People in or near retirement should have a clear and realistic plan to support their financial needs during retirement. A retirement income plan provides for the spending needs of a retiree (or a couple), the basic elements being the retirement assets, how the assets are to be invested, how and when the assets will be liquidated and the rate at which the assets will be spent.

While the reasons why such plans fail are unique to each individual, several common characteristics define a successful retirement income plan. The checklist below outlines ten key features against which any retirement income plan may be assessed.

Checklist For A Successful Plan

1. Is the plan specific enough? The plan must be sufficiently detailed to implement, or it is not truly a plan. It should define spending needs and all sources of current and future cash streams and budgets. It should account for certain contingencies, such as market volatility, liquidity of investments and health risks. For example, a plan may set aside a portion in the form of liquid assets for unexpected contingencies. Finally, the plan should be written out in detail.

2. Is the plan individualized? No two retirees’ circumstances are alike. Everyone needs a plan designed to meet his or her own specific needs. If the retiree has a spouse, both individuals’ needs should be accounted for in the plan.

3. Is the plan reviewed regularly and in detail? The plan should be reviewed at least once a year or whenever a major change to the retiree’s circumstances occurs. Circumstances may be specific to the individual, such as a major illness; or related to external events, such as a market downturn that erodes the value of assets.

Reviewing the plan involves measuring current asset values and actual spending against previously assumed and projected amounts; determining if anything has occurred since the last review that warrants a plan change; and making the necessary changes, such as short-term or long-term behavioral changes or altering the direction of the investment portfolio.

4. Is the plan flexible? No retirement income plan can anticipate every contingency. Flexibility is afforded through setting aside funds for contingencies or through insurance products. Regardless, the plan should be flexible enough for modification as necessary. For example, making irreversible investments into assets (e.g., lifetime annuities) may require greater care and forethought than investing in assets that are more easily liquidated.

5. Is the age appropriate? A person who is 85 years old today is a different person than when he or she was 65, as are his or her needs, interests, priorities and abilities. Most importantly, his or her ability to manage a complex income plan may diminish with age. This may be due to decreased acuity or the loss of a relationship with a financial planner. For this reason, the plan should adjust to the retiree’s age.

6. Does the plan have a reasonable spending rate? A reasonable spending rate is one that’s sustainable, given the retiree’s wealth and projected longevity. And it has a cushion in case the retiree lives longer than expected.

Example: An individual retiring at age 65 and making $60,000 per year before retirement may need an additional 10% to 15% of total assets to sustain the pre-retirement lifestyle until age 95, instead of 85. Alternatively, he or she may spend less per year to make the money last longer.

At least four reasons may explain why retirees exhaust their wealth prematurely, even with a retirement income plan. Each is listed in the table below, along with possible solutions:

7. Does the plan have an appropriate and acceptable level of investment risk? Without taking on investment risk, retirees may not be able to meet their retirement income needs. But taking on more risk than can be tolerated may result in exposure to market volatility that may jeopardize even basic spending needs. Whether investment risk is defined as the volatility of asset values or the probability of not being able to spend a certain amount each month, the retiree’s tolerance for these risks should shape the plan.

8. Is inflation factored into the plan? When considering inflation, what matters most are changes in prices for items the retiree will buy rather than the numbers released by the government, such as the consumer price index. As an example, housing price changes are relatively unimportant to a retiree who owns a home. The rate of health care cost increases, however, are of greater importance because the retiree may spend an increasing amount each year on hospital visits, prescription drugs and other health care expenses.

A successful plan accounts for inflation in two ways. The absolute dollars in the spending portion of the plan should increase in line with the retiree’s inflation exposure. In addition, the overall retirement asset portfolio should be invested to protect against high episodic or chronic inflation.

9. Is longevity factored into the plan? Longevity risk is the risk of outliving retirement savings. Compounding this problem is that most people reach retirement as a couple. Thus, not only does the longevity of the retiree matter but also the longevity of the surviving spouse.

The most common approach to address longevity is for retirees to assume they will live longer than what statistics say to expect, and to spend prudently. Longevity can also be factored into the retirement income plan by investing a portion of the retirement asset portfolio in products that pay lifetime benefits (i.e. insured products); or if the retirement asset portfolio contains no lifetime benefit products, by calculating a spending rate that uses a longer-than-average longevity assumption.

10. Is the plan easy to understand and manage? A plan should not be more complex than necessary to accomplish its goals. In addition, the retiree’s (or the financial planner’s) ability to manage complexity must be factored into the plan design. A simple plan is more likely to be properly executed and its management can more easily be delegated if the retiree becomes unable to manage his financial affairs.

Conclusions And Next Steps

Identifying the features of a successful retirement income plan is relatively easy. Building and managing one can be significantly more difficult. The bright side is that most people may enjoy financial security during retirement by saving enough, spending wisely and making prudent investment decisions.

Retirees’ circumstances change regularly, so there are typically many opportunities for refinements to even the most effective retirement income plan.

Matt Smith is senior vice president at Aon Consulting, Minneapolis, Minn. You may e-mail him at matt_smith@aon.com.