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August 10, 2005 at 08:00 PM
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.
