investment – Retirement Income Center

If you’re a subscriber to Retirement Income Visions™, you may have noticed that, although there have been nine posts prior to this one, none of them has stayed true to the theme of this blog, i.e., Innovative strategies for creating and optimizing retirement income. This post will be no exception. As the saying goes, there’s a method to my madness. In order to understand and appreciate the strategies and apply them to your situation, it’s important to understand the origin of retirement income planning, including the limitations of the retirement asset planning approach.

As explained in The Retirement Planning Paradigm Shift – Part 2, retirement planning is undergoing a paradigm shift. Instead of relying on retirement asset planning as a solution for both the accumulation and withdrawal phases of retirement, people are beginning to recognize, understand, and appreciate the need for, and value of, employing retirement income planning strategies during the withdrawal phase. No doubt about it, per Retirement Asset Planning – The Foundation, retirement asset planning is the way to go in the accumulation stage to build a solid foundation for a successful retirement plan. However, as discussed in The Retirement Planning Shift – Part 2, as a result of the uncertainty of traditional retirement asset planning as a solution for providing a predictable income stream to match one’s financial needs in retirement, retirement income planning was born.

Is Your Retirement Plan At Risk? introduced six risks common to all retirement plans: inflation, investment, income tax, longevity, health, and Social Security benefits reduction.

Beginning with Retirement Asset Planning – The Foundation, the inadequacy of retirement asset planning during the “spend-down” phase was discussed. This begins with the process itself. Unlike most types of financial planning where you get to see the results of your plan after reaching a specified target date, this is not the case with retirement asset planning since the timeframe is undefined.

Withdrawal Drag – The Silent Killer contrasted the beauty of compound rates of return during the accumulation stage with the erosion of portfolio income and the associated benefit of compounding, otherwise known as “withdrawal drag,” in the withdrawal stage of retirement. There is yet another phenomenon that can wreak havoc on your portfolio if you only rely on a retirement asset planning strategy during your retirement years. The Sequence of Returns – The Roulette Wheel of Retirement exposed this investment phenomenon and provided an example of how “luck of the rate-of-return draw” can prematurely devastate a conservative, well-diversified portfolio.

As if all of these variables and financial phenomenon were not a wake-up call to your planning, we mustn’t forget about the “safe withdrawal rate.” Safe Withdrawal Rate – A Nice Rule of Thumb demonstrated how the widely-accepted 4% “safe” withdrawal rate doesn’t necessarily guarantee that you won’t outlive your investment portfolio. Furthermore, the withdrawal amount that is calculated using this methodology typically won’t match your retirement needs.

All of the foregoing financial risks and phenomenon contribute to the inherent uncertainty associated with the retirement asset planning process during the withdrawal phase of retirement. As pointed out in Retirement Asset Planning – The Foundation, even if you’ve done an excellent job of accumulating what appear to be sufficient assets for retirement, you generally won’t know if this is true for many years

Retirement income planning is truly the end game in financial planning. Assuming that your goal is to generate a predictable income stream to match your financial needs in retirement while minimizing your exposure to withdrawal drag, the sequence of returns, and the various risks common to all retirement plans, it generally makes sense for you to begin employing retirement income planning strategies for a portion of your assets ten years before you plan to retire. The amount of assets and the exact timing of implementation are dependent upon your particular retirement and other financial goals as well as your current and projected financial situation.

Before I write about the specific risks associated with retirement asset planning and the strategies that retirement income planners use to address, and, in many cases, mitigate, these risks, let’s take a look at risks that are common to all retirement planning. While many of these are uncertain and/or uncontrollable, each of them needs to be addressed in a retirement plan.

The risks that will be discussed are as follows, with the first three common to all types of financial planning, and each one intended to be a brief introduction vs. a comprehensive discussion:

Inflation
Investment
Income tax
Longevity
Health
Social Security benefits reduction

Inflation

Although it is unpredictable as to amount and fluctuation as it pertains to individual and overall variable expenses, a key risk that must be considered in the design and funding stages of all retirement plans is inflation. Unlike most types of financial planning where it is a factor only in the accumulation phase, inflation is equally, if not more important, during the withdrawal stage of retirement planning. The longer the time period, the more magnified are the differences between projected vs. actual inflation rates insofar as their potential influence on the ultimate success of a particular retirement plan.

Investment

Unless you are living solely off of Social Security or some other government benefit program, you are directly or indirectly exposed to investment risk. Even if you are receiving a fixed monthly benefit from a former employer, although it isn’t likely, your benefit could potentially be reduced depending upon the investment performance of your former employer’s retirement plan assets and underlying plan guarantees. Whenever possible, investment risk should be maintained at a level in your portfolio that is projected to sustain your assets over your lifetime while achieving your retirement planning goals, assuming that your goals are realistic.

Income Tax

Even if income tax rates don’t change significantly as has been the case in recent years, income tax can consume a sizeable portion of one’s income without proper planning. With the exception of seven states (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming) that have no personal income tax and two states (New Hampshire and Tennessee) that tax only interest and dividend income), the rest of us need to be concerned about, and plan for, state, as well as, federal income tax. In addition, if you have a sizeable income, it is likely that income tax legislation will be enacted that will adversely affect your retirement plan on at least one occasion during your retirement years.

Longevity

Unlike other types of financial planning, the time period of retirement planning is uncertain. Although life expectancies are often used as a guide to project the duration of a retirement plan, no one knows how long someone will live. The risk associated with the possibility of outliving one’s assets is referred to as longevity risk. In addition, life expectancies, themselves, are changing from time to time. The August 19, 2009 edition of National Vital Statistic Reports http://bit.ly/pAgRk announced a new high of nearly 78 years for Americans. Planning is further complicated for married individuals since you are planning for multiple lives.

Health

An extremely important risk that is sometimes overlooked or not given enough consideration in the design of retirement plans is health. Under-, or uninsured, long-term care events as well as premature death in the case of a married couple, can deal a devastating blow to an otherwise well-designed retirement plan. It is not unusual for a prolonged long-term care situation, such as Alzheimer’s, if not properly planned for, to consume all of one’s retirement capital and other assets. Inadequate life insurance to cover the needs of a surviving spouse can result in dramatic lifestyle changes upon the first spouse’s death.

Social Security Benefits Reduction

Once considered to be unshakable, the security of the Social Security system, including the potential amount of one’s benefits, is questionable. In addition, it was announced in May that for the first time in more than three decades Social Security recipients will not receive a cost of living adjustment, or COLA, increase in their benefits next year. While beneficiaries have received an automatic increase every year since 1975, including an increase of 5.8% in 2009 and a 14.3% increase in 1980, this will not be the case in 2010.

Each of the foregoing six risks needs to be considered, and appropriate strategies developed, in the design and implementation of every retirement plan to improve the chances of success of the plan.