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Making Retirement Income More Predictable

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The volatility in financial markets in the closing months of 2018 has rightly renewed the vigor with which clients and their advisors are reviewing and benchmarking retirement portfolios.

A market correction should not necessitate a panicked move to scrap the financial plan, move to cash, or to slow retirement savings. In fact, for those systematically saving toward a future goal, this volatility can ultimately be a great ally on the road to accumulation.

(Related: Maximizing the Retirement Paycheck)

Still, many individuals wonder how this accumulation can translate into a stream of predictable income throughout retirement, whatever the state of the markets. “Sustainable” withdrawal rates are a good start, and by using historical data and Monte Carlo testing we can help clients plan for the income that can be generated from a portfolio.

There are some potential issues with the concept of sustainable withdrawal rates, however. Most notably, we must make a planning assumption around the retirement time horizon, and although statistical life expectancies can inform this assumption, we cannot say with any certainty how long an individual client will live.

The dilemma: Assume we planned on a 25-year retirement for our client, Sue.

If Sue ultimately lives only 10 years, our (too conservative) plan forced her to live a less comfortable lifestyle to preserve assets for the later years, but those were not actually needed. Conversely, if Sue lives for 35 years, the probability that she runs out of money compounds because our sustainable withdrawal rate was based on a shorter timeline.

This dilemma highlights two of the challenges that we must address in retirement income planning: longevity and sequence of returns risk.

A white paper by Professor Wade Pfau of the American College examines the efficacy of addressing these risks with a traditional portfolio approach versus a portfolio consisting of investments, life insurance and income annuities. Investments provide necessary liquidity and growth, while the combination of permanent life insurance and income annuities introduces actuarial science to the planning and can lead the individual client portfolio to perform “more like a defined benefit plan,” according to Pfau.

(Related: Balancing the Retirement Income Plan)

Here’s how it works: A client can take a portion of retirement assets and purchase a single premium immediate annuity at retirement. This will generate guaranteed lifelong income that will cease at the annuitant’s death.

Returning to our example, if Sue lives for 35 years she continues to receive income payments every month. But what if Sue dies in 10 years? That doesn’t seem to be a compelling value.

That is where the life insurance comes in: If Sue owns life insurance, then although the income ceases, the life insurance death benefit pays out to her beneficiary. The combination of permanent life insurance and income annuities creates what Pfau calls “actuarial bonds.”

At Barnum Financial Group, we have started introducing this concept to many of our pre-retiree clients to prepare them now to employ this strategy when they reach retirement. We have found that maximum impact is created when clients transition into retirement with their life insurance already in place.

In many of these scenarios, our models indicate clients may be able to increase their retirement income by 10%, 20%, or even more by deploying this strategy versus a traditional sustainable withdrawal rate approach.

But perhaps the biggest positive impact to clients is the psychological benefit of knowing that short-term market fluctuations like those in recent months, or more sedate markets, will not cause them to run out of income, even if they live beyond assumed life expectancy.

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Matthew R. Teel (Photo: Barnum)Matthew R. Teel, CFP, CLU, is a senior vice president at Barnum Financial Group of Shelton, Connecticut, and a registered representative of MML Investors Services LLC.