When clients enter retirement, rethinking the accumulation mindset may pose challenges. They and their advisors will need to focus on understanding “decumulation,” or thinking of saved wealth in reverse terms.
Instead of thinking about how to add and grow assets efficiently, they’ll need to focus on how to expend these assets effectively.
But there are inherent challenges and financial pitfalls associated with this. These risks are not necessarily well understood, but they need to be. Here are examples.
o Life expectancy: As one would expect, increasing life expectancies are leading to longer retirement periods. Couple this with early retirement trends and the result is a dramatically longer retirement income planning window. Although a long life is certainly a nice problem to have, it presents an unprecedented challenge for planners, especially when using the client’s life expectancy as the financial planning horizon. Life expectancy is just that–a measure of average expectations. That means half a firm’s clients will live beyond their life expectancy, creating a very real possibility of outliving their income.
o Self-withdrawal plans: “I can manage my own retirement income” is a common refrain of pre-retirees. Gaps in retirement consumption are typically met any number of ways, including popular methods such as systematic withdrawals from a deferred annuity, interest and dividend income, IRA distributions, and trust income. However, each method has serious implications, particularly in regards to taxation. If planning doesn’t take place early in retirement, mapping out when and how income will be distributed, withdrawals might need to be taken under very tax-inefficient circumstances. Worse, poor planning may force depletion of valuable tax-deferred vehicles, leading to lost investment opportunities.
o Inflation: Never underestimate the effects of inflation on a retiree. Actual “senior inflation” can be dramatically higher than traditional measures due to higher health care needs. Also, purchasing power erosion during retirement is double jeopardy. Not only is income capacity eaten away but also retirees have few or no options to make up the difference. Furthermore, the risk of inflation is a silent menace because the impact is slow and deliberate. (By contrast, a younger person in the accumulation stage who faces income erosion or asset mismanagement often has options such as working longer, or in more than one job.)
o Asset allocation: The way assets are allocated in retirement is a critical part of the income planning picture. For years, people accepted the wisdom of significantly lowering their investment risk profile in retirement, figuring that they could not afford to take any risk at all. Clients are often so concerned about “risking” their principal, they often do not include growth vehicles that will allow them to keep up with inflation.
But with inflation and longevity risks, the inverse is true; clients need to think hard about their investment risk levels. It is likely that, when all of risks are considered, their asset position might tilt more toward higher-yielding investments than they imagined. Consider a client, age 65, who would like to withdraw 7.5% of assets (adjusted for inflation) yearly. Even with as much as a 60% equity allocation, the change is 1 in 5 of not generating sufficient income to make it through retirement.
o Sequence of investment returns. During accumulation, the sequence at which market returns occur has little impact. But during retirement, the sequence becomes a much bigger issue. Why? Consider the concept of dollar-cost averaging, or systematical purchase of assets at lower average cost over the long term. Taking income can be thought of in opposite terms, or “reverse dollar cost averaging,” so now there is the risk of selling assets at lower average prices to generate income.
Volatile investment performance early in retirement can lead to more assets being sold and, subsequently, to severe long-term implications on income and asset levels. A client needs to balance risks to ensure that short-term income is funded with less volatile short-term investments but still consider more aggressive long-term investments, which will act as the engine to provide for future retirement income.
In view of these financial hurdles, clients will look to their advisors for solutions to making accumulated nest eggs provide income for life. The market is at critical mass, the demographics are right and pre-retirees have investing knowledge that makes them more open than ever to education on the risks they face. All the pieces are in place for positioning a practice to take advantage of this growing retirement income opportunity.
John G. Bonvouloir, CLU, is vice president-product management with Aviva Life Insurance Company, North Quincy, Mass. His e-mail address is firstname.lastname@example.org.
Clients will look to their advisors for solutions to making accumulated nest eggs provide income for life.