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Martha Shedden

Retirement Planning > Spending in Retirement

The 5 Elements of a Comprehensive Retirement Plan

By Martha Shedden

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What You Need to Know

  • The decline of pension means planning for the distribution phase of retirement is more important than ever.
  • Morningstar has quantified five ways better financial planning decisions can help clients increase retirement income.
  • A holistic retirement plan should include a dynamic withdrawal strategy and tax planning.

You’ve probably heard the phrase, “It’s not your parents’ retirement.” How true that is today. The distribution phase of retirement financial and tax planning is very different from the accumulation process of investing and saving. And today, it is even more critical to plan for this phase than it has been in the past.

Retirement Planning History

During the rise of employer-provided defined benefit pensions, most older workers were able to count on two guaranteed sources of retirement income — a pension from their employer and Social Security. With two sources of guaranteed, inflation-adjusted income, in addition to savings, retirees could predict and rely on a specific consistent income and standard of living in their later years.

The rise of 401(k), 403(b), IRA and Roth retirement accounts in the late 1970s through 1990s shifted the burden and risks of investment decisions for today’s workers largely to the employee, with some employer contributions.

However, many individuals have not worked for employers who offered these types of accounts, could not count on using them to their fullest potential or simply were not able to save. Others who took on the task of contributing, investing and monitoring their own accounts have achieved mixed results. Those who have work with financial professionals found their advisors, understandably, focused on the accumulation of their assets.

For all of these workers now approaching retirement, the need for their financial professionals to understand the value of providing comprehensive and holistic retirement planning and management is greater than ever.

Comprehensive Retirement Planning

As first mentioned in the 2013 Morningstar study, Alpha, Beta, and Now … Gamma, an increase in retirement income can be quantified by using these five strategies: 1) a total wealth framework (including Social Security), to determine optimal asset allocation, 2) a dynamic withdrawal strategy, 3) incorporating guaranteed income products (i.e., annuities), 4) tax-efficient allocation decisions and 5) portfolio optimization that includes liability-relative asset allocation optimization.

The financial terms “alpha” and “beta” refer to the measure of time and effort spent on selecting “good” investment funds and managers, the alpha decision, and the allocation of assets or the beta decision.

When it comes to retirement income planning, these are just two elements of the numerous financial and tax planning decisions that can have a significant effect on the longevity of portfolios and resulting secure standard of living in retirement.

Therefore, Morningstar suggests using the term “gamma” as “the measure of economic gain from making more intelligent financial planning decisions, which can be quantified by calculating the net present value of the additional income generated by the improved strategy.”

Most workers approaching retirement are not likely to be aware of the significant benefit that can be achieved by considering all financial and tax aspects of retirement. Especially since more than two-thirds (67%) of pre-retirees ages 55 to 65 have not met with an advisor to create a financial plan, and less than one-third (31%) have.

Among the five types of “gamma” that Morningstar tested, using a dynamic withdrawal strategy was determined to be the most important, followed by the total wealth asset allocation approach, and then making tax-efficient allocation decisions. The opportunity is there for financial professionals who focus on offering clients strategic planning to create a tax-efficient sequence of withdrawal and monitoring of their clients’ retirement finances.

Dynamic Withdrawal Strategy

Simply put, this means examining and revising portfolio withdrawal decisions on a regular basis, at least annually, to ensure the portfolio withdrawal amount is still safe and reasonable given the most recent return expectations and expected remaining length of the retirement period. Compared with an assumed constant withdrawal rate of, say, 4% annually, adjusted for inflation, dynamic withdrawal can better track the annual withdrawal amounts based on the ongoing likelihood of success of the portfolio and mortality estimates.

This static withdrawal strategy bases the annual withdrawal during retirement only on the initial account balance at retirement, increased annually for inflation. It is not updated based on market performance or expected investor longevity.

Total Wealth Asset Allocation

True retirement financial security is achieved by obtaining guaranteed, inflation-adjusted income. The knowledge that we will not outlive our funds and can maintain the same standard of living is the definition of a secure retirement plan.

Morningstar defines the total wealth framework as a portfolio consisting of not just financial capital — assets and income sources such as pensions and Social Security — but also other forms of human capital (an investor’s future potential savings). Each of these comprises an individual’s holistic (total) wealth, and each has different risk characteristics.

Tax-Efficient Allocation Decisions

It should go without saying that a retirement financial plan that does not consider the tax consequences of all streams of income is not complete. Taxes in retirement can significantly disrupt the performance and real returns of a portfolio. Complicating the management of taxes is that some funds are 100% taxable, others may be tax-free, and Social Security income may be up to 85% taxable.

By strategizing the sequence and amounts of withdrawals from particular types of accounts, the longevity of retiree portfolios can be improved.

Social Security is one of the first retirement financial decisions to be made. By examining retirees’ claiming age(s), in concert with the tax ramifications of using other funds to bridge an income gap if waiting to claim, a more tax-efficient withdrawal strategy can be achieved.

For instance, using some 100% taxable retirement account funds, to bridge an income gap between retiring and collecting a higher Social Security benefit later, can then help lower income taxes in general and even the percentage of Social Security benefits subject to taxation. Then the eventual fully taxable required minimum distributions at (currently) age 73 will be lower.

The remaining two “gamma” types briefly described below include incorporating guaranteed income products and liability-relative asset allocation:

As a registered Social Security analyst (RSSA), I understand that Social Security is like an insurance product and, for many people, their largest asset, that will pay them a guaranteed, inflation-adjusted monthly income for life.

It therefore makes sense that insurance agents are in the perfect position to be RSSAs. Life and health, long-term care and Medicare insurance are a vital part of retirement planning. Under the right circumstances, similar to insurance, annuity products can be an excellent retirement financial tool since they provide the guaranteed income for life that cannot be created from a traditional portfolio.

Many retirees want to save or accumulate wealth to fund some kind of goal or obligation (liability). Traditional mean-variance optimization of assets focuses entirely on the risk of the assets and ignores the risks of the goals that the assets are meant to fund. It is important to consider the risk attributes of that obligation when building and managing the portfolio.

In addition to the five key Morningstar strategies, I would add in consideration of the long-term effects of Roth conversions when increasing taxes are expected and the use of home equity conversion mortgage (HECM) options such as reverse mortgage lines of credits if applicable.

Comprehensive financial and tax planning and monitoring throughout the retirement years can significantly extend the longevity of portfolios, providing retirees with a consistent standard of living and the peace of mind that they are making the most of their hard-earned assets.

(Pictured: Martha Shedden)

Martha Shedden is the president and co-founder of the National Association of Registered Social Security Analysts (NARSSA) in which she leads the development of the education and training program for all registered Social Security analysts (RSSAs). As an RSSA and CRPC, she is a leading expert in the field of Social Security. She is also the host of a podcast, Social Security: Answers From the Experts. Follow Martha and NARSSA on LinkedIn.

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