Annuities Deferred Income Annuities Fixed Index Annuities Retirement Income Planning

Is Your Investment Advisor Afraid of Losing AUM?

When it comes to retirement income planning, one of my philosophies is a bird in the hand is worth two in the bush. As defined in Urban Dictionary, this expression means that it is better to have an advantage or opportunity that is certain than having one that is worth more but is not so certain.

One of the ways that I use this approach is to look for opportunities to convert what amounts to a sliver of a client’s portfolio into a deferred sustainable income stream beginning in a targeted year during my client’s planned retirement. The income stream, while it’s often for life, is sometimes for a specified period of time to close a projected retirement income gap (See Mind the Gap).

The opportunities to which I’m referring are sizeable abnormal increases in the stock market that inevitably are followed by market corrections, or downturns. Rather than celebrating what often proves to be temporary good fortune, when appropriate, I will recommend to my clients who need sustainable retirement income that they consider transferring a small portion of their investment portfolio into one or more new or existing fixed income annuities. These include fixed index annuities (“FIA’s”) with income riders, deferred income annuities (“DIA’s”), and single premium immediate annuities (“SPIA’s”).

This is a natural timely conversation that invariably makes sense to the clients to whom I recommend this approach since it is in their best interest. Furthermore, it’s an easy conversation for me to initiate since I specialize in retirement income planning, am a Retirement Income Certified Professional® (RICP®), CPA, CFP® professional, and a licensed insurance agent in addition to my firm being regulated as a Registered Investment Advisor (“RIA”). There’s no conflict of interest when I make the above recommendation to a client since, unlike most investment advisors, my income isn’t tied to a single compensation model.

The compensation model to which I’m referring is assets under management, or “AUM.” While many firms charge financial planning fees, the lion’s share of compensation earned by most traditional investment management firms is derived from AUM. As the name implies, the fee is typically calculated as a declining percentage of the value of a client’s investment portfolio. The greater the value of a portfolio, the smaller the percentage is that is applied to calculate the investment management fee. This is one of several compensation models offered by my firm.

Firms that are tied to an “AUM” compensation model generally don’t offer retirement income planning solutions that require insurance licensing and ongoing specialized insurance and annuity training. Most “AUM” driven firms are reluctant to refer clients to advisors like myself who offer a total retirement income planning approach since, in addition to the obvious revenue loss, this would be tantamount to an admission that they’re unable to provide a total retirement income planning solution.

An “AUM” model, while it’s appropriate for assisting clients with their retirement planning, i.e., asset accumulation, needs, isn’t designed for addressing lifetime sustainable income and other retirement income planning solutions. For clients seeking sustainable retirement income, it’s like trying to fit a square peg in a round hole.

Retirement Income Planning

Do You Have a Retirement Income Portfolio?

Investopedia® defines a portfolio as “a grouping of financial assets such as stocks, bonds and cash equivalents, as well as their mutual, exchange-traded and closed-fund counterparts.” It completes the definition by saying that “portfolios are held directly by investors and/or managed by financial professionals.”

In other words, an investment portfolio consists of a mixture, or collection, of financial assets. During our working years, we typically finance our fixed and discretionary expenses from current sources of employment income, including salary, if we’re employed, and from draws, if we’re self-employed or a partner. Employment income is also used to fund an investment portfolio, including retirement and nonretirement investment plans through, and independent of, employers.

Following the concept that income is required to pay for expenses, when we retire, we need retirement income to pay for our fixed and discretionary retirement expenses. Given the fact that traditional pension opportunities are dwindling, combined with the uncertainty of Social Security in its present form, it’s incumbent on us to have a retirement income plan in place several years before we retire.

Every retirement income plan should include a plan for transitioning a portion, or in some cases, all, of one’s traditional investment portfolio into a retirement income portfolio. The amount and timing of the transition is dependent upon projected non-asset sources of retirement income compared to projected retirement expenses. Projected non-asset sources of retirement income consists of income that you will receive that is independent of assets that you own and are projected to own. This includes Social Security and private and government pensions.

Projected retirement expenses should be the focus of every retirement income plan. While current expenses can be used as a starting point, it’s important to remember that the expenses that we incur today are most likely quite a bit different than those we incurred ten or twenty years ago. Similarly, it’s critical that we visualize our retirement lifestyle since the type and amount of expenses that we incur during our retirement years are likely to be different than what we’re experiencing today. In addition, retirement should be broken down into different stages to take into consideration potential decreased levels of physical activity and different types of expenses associated with each stage.

Care must be taken to include potential extraordinary expenses in one’s list of projected retirement expenses, especially those related to health and long-term care needs. In addition, an appropriate inflation factor needs to be applied to all non-fixed expenses. Furthermore, different inflation factors should be applied to different expenses to reflect the projected reality of the marketplace.

Once we have a handle on our projected annual retirement expenses and subtract projected non-asset sources of retirement income, the difference will be the annual projected after-tax income that is required to be generated from our retirement income portfolio. It is then, and only then, that the individual components that will comprise the retirement income portfolio can be determined. As with traditional investment portfolios, it often makes sense to turn to a professional, in this case a retirement income planner, for guidance.

Retirement Income Planning

Is Your Income Portfolio Plan Laddered?

After ten previous posts, last week’s blog introduced the first strategy for creating and optimizing retirement income – an income portfolio plan. It explained that an income portfolio uses streams of income to close the gap between projected income needs and projected income sources while accomplishing the same objective as a traditional investment portfolio, i.e., minimization of investment risk. It also stated that the investments used to generate the income streams include, but are not limited to, CD’s, bonds, life insurance, and annuities.

Generally speaking, no single investment can be used to fund a financial plan. The success of any plan is dependent upon a combination of investments, each serving a specific purpose, working together to achieve the goals of the plan. In the case of an income portfolio plan, streams of income from several investments are used to achieve the goal of the plan, i.e., to close the income gap, or difference between projected income needs and projected income sources. While the income streams can occur simultaneously, this post discusses sequential, or laddered, income streams.

What are laddered income streams and why should they be used to fund a retirement income plan? If you know that you are going to retire at age 65, live to age 85, your annual expenses will be $60,000 with no changes, there will be no inflation, you will not be subject to federal or state income taxes, your annual Social Security benefits will be $20,000, you have $800,000 that you want to live off of the income and leave to charity when you die, and the interest rate on high-quality 20-year corporate bonds is 5%, you could simply invest your life savings in one or more bonds to generate the $40,000 per year ($800,000 x 5%) that is required to close your income gap (annual expenses of $60,000 less Social Security benefits of $20,000).

As we all know, life is not so simple. There are numerous variables that need to be considered when designing an income portfolio plan. Many retirement plans either assume an initial annual expense amount that increases by a fixed inflation factor from the date of retirement through the date of death or are instead based on a rule of thumb that your retirement income needs to be a specified percentage, say 80%, of your pre-retirement income.

Neither one of these approaches takes into consideration the fact that our financial situation and needs will change at different stages of our retirement years. As a result, the primary goal of an income plan should be to generate different and distinct income streams to match our expense needs associated with each stage while also funding periodic one-time needs, e.g., home improvements, car purchases, child’s wedding, etc.

It’s essential when designing an income portfolio plan to identify the various projected stages, or segments, in retirement and the associated expenses associated with each stage. Once this is done, the projected known income sources can be taken into consideration to determine an appropriate investment strategy for generating specific income streams to close the gap between one’s projected income needs and projected income sources in each stage. Since the projected income shortages will differ in each stage depending upon needs vs. available resources, different types of investments and investment strategies can and should be used.

The end result should be a plan that is designed to generate sequential, or laddered, streams of predictable income to match one’s needs. Like any financial plan, an income portfolio plan needs to be periodically monitored and modified to reflect one’s changing financial situation and needs.

Retirement Income Planning

Do You Have An Income Portfolio Plan?

We’re all familiar with the concept of an investment portfolio. Wikipedia defines it as “an appropriate mix or collection of investments held by institutions or a private individual.” It explains that “holding a portfolio is part of an investment and risk-limiting strategy called diversification.”

A well-diversified, professionally-managed investment portfolio can enable you to pursue various financial goals, including financial independence, in the accumulation stage of your life. As you approach, and move into, retirement, a customized income portfolio plan is essential for enabling you to close the gap between your projected income needs and your projected income sources without worrying about, and being dependent upon, the gyrations of the stock market.

How many of us have heard of a “retirement income portfolio,” or the term that I have coined, “Financial Independence Income Portfolio™?” I would suspect that not many people are familiar with these terms. I will simply use “income portfolio” for the remainder of this post to introduce this innovative planning strategy and explain why it should be the cornerstone of every retirement income plan for all individuals beginning ten years before retirement.

You may be wondering, what is an income portfolio? Whereas an investment portfolio uses a mix of assets, including stocks, bonds, and other types of investments with the goal of minimizing investment risk, an income portfolio uses streams of income to accomplish the same objective. The income streams can be produced at different intervals, i.e., monthly, quarterly, semi-annual, or annual, based on your needs.

There are several types of investments that can be used to generate income streams, each with their own advantages and disadvantages. These include, but are not limited to, CD’s, bonds, life insurance, and annuities.

Depending upon your situation, one or more of these investment vehicles can be used to design a strategy, or plan, to close the gap between your projected income needs and your projected income sources. Similar to an investment portfolio that is used in the accumulation stage, a secondary benefit to be derived from an income portfolio is minimization of investment risk.

It’s a fact of life that, unlike our parents’ generation who could depend on a monthly pension supplemented by Social Security, most individuals retiring today don’t receive a monthly income. Consequently, although no small task, we must create, manage, and protect our own income streams. The means to accomplish this, i.e., an income portfolio plan, should be the cornerstone of every retirement plan for all individuals beginning ten years before retirement.

Retirement Asset Planning

Safe Withdrawal Rate – A Nice Rule of Thumb

Last week’s post, The Sequence of Returns – The Roulette Wheel of Retirement, showed how “luck of the rate-of-return draw” can have a dramatic affect on a retirement asset plan in determining whether you will outlive your investment portfolio. In two scenarios where the retirement age (65), portfolio beginning value ($500,000), average rate of return (7%), withdrawal rate (5%), and inflation factor applied to the withdrawal rate (3%) were identical, and the only variable was good vs. bad early years, there were quite different results. With the “Good Early Years” scenario, after 25 years, at age 90, distributions totaled $964,000, the portfolio earned $1.385 million, and the portfolio value was $921,000. Under the “Bad Early Years” scenario, the portfolio was depleted after 16 years at age 81 after taking distributions totaling $541,000 and the portfolio earning $41,000.

Many people would argue that 5% seems like a reasonable withdrawal rate, however, as we saw, under the “Bad Early Years” scenario, this proved to be too aggressive. The financial planning industry, after many years of debate, has settled on a rule of thumb of 4% as a “safe withdrawal rate.” That is to say, you can withdraw 4% of the value of your portfolio in your first year of retirement and then increase your withdrawal amount by an inflation factor in subsequent years without depleting your portfolio during your lifetime. As an example, assuming a portfolio value of $500,000 at retirement and a 3% inflation factor, you could withdraw $20,000 ($500,000 x 4%) in Year 1, $20,600 ($20,000 x 1.03) in Year 2, $21,218 ($20,600 x 1.03) in Year 3, etc.

Is a “safe withdrawal rate” something we should live by or is it simply a rule of thumb? While a 4% withdrawal rate during retirement can potentially enable you to sustain your retirement capital for the duration of your retirement, this is not always the case, particularly in “Bad Early Years” scenarios. In addition to the withdrawal rate, the interplay of the following ten variables will determine whether or not you will outlive your portfolio:

  1. Type of portfolio, i.e., nonretirement vs. retirement
  2. Income tax rates
  3. Source of income tax payments, e.g., checking account, nonretirement sales proceeds, IRA withdrawal, etc.
  4. Retirement duration
  5. Average rate of return
  6. Sequence of returns
  7. Timing of earning of income
  8. Inflation rate
  9. Frequency of withdrawals
  10. Timing of withdrawals

As an example of the interplay of several of these variables, let’s make the following assumptions:

  1. Retirement age: 65
  2. Beginning portfolio value: $500,000
  3. Average rate of return: 6%
  4. Sequence of returns: Bad early years
  5. Withdrawal rate: 4%
  6. Inflation rate: 3%
  7. Frequency of withdrawals: Annual
  8. Timing of withdrawals: Beginning of year

In this scenario, despite the fact that the withdrawal rate has been reduced from 5% per the “Bad Early Years” scenario in the last post to 4%, which is generally considered to be a “safe” withdrawal rate, by simply changing one other variable, i.e., reducing the average rate of return from 7% to 6%, per Bad Early Years Assuming 6% Average Rate of Return, the portfolio is depleted at age 85. While the frequency and timing of withdrawals in this example may not be typical, the “safe withdrawal rate” of 4% isn’t conservative enough.

There are other scenarios where the interplay of the various variables is such that a withdrawal rate of 4% can prove to be problematic. As is typically illustrated, the previous example assumed an inflation rate of 3% each and every year. What happens if inflation averages 3%, however, the sequence of inflation rates is such that it is much higher in the first five years, say 7%. This would result in larger withdrawals in years 2 through 6, and, depending upon the rate of return, sequence of returns, and duration of retirement, this could result in premature depletion of the portfolio.

Mathematics aside, there are several other issues to consider when planning to use a safe withdrawal rate. For starters, why should you base your withdrawals for the duration of your retirement on the value of your retirement portfolio on a single day, i.e., the day before you retire? Also, it does not consider the fact that a sizeable portion of your expenses may be for mortgage and/or other fixed payments that don’t increase each year, and, as such, don’t require an inflation factor to be applied to them. In addition, the safe withdrawal rate methodology doesn’t take into consideration the fact that we typically incur nonrecurring expenses, planned and unplanned, e.g., new car, home improvements, wedding, etc., in addition to our ongoing expenses.

Another factor not incorporated in safe rate withdrawal calculations is the affect of differences in sources and amounts of non-portfolio income, e.g., Social Security, pensions, part-time income, etc. on portfolio values. What about the impact of inheritances on the amount of subsequent withdrawals? Finally, who is going to be responsible for doing the accounting to ensure that the amount of withdrawals doesn’t exceed the targeted amount in a particular year?

While the amount of withdrawals calculated using safe withdrawal rate methodology may match your income needs in some years, this probably won’t be the case in most years. This is arguably its single biggest weakness. I don’t know about you, but I don’t want to live my life based on a simple calculation that doesn’t consider my changing financial needs. While a safe withdrawal rate is a nice starting point, or rule of thumb, for calculating retirement withdrawal amounts, its limitations need to be considered when applying it to one’s retirement plan.

Retirement Asset Planning Retirement Income Planning

The Sequence of Returns – The Roulette Wheel of Retirement

So here you are, crossing the threshold from earning a living to going into retirement. You worked hard for many years. You built a sizeable, diversified investment portfolio. You hedged your bet by purchasing life insurance and long-term care insurance. Your will and other estate planning documents have been updated to reflect your current goals and financial situation. Everything’s in place, or so you think.

Welcome to the roulette wheel of retirement, otherwise known as the “sequence of returns.” If you haven’t planned for this financial phenomenon, your retirement could be quite different than you envisioned. To illustrate this important concept, let’s take a look at three hypothetical scenarios. In each one we’ll use the following five assumptions:

1. Retirement age: 65
2. Portfolio value: $500,000
3. Annual withdrawals: $25,000, or 5% of the initial portfolio value,
increasing by 3% each year
4. Life expectancy: 25 years, or until age 90
5. Average rate of return: 7%

The last assumption is the most critical one and can wreak havoc on your portfolio if you only rely on a retirement asset planning strategy during your retirement years.

Let’s start with Scenario #1 – 7% Return Each Year. While this scenario never occurs in real life, it’s often used for illustration purposes. Once you review Scenario #1 – 7% Return Each Year, you will see that even after taking out withdrawals that begin at $25,000 and more than double to $52,000 at age 90, your portfolio value increases from $500,000 at age 65 to $576,000 at age 78 and then gradually declines in value to $462,000 at age 90. You’ve taken distributions totaling $964,000 and your portfolio has earned $926,000 over 25 years. Nice result!

Scenario #2 – Good Early Years assumes that you are fortunate enough to retire at the beginning of a bull market where your investment returns exceed your inflation-adjusted withdrawal rate of 5% for several years, you experience a couple of years of negative rates of return, and a bear market kicks in your final three years, resulting in negative rates of return each year. Per Scenario #2 – Good Early Years, although it doesn’t occur in a straight line, your portfolio increases from $500,000 at age 65 to a peak of almost $1.5 million at age 87, with a final value of $921,000, or double the value of Scenario #1, at age 90. Like Scenario #1, you’ve taken distributions totaling $964,000 and your portfolio has earned $1.385 million over 25 years. Life is great!

So far, so good. To illustrate Scenario #3 – Bad Early Years, let’s simply reverse the order of investment rates of return that we assumed in Scenario #2. As in Scenario #1 and Scenario #2, over 25 years, we’re going to end up with the same average rate of return of 7%, however, the first three years are going to be bumpy, to say the least. Unlike Scenario #2, where your portfolio value increases by $208,000 the first five years, going from $500,000 at age 65 to $708,000 at age 70, per Scenario #3 – Bad Early Years, it decreases by $224,000, going from $500,000 at age 65 to $276,000 at age 70, or a swing of $432,000 during the same period.

Your portfolio continues to decrease in value each year until it is depleted at age 81. Instead of taking distributions totaling $964,000 as you did in Scenarios #1 and #2, your total distributions over 25 years are only $541,000. Furthermore, instead of realizing portfolio income totaling $926,000 in Scenario #1 and $1.385 million in Scenario #2 over 25 years, your total portfolio income is a measly $41,000. Yikes!

In both Scenario #2 and Scenario #3, there are negative rates of return in only five, or 20%, of the total of 25 years of retirement. Two years of negative rates of return out of ten years, on the average, is fairly typical for long-term historical rates of return for a diversified equity-based portfolio. As you can see, in Scenario #3, it doesn’t matter that 80% of the returns were positive, nor is it relevant that there was an average rate of return of 7%. As a result of the portfolio being depleted at age 81, the hypothetical individual in this situation wasn’t able to experience the 11.4% average rate of return during the final nine years.

The most important factor in Scenario #3, and the #1 risk to any retirement asset plan, is the sequence of returns. While you have no control over this investment phenomenon, you don’t need to play roulette with your retirement assets.