses. "Whether they are taxable or not or pensioned or not, they are worried," says Milevsky. "They are hiding money under the mattress in T-bills and bonds earning nothing. They need to be encouraged to go back to the market with training wheels with some sort of downside protection. That's where the guarantees of annuities come into play."
What is a safe withdrawal rate?
The industry standard puts the safe withdrawal rate at 4 to 4.5 percent. New research from Michael Kitces, who did groundbreaking research a few years ago into whether that rate is too conservative, concludes: "What we've found is that 4 to 4.5 percent is still a good number when we are in really risky environments. Once we leave the riskiest environments, the withdrawal rate is actually higher: 5 to 5.5 percent." At this writing, in the third week of September, Kitces considered 4.5 to 5 percent to be a safe withdrawal rate.
His thinking? "While portfolios may have gone down a little, you can still spend what you were spending because markets are valued more reasonably. It helps support stable spending. It's this idea that your spending can remain stable even when markets are volatile -- because they are in fact self-correcting," according to Kitces, director of research for Pinnacle Advisory Group in Columbia, Md. "It means at some point, as we get to the back end of the bear market, we generally have higher withdrawal rates because we're done with our bear markets."
One twist that has shown up in the new research: Value matters.
"You cannot spend as much in retirement in overvalued markets as you can in fairly valued markets. That has a huge impact," Kitces says. "It creates some challenges in terms of working out when we are in an undervalued or overvalued environment."
The question that is driving Kitces' research now: If market valuation affects withdrawal rates that are most effective, should you adjust your client's portfolio to protect that withdrawal rate?
"Early work suggests the answer is yes," he says. "Relatively basic portfolio changes in response to extreme market effects can noticeably increase your lifetime spending."
Where do you search for returns without taking too much risk?
With the markets still in tumult, portfolio manager James Camp would rather see retirees adjust their consumption than take on more risk.
"This is uncharted territory. Two years ago, the world was on the edge of collapse. It was absolute Armageddon. People are short-sighted in this country," says Camp, portfolio manager for Eagle Asset Management's Eagle Fixed Income Strategies. "For us today it's more about what yield is prudent right now. If, in fact, lower inflation or deflation is the new norm for a couple of years, you will consume more with less income. For us right now, we're OK with a nominally low yield in a capital preservation framework. It's a good time to sell umbrellas."
Camp's guiding compass: Is the yield commensurate with the risk?
At the moment, Camp is underweight in the Treasury market, preferring instead industrial corporate bonds and tax-free municipal bonds. He's also invested in instruments that mature in 10 years or less. When building a retirement income portfolio, he recommends having cash on the side that would last six months to a year. "There is unprecedented uncertainty, economically and politically," he says. "Keep some powder dry."
What is the future of retirement planning software?
A champion of economics-based retirement planning software, economist Larry Kotlikoff, a professor at Boston University, hopes that conventional software goes the way of the dinosaur.
"Most financial planning programs out there have maybe five questions. You can't go to a doctor and have a five-second checkup and expect to get the right medicine. If your doctor is selling you the medicine, their interest is in making that visit as quick as possible and selling you the drugs," says Kotlikoff. "That's what we see in this industry: a quick financial checkup and then they sell you the drugs."
Kotlikoff has spent 15 years creating a software program focused on helping retirees find the highest sustainable standard of living. Among the points it considers: whether to use a Roth IRA or a traditional IRA; refinance with points; take a job with higher pay in a higher-cost city; whether to retire to Florida, where there is no state income tax. The software spits out the answer in two seconds -- and the basic version of the software is free at Kotlikoff's website.
Kotlikoff's main gripe is that traditional software is product-based and "has no real connection to what economics prescribes." As an example, he says conventional programs use 80 percent as the rule of thumb for the income replacement rate in retirement. He calls it the "rule of dumb." For some retirees, 80 percent could be the right number. For many others, he says 50 percent is the more realistic option.
"I hope it gets a harder look. I think it should," says Kotlikoff. "Being able to raise your living standard safely in these troubled times is a big advantage. I think eventually people will gravitate to this approach."
What are the leading practices of the most successful retirement income advisors?
Research from The Continued Evolution of Retirement Income Delivery shows that best practice advisors are fee-based, operate with a team-based approach, focus on affluent clients, and provide customized solutions.
One of the practices that best defines the successful retirement income advisor is a very deep initial discovery process.
As co-author Howard Schneider puts it: "Often a client comes in with a single question: 'Do I have enough money to live in retirement?' The advisor says: 'We don't start with that. Tell me what you want to do.' They help the client develop a clearer vision of what retirement is."
Other questions that routinely surface: Who else are you financially responsible for? Do any of you have special needs? How sound is your health?
That leads to another best practice: a deep bench. Retirement income support goes beyond investment management and can include career coaching, elder care and health care guidance and end-of-life planning.
Leading advisors, according to Schneider, aren't in search of "the" retirement income solution. Their interest is in integrating solutions. "That's the investment message we've heard over and over," he adds. "I'm integrating. I'm a chef bringing together a variety of ingredients. It's not a hot dog; it's the whole picnic."
Top advisors also decline to deal with clients who won't aggregate assets with them. "You cannot manage retirement income effectively on a piecemeal basis," Schneider says. They also won't work with clients who don't share their philosophy. "They're much more selective. They recognize they're going to have this relationship for 10, 20, 30 years," he adds. "They want to make sure the client buys in."
The takeaway: Along with strong technical expertise, the retirement income advisor needs to be more relationship-oriented, skilled at eliciting client input. "It's about dealing with them as people," Schneider says. "Not as wallets."