Low interest rates, market volatility, and longer lives for many Americans have upped the challenge of creating reliable retirement income for clients.
While the traditional 4% annual withdrawal from savings is a good rule of thumb, it’s certainly not set in stone. Research and some financial advisors now recommend levels as low as 2.5%. With all these challenges and some other common pitfalls along the road of pre-retirement and retirement, what is the best path to provide people financial security in their post-employment years?
In a previous article in Think Advisor (Jan. 30) my colleague Matt Teel explained how new research by Professor Wade Pfau of the American College tackles the issues of longevity and sequence-of-return risk.
(Related: Making Retirement Income More Predictable)
The Pfau research and our experience with clients also tells us that familiar methods and techniques can be complementary to the research and can help provide clients with smoother sailing in both pre-retirement and retirement.
Taking a broad overview, traditionally there are two different schools of thought about creating retirement income:
- Withdrawal-based solutions. In other words, there’s a pot of money from which the client will take systematic distributions. Strategies such as a “safe” withdrawal rate, variable spending (adjusting spending based on market performance over time), and “bucketing” (allocating investments by certain time horizon segments throughout retirement) all fit within this category.
- Income-based solutions. These entail leveraging guaranteed income sources such as pensions, Social Security and annuities to cover all or most of a client’s expenses. Techniques such as covering essential expenses with guaranteed income, known as “flooring,” would be an example of an income strategy at work.
We are learning from academic research that incorporating permanent life insurance into retirement income strategies can enhance overall income and increase the probability of success of the portfolio. This can be true when utilizing withdrawal-based solutions or income-based solutions.
The withdrawal-based approach uses life insurance cash values as an asset to pull from in years after a downturn in the market to give the portfolio an opportunity to recover. This is commonly referred to as a buffer strategy. The “sweet spot” is having three to five years of retirement expenses in cash value.
The income-based approach uses single-life single premium immediate annuities (SPIAs) to provide income security. To determine how much to put into an annuity, we look at how much permanent life insurance the client has in force. Whatever the death benefit, that’s how much can go into a SPIA. This allows the client to take the maximum income, leveraging an insurance company’s balance sheet. If the client dies prematurely, the death benefit will be received by the spouse or other beneficiaries to replace the assets — a concept Wade Pfau calls “actuarial bonds.” In either of these approaches, retirement income can be increased substantially.
What we find in practice is that it doesn’t have to be all or nothing, and we can develop an integrated strategy leveraging both schools of thought and produce more retirement income for our clients, based on their preferences. Clients appreciate the flexibility these plans generate and how all the pieces tie together. The key is to have clients understand that they are not locked into one strategy or another now, but rather are creating more options for themselves when they actually get to retirement.
Moreover, there are variations of these strategies that prove useful. For example, our firm has used different types of annuities before the client gets to retirement, such as equity-indexed, structured, and lifetime withdrawal guarantee riders that will provide protection from a downturn in the market right before retirement.
Most importantly, while many clients just want to focus on the end-game of retirement and retirement income, it is imperative to help them understand how pre-retirement risks, such as disability, premature death of one spouse, job loss, or conflicting goals, (e.g. funding a child’s education), will impact their retirement success. An integrated and comprehensive approach can provide the best outcome.