There has been much discussion in the financial press about how to fund income for retirement. Much of this discussion deals with how to safely take withdrawals from an investment account in a manner that will make the funds last at least as long as the individual’s life expectancy.

Many of these models use modern portfolio theory to allocate assets among different classes and then run these various asset classes through “Monte Carlo” scenarios to figure out the odds of the assets lasting as long as the client. The results of these studies usually are phrased in sentences like: You have a XX% chance of your money lasting until age YY as long as you only withdraw Z% of your portfolio per year. After working with several individuals who had based their retirement planning on this logic and then retired in 1999 and 2000, I thought that there had to be a better way.

There are three basic flaws in this sort of planning that need to be addressed:

1. A 30% drop in portfolio value early in retirement would devastate the income safely available. While not common, we are well aware this has happened more than once.

2. It’s impossible to die exactly at your life expectancy. If you plan at age 60 for 20 years of additional life, when you are at age 80 (when 60-year-old males are supposed to die), you have a life expectancy of about eight more years. At 88 you have almost five more years to live. Thus the life expectancy model is a moving target that will never be accurate. Life expectancy is based on the law of large numbers and can’t be brought down to the individual level.

3. Should the money not last as long as the client, what will the client do for income? Social Security will not be adequate.

Annuities have been shunned because of their lack of liquidity, their inability to adjust for inflation and the lack of an inheritance for the heirs. While some of these objections can be overcome with newer products, the loss of control over the money keeps annuities from being the perfect stand-alone answer.

A combination of these solutions can be made into the ideal solution for retirees. In the effort to compare and contrast investments with insurance, I have combined stocks, bonds, investment real estate, mutual funds, CDs and any other investments into a “Nest Egg” earning a stated percentage return. Using Excel 2003, it is possible to look at some hypothetical scenarios for a male retiring at age 65 with a $1 million portfolio balance.

Assumptions:

) Social Security will pay $22,800 a year.
2) Desired income is $72,000 a year.
3) Absolute necessities of survival equal $48,000 a year.
4) Inflation will run 3.5% per year and is applied to the desired income, the survival income and Social Security benefits.
5) Six percent will be earned on the portfolio each year.

The first scenario pays the inflation-adjusted desired income until age 94, when the portfolio drops to zero. Only Social Security income of $61,831 is left when desired income would be $195,255 and the necessities would be more than double the income at $130,170. A total of $3,675,385 would have been paid out at age 94.

In our second scenario, we take $500,000 out of the portfolio and put $300,000 into a life and 10-year certain Single Premium Immediate Annuity (SPIA) with a 3% annual benefit increase feature.1 It will generate $17,880.18 a year to start. We then put $200,000 into a deferred annuity that we will assume will earn 4% over its life and we will annuitize on a life-only basis at age 75.2

This scenario pays the inflation-adjusted desired income until age 97 when the nest egg drops to zero. Social Security income of $68,553 and combined annuity income of $75,194 would total $143,747 when desired income would be $216,483 and the necessities would be at $144,322. A total of $4,291,886 would have been paid out at age 97.

The advantage of this second scenario is that the gap between the actual income and the survival income has been greatly reduced once the nest egg hits zero. Also advantageous is that the decision to annuitize the deferred annuity can be adjusted (in this case to age 75). Thus if the client was in poor health at that point in time, other options would be available than a lifetime income.

Our third scenario takes $900,000 to purchase the Life & Ten SPIA with a 3% annual increase. The $100,000 left is invested at 6%.

This scenario pays the desired income to at least 120 years old with principal still growing. At age 100 the total payout would be $5,040,547 and the portfolio would be worth $914,521.

It’s been said that the only certainties in life are death, taxes and change. This type of analysis depends on the assumptions that have gone into the projections. While the assumptions used here seem realistic to the author, it is important to use the client’s own crystal ball (perhaps with some guidance from the advisor) to determine the assumptions used in each situation. For the more loss-adverse client, this type of analysis eliminates the life expectancy assumption that many other methods use to determine sustainable retirement income. It also lends itself to revisiting the process as the years in retirement progress.

I used a simple SPIA with a 3% compounding feature on it, as it is readily available from several companies and is simple to understand. Newer products are coming on the marketplace that may be a better fit or could be combined to produce the desired results. SPIAs are now being offered that will index their payments to an equity index; some are providing cash surrender and withdrawal features, while variables can guarantee a lifetime of uncertain income. Lifetime withdrawal guarantees are appearing in fixed deferred annuities now as well as variable.

The high-rolling risk-taker will leave all the money at risk, while the mattress-stuffer will insure 100% of his or her income. The rest of us need to strike a balance that will allow us to live the retirement we dream of while still sleeping soundly at night and leaving some sort of legacy to our heirs.

Carl Berdie, CLU, FLMI, is vice president; advanced sales and sales support for American Financial Marketing, Inc. He has been in the business since 1972 as an agent and advanced underwriter. Mr. Berdie produced some of the first hypothetical indexed annuity systems for back-testing products and more currently works with income rider comparisons.

Footnotes:
1. American General Life Insurance Co., Male 65, Life & 10 years Certain, Non Qualified, Minnesota resident, 2/18/2009.
2. Annuity 2000 Mortality Table at 1% interest.