A newly released study by global asset manager Schroders shows almost half of Americans over the age of 45 are concerned about the possibility of outliving their assets. Their concern creates an ideal opportunity for advisors to demonstrate their value. Moreover, as clients track fast-moving market plunges related to the coronavirus pandemic, helping them devise solid income streams is vitally important.
The right approach to creating income streams will depend on your client’s appetite for risk, their tolerance for uncertainty and their expectations for market returns. Start the conversation by discussing two basic approaches.
1. Safety First Seeks Guaranteed Income
Recently popularized by retirement planning expert Wade D. Pfau, the safety first approach seeks financial security in retirement through guaranteed income streams aimed at meeting your client’s spending needs for the remainder of their life. With this approach, your client shifts his or her risk to one or more insurance companies by purchasing immediate and deferred-income annuities or variable annuities with guaranteed withdrawal benefits.
There are, of course, risks associated with even “risk-free” strategies. With most plain-vanilla immediate and deferred-income annuities, if the client were to pass away suddenly, his or her heirs would get nothing (unless the policy has a death benefit). Additionally, if inflation rises faster than anticipated, the value of the future income streams will erode.
2. Probability-based Planning Seeks to Maximize Lifestyle
A probability-based approach to retirement income planning starts with the question of how much your client can withdraw from their portfolio without running out of money. In this approach, your client retains the market risk, as well as control of the assets. Your client invests in any combination of market-driven instruments (e.g., mutual funds, ETFs and other liquid assets) with the goal of generating cash flow to fund their spending needs. An advisor typically uses Monte Carlo simulation to stress test a planned withdrawal rate that will keep the portfolio viable within a given probability distribution. While a 4 percent withdrawal rate is a common rule of thumb, that may be too high (or too low), given your client’s circumstances.
The main risk with a probability-based approach is that your client lives beyond the life expectancy used to calculate their withdrawal rate. In addition, because Monte Carlo simulation relies on historical returns in an effort to predict future performance, future return probabilities will not be perfect. For this reason, it’s important to revisit your client’s spending plan annually to ensure that only small, manageable changes are required over time.
The Practicality of the Matter
For most clients, the answer to the question of income in retirement will be a combination of these two approaches. For example, a safety first approach that covers living essentials (food, rent, healthcare) combined with a probability-based portfolio for discretionary spending (a vacation, charitable giving, a hobby) often works well.
As you broach income planning with your clients, remember there is opportunity in the planning process itself, as well as in finding the ultimate solution. Introduce these two approaches to better understand your client’s attitude toward risk, their concerns and hopes for the future. Putting a plan in place to address a client’s top concern can yield peace of mind and deepen your relationship.