Retirement income planning is now more important and relevant than ever to an aging American population. With more than 77 million baby boomers beginning to make the transition from saving for retirement to spending in retirement, new strategies are needed for retirement income planning that help individuals identify, quantify and balance a number of retirement risks so that they can increase the likelihood of meeting their financial retirement goals.
Why? Because the familiar methods and approaches often lead to retirement plans that are doomed for failure.
The abundance of retirement risks includes not only market volatility (both equity and interest rate) but the likelihood, and severity, of illness; longevity, including that of partners; the order of death for a couple; and the variable nature of inflation.
While addressing these risks is complicated enough on its own, there are two added layers of complexity when building retirement income plans: one, the delicate combination of the clients’ risk tolerance and their personal definition of success…whether that means the lifestyle they hope to lead in retirement, or their desire to transfer wealth (for many, success is some combination of both); and two, the fact that for many, they will not be able to achieve everything and will need to make decisions involving risk/reward trade-offs.
However success is defined, here are 10 mistakes to avoid if your clients are to increase their odds of achieving their retirement income goals:
1. Planning to a Specific Life Expectancy. Average life expectancies are deceiving. Mortality is variable, not fixed. Planning to a specific age can be dangerous because by definition, 50% of people will live longer than this estimate. In fact, more than 25% of people will outlive their life expectancy by a period of 8 years or greater. Clearly planning for assets to sustain a plan to a specified age can lead to a situation where assets are exhausted before death. Couples must also discuss the possibility of a spouse living for an additional 20 years without their partner, which can have a significant impact on cash flow (both income and expenses) for the surviving individual.
2. Relying on Average Rates of Return for Assets. Traditionally, asset accumulation planning has relied on an assumed fixed rate of return. Unfortunately, no one can predict future performance of any asset class unless it has a guaranteed rate of return. Market volatility needs to be reflected realistically in the development and testing of an effective retirement plan.
3. Following the Herd. Do not let your clients act according to fads or popular trends. Everyone needs to examine the risk trade-offs they are willing to make and evaluate their objectives and plan accordingly. What are their goals? Lifestyle requirements? Priorities? Willingness to assume risk?
Some clients can afford to take more risk with their financial planning, while others need to be conservative, and planners can help determine what mix of products and strategies works best for their customers. If individuals follow the herd, they are planning based on the needs of others, not their own. It’s important to help clients remember that retirement income planning is not a “one size fits all” solution and following a canned formula could provide less than satisfactory results.
4. Forgetting Uncle Sam. Retirees need to understand that liquidating assets often comes with an expensive price tag from the government. For example, the tax implications will be different for withdrawals from a deferred fund vs. a tax-free fund. The choice of timing when withdrawing assets depends on your client’s total financial picture and should be reviewed with a qualified tax advisor.
Tax advisors can guide prospective retirees in the selection of an efficient order of liquidation based on their specific situation using specialized tools and methodologies to optimize the process. Planners need to be upfront about various tax implications so that retirees will not be surprised when the taxman comes knocking at their door on April 15.
5. Avoiding the Stock Market. Investors should not make irrational decisions based on fear. A precipitous exit from the stock market can result in permanent decreases in a client’s asset base. Yes, the stock market can be scary and there are no guarantees, but on the flip side it is a mistake to avoid the equity markets entirely. Depending on where individuals are on the road to retirement, having a mix of stocks and bonds creates a diversified portfolio, which can contribute positively to the likelihood of success, and effectively manage the risk associated with market conditions near the date of retirement. As individuals move closer to retirement, a shift in strategy to protect what has been accumulated is prudent and may involve changes in asset allocation or the purchase of financial products.
6. Failure to Anticipate Health Care Costs. According to recent industry information, average nursing home costs are more than $70,000 annually and individuals are expected to spend approximately 2.4 years in a nursing home…bringing average long term care costs to more than $140,000, and these costs are only expected to rise. Failing to consider health care costs as part of a needs analysis in a retirement income plan can impair significantly the likelihood of success for a retirement plan. However, this is another situation where planning using averages does not realistically reflect the risk. Health conditions can have a significant impact on the level of anticipated future cost and should be considered individually.
There are financial vehicles such as long term care insurance policies that can provide valuable albeit finite protection, and because they are often expensive, individuals should carefully consider their needs and level of wealth to determine if a policy will help them meet their objectives.
7. Lack of 401(k) Asset Management. For many in the middle market, the only significant liquid asset they will have to provide for their retirement needs will be their 401(k) plan. All too often this asset is not managed in an appropriate fashion. In particular, since individuals now change jobs frequently (studies have shown on average every 7 years), and often leave behind a trail of forgotten 401(k) dollars, planners can play a significant role in managing this asset effectively. Planners can assist in the consolidation of these accounts and provide insight on various rollover options. As with any portfolio, regular reviews, rebalancing and reallocation are essential to realizing maximum benefit from these plans.
8. Retirement Dreams that Don’t Match with Reality. Clients have to be realistic about what they can achieve and that there will be trade-offs. Dreams are great. Reality is better. Planners must help define attainable goals and create a plan that matches a client’s ability to follow through. If an individual was not taking five vacations a year when he or she was working, that individual most likely will not be doing that in retirement.
9. Going it Alone. Retirement planning is complex. The risks are complex, the strategies can be difficult to follow, and the product solutions innumerable. Planners must be partners offering insight into the relevant risks and the solutions that are available to manage those risks. With so many products on the market today and more on the horizon, a planner can play a vital role in assisting the client with which products are “best” for their situation.
10. Not Understanding Retirement Risks. A lot can happen during the retirement years, and much of it is not good. Retirees need to understand the risks they face and how they may change over time. What is a tolerable risk to them as they accumulate wealth may be unacceptable as they approach and transition into retirement. It’s human nature to look for ways to simplify decisions and make them final; however, financial planners must help fight this tendency in order to ensure that clients fully understand and periodically re-address the risks they choose to take and the inevitable trade-offs they will need to make in retirement.
As you guide clients along the path to retirement, it is crucial to educate them about the pitfalls of ignoring or oversimplifying the income planning process. Next generation methods are beginning to emerge that allow planners to create multi-scenario, forward-looking demonstrations that reflect risks that are based on an individual’s specific circumstances and help make many of the issues discussed above an understandable reality (albeit a complex one). Planners committed to providing their clients with sound advice will need to lead the shift from the current approach to this more complex but more appropriate paradigm.
Chris Raham is senior actuarial advisor, Ernst & Young’s Insurance and Actuarial Advisory Services (IAAS) practice.
The familiar methods and approaches often lead to retirement plans that are doomed for failure