Many people presume that inheritance planning issues are solely the domain of the rich.
But think again, because not having a bequest goal can be costly to you or your clients!
Longevity risk, from an individual’s perspective, is the chance that someone might outlive their savings. It’s a well-known issue that’s widely discussed in the media.
But retirees face another legitimate financial planning risk: the risk of failing to achieve one’s legacy goals, or the bequest risk. This has received much less attention than it should.
The word “risk” usually connotes a downside to protection; something that needs to be reduced. Bequest risk does not fall in this category.
Leaving a bequest that is less than desired may cause disappointment. On the other hand, leaving a bequest that is more than desired may be the result of unnecessarily curbed spending and enjoyment through retirement.
Both are undesirable outcomes!
We believe that all retirees should incorporate a bequest goal into their planning. This goal may be to leave nothing behind, or the so-called “die broke” objective. If this is the goal, then an individual’s retirement strategy should leverage their personal assets in a way that maximizes recurring income during retirement.
Alternately, a bequest can involve large legacies for a spouse, children, grand-children, great-grand-children, charities or others.
It all depends on an individual’s personal situation, capabilities, needs and preferences.
Poor financial planning means not having a bequest goal at all. If, on the other hand, leaving an inheritance is important to you or your clients, it makes sense to plan accordingly.
A bequest goal should be somewhat independent of time of death, which is generally unknown at the beginning of retirement.
Let’s look at a practical example
A 65-year-old widowed woman with one son, who is currently 35 years old, might use the following approach: withdraw funds at a certain rate periodically, such as 4 percent, with a high degree of confidence that this source of income will last until she is 90 years old.
Assuming that future investment performance behaves exactly as planned, many things can happen. Let’s look at three different scenarios:
- The woman passes away at 70 years old: She would leave a significant bequest.
- The woman passes away at 90 years old: She would leave no bequest.
- The woman passes away at 100 years old: She would leave no bequest and would have required some financial support prior to that.
Why would it make sense for this woman to leave a significant bequest to her son when he is 40 years old (scenario A), or no bequest when he is 60 years old (scenario B)? Scenario C is obviously undesirable and is commonly known as… longevity risk!
From the son’s perspective, he faces:
- A significant bequest in possibly his prime earning years.
- No bequest when he may start thinking about retirement.
- A liability while he may be in his retirement.
The presence of lifetime income in a retiree’s portfolio helps mitigate bequest risk. Lifetime income sources can include traditional defined benefit plans and social security as well as insurance annuities (in their distribution phase).
A pure lifetime income annuity such as a single premium immediate annuity (SPIA) without a death benefit provides no bequest. But while the retiree is alive, the ability to pool mortality experience generates a recurring higher dollar amount than a fixed income security with a similar credit rating. These recurrent dollars allow the retiree to depend less on periodic withdrawals from the remainder of their portfolio to pay for recurring expenses while alive, hence making the bequest less dependent on time of death.
Lifetime income helps retirees control how much of an inheritance a retiree can able to leave. In general terms, for a given constant reasonable spending flow through retirement, lifetime income decreases a bequest if the retiree dies earlier than expected, and increases a bequest should the retiree live longer than expected.