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Essential versus discretionary: Funding income needs

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Flooring (essential versus discretionary) can be defined as funding essential income needs with less volatile assets, building an income floor, while investing in more aggressive assets for discretionary expenses.

While a probability-based approach, or total return, like systematic withdrawals may be fine for retirees who are comfortable with market risk and adjusting their plans periodically, others will find great comfort in a safety-first approach to retirement income planning. Flooring can provide meaningful psychological benefits to retirees while simultaneously easing some practice-management burdens to advisors.

Imagine flooring as creating a pension-like income in a world that offers fewer formal pension plans. By targeting an income floor amount, and connecting that amount with certain or guaranteed income sources, any remaining assets are freed-up from income generation duties and are able to remain at-risk for purposes of discretionary wants, inflation protection, long term care needs, and giving.

With the concept understood, how might an advisor structure such an arrangement? Typically, the income floor is constructed using either a bond ladder or income annuities. Because either choice allows some degree of certainty of income, it is possible to pair the income generated with the need.

Choosing whether to use a bond ladder or annuity strategy (a SPIA, FIA or VA with a guaranteed income rider) is a matter of prevailing interest rates, and product feature competitiveness. Remember that the goal is to build a lifetime of income, so normal constraints of surrender charges or other liquidity concerns are no longer the highest priority. This is, by design, a long-term strategy.

Remaining assets not needed for income generation in the floor can be deployed in a risk-based portfolio that is congruent with the client’s appetite for risk and likely use. In other words, the principles of prudent investing still apply, but the need for those assets to generate consistent income has been removed, thanks to the income floor.

What are the downsides of flooring? To start, there is a risk that building the floor with bonds will subject a retiree to interest rate risk and reinvestment risk. With rates at historic lows, the future is likely to hold rising interest rates.

If building the floor with a SPIA, the risk of the retiree passing too soon means the premium exchange was not a “good deal.” Yes, that person has passed and likely won’t be too concerned; however, data suggests that we collectively underestimate our longevity, causing few to be willing to pull the trigger on a lifetime income product, no matter how prudent it may be.

With all of this in mind, for whom might a flooring approach be suitable?

  • Retirees who wish to transfer various risks such as: market, sequence of returns, frailty, and advisor risk

  • Those who wish to maximize income predictability (as compared to a probability-based approach, which we covered in the last installment)

  • Retirees who desire a balance between predictable income and asset flexibility

  • People who are comfortable using insurance-based products and/or individual bonds to generate income

While this discussion was never intended to be an exhaustive analysis of flooring, I hope it inspires you to learn as much as possible before committing client assets to an income planning strategy. As a safety-first approach, flooring offers a lot of possibility for those families and advisors who wish to provide certainty and reliability of income.

In the next installment, we’ll discuss “bucketing,” also known as Age-Banded. A rules-based approach to income planning, bucketing seeks to reduce the complexity and duration of a multi-decade retirement into smaller pieces, allowing a better understanding of how the plan and its component parts will operate.