Bequest goals: more than just an issue for the wealthy

Smart retirement planning takes into account inheritance intentions along with longevity risk

Failing to plan for a bequest goal can be costly. (Photo: iStock) Failing to plan for a bequest goal can be costly. (Photo: iStock)

Many people presume that inheritance planning issues are solely the domain of the rich.

But think again, because not having a bequest goal can be costly to you or your clients!

Longevity risk, from an individual’s perspective, is the chance that someone might outlive their savings. It’s a well-known issue that’s widely discussed in the media.

But retirees face another legitimate financial planning risk: the risk of failing to achieve one’s legacy goals, or the bequest risk. This has received much less attention than it should.

See also: Here are 9 ways to preempt a will contest

The word “risk” usually connotes a downside to protection; something that needs to be reduced. Bequest risk does not fall in this category.

Leaving a bequest that is less than desired may cause disappointment. On the other hand, leaving a bequest that is more than desired may be the result of unnecessarily curbed spending and enjoyment through retirement.

Both are undesirable outcomes!

See also: 4 common retirement risks (and possible solutions)

We believe that all retirees should incorporate a bequest goal into their planning. This goal may be to leave nothing behind, or the so-called “die broke” objective. If this is the goal, then an individual’s retirement strategy should leverage their personal assets in a way that maximizes recurring income during retirement.

Alternately, a bequest can involve large legacies for a spouse, children, grand-children, great-grand-children, charities or others.

It all depends on an individual’s personal situation, capabilities, needs and preferences.

Poor financial planning means not having a bequest goal at all. If, on the other hand, leaving an inheritance is important to you or your clients, it makes sense to plan accordingly.

A bequest goal should be somewhat independent of time of death, which is generally unknown at the beginning of retirement.

Let’s look at a practical example

A 65-year-old widowed woman with one son, who is currently 35 years old, might use the following approach: withdraw funds at a certain rate periodically, such as 4 percent, with a high degree of confidence that this source of income will last until she is 90 years old. 

Assuming that future investment performance behaves exactly as planned, many things can happen. Let’s look at three different scenarios:

    1. The woman passes away at 70 years old: She would leave a significant bequest.
    2. The woman passes away at 90 years old: She would leave no bequest.
    3. The woman passes away at 100 years old: She would leave no bequest and would have required some financial support prior to that.

Why would it make sense for this woman to leave a significant bequest to her son when he is 40 years old (scenario A), or no bequest when he is 60 years old (scenario B)?  Scenario C is obviously undesirable and is commonly known as… longevity risk!

From the son’s perspective, he faces:

    1. A significant bequest in possibly his prime earning years.
    2. No bequest when he may start thinking about retirement.
    3. A liability while he may be in his retirement.

The presence of lifetime income in a retiree’s portfolio helps mitigate bequest risk. Lifetime income sources can include traditional defined benefit plans and social security as well as insurance annuities (in their distribution phase).

A pure lifetime income annuity such as a single premium immediate annuity (SPIA) without a death benefit provides no bequest. But while the retiree is alive, the ability to pool mortality experience generates a recurring higher dollar amount than a fixed income security with a similar credit rating.  These recurrent dollars allow the retiree to depend less on periodic withdrawals from the remainder of their portfolio to pay for recurring expenses while alive, hence making the bequest less dependent on time of death.

Lifetime income helps retirees control how much of an inheritance a retiree can able to leave. In general terms, for a given constant reasonable spending flow through retirement, lifetime income decreases a bequest if the retiree dies earlier than expected, and increases a bequest should the retiree live longer than expected. 

The same issue, from a slightly different angle

A 65-year-old man who buys a SPIA and a 30-year government bond will experience the following return on investment, looking at three different scenarios:

    1. The man passes away early: The bond will yield to a superior return.
    2. The man passes away around his life expectancy: The bond and the SPIA will yield similar returns.
    3. The man passes away late: The SPIA will yield to a higher return.

For a large segment of society, lifetime income offers individuals stronger control over their future, grants additional security to their family, and allows them to exert a much greater grasp of their desired bequest amount. This type of retirement plan also provides income while a retiree is alive, which is particularly fitting, as there is a variable cost associated with living.

See also:

Addressing beneficiaries in estate planning

10 common estate planning mistakes (and how to avoid them)

2 more surprising uses for life insurance

Lifetime income is an essential financial tool that helps individuals strike the right balance between recurring income during retirement and their bequest goals.

Lifetime income is an essential financial tool that helps individuals strike the right balance between recurring income during retirement and their bequest goals. (Photo: iStock)

One more consideration

Bequest goals do not have to be measured only in dollars. They can also be stated in terms of specified assets such as real estate, equity shares in a company or fund, the principal amount of a bond, or even valuable items such as art or jewelries. Some of these assets — such as stocks or bonds — may generate recurring income. When combined with lifetime income, these other types of assets can form a solid basis for replacing a paycheck during retirement.  They also have varying value over time, so depending on market conditions at the time of the retiree’s death, the value of these assets can impact the ultimate inheritance size. Still, they can serve as a relative estimate for a bequest.

For example, a retiree who owns real estate and lives off of rental property income does not know how much the property will be worth in a year or a decade. But, leaving the actual property as a bequest, regardless of when death occurs, does provide some relative consistency over time.

Providing the right amount of lifetime income in a portfolio can help a retiree achieve the right balance between recurring income while alive and the amount left for an inheritance.  A very wealthy individual may be able to earn a comfortable paycheck replacement with the income produced by investments without having to sell any of them, and could leave those assets as a bequest.  Alternatively, that strategy may not work for a less-wealthy individual without any pension income who will need to consume a portion if not all of their retirement savings in order to have adequate recurring income while alive.  In that case, the individual could convert some assets to lifetime income to increase and secure recurring revenues while alive and lower the expected bequest.

Buying lifetime income provides many benefits, most notably the security and peace-of-mind that comes from knowing that one cannot outlive their income. This confidence, in turn, can translate into more comfortable spending during retirement. What’s more, it is the only type of financial vehicle that depletes individual capital in a lifetime-efficient fashion.

On the flip side, it exposes a purchaser of lifetime income annuities to possibly significant negative returns on their investment in the event of an early death. It follows that an individual’s health status should be taken into account when evaluating the purchase of a lifetime income annuity, since the benefits are diminished for someone in poor health, unless it is medically underwritten. If the lifetime income annuity provides a limited death benefit, (e.g., guaranteed income for a certain period or a return of premium) this can help mitigate the risk of steep losses triggered by an early death while also increasing bequest. The tradeoff is reduced recurring income as the implied benefit from mortality pooling is reduced.

Accumulating savings during working years is fairly straightforward. The more one accumulates as an individual, the better off he or she will be at retirement, all else being equal.

But spending those funds during retirement is far trickier because the depletion time frame is unknown people can rarely predict when they will die.

Just like everything else in this world, these issues should be looked at on a comprehensive basis and adapted to personal situations.

See also:

How to annuitize an inheritance

What to expect when expecting... an inheritance

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