Retirement Income Planning
The Insurance Industry’s Best Kept Secret
By David E. Wirsing
We’ve all heard about the baby boomer generation and while some might be growing weary of hearing more, the compelling fact is that they amount to almost 80 million people. This significant block of individuals represent almost 30 percent of the population and they are now beginning the process of retirement. It bears repeating even if you’ve heard it before: This is likely to set into motion the greatest intergenerational wealth transfer ever seen in this country.
Boomers control more than $7 trillion dollars of wealth, own 70 percent of the total net worth of American households and are the fastest growing age group in the U.S. Those Boomers who grasp the gravity and adjust their retirement portfolios to cover income planning in addition to asset accumulation will have a head start on a healthy and wealthy retirement. They understand that the distribution of assets will be the most significant financial issue facing those nearing retirement over the next decade or more.
For the past several years the burden of providing guaranteed lifetime income in retirement has been shifting from employers to individuals as defined benefit pensions and reduced employer matching of individual retirement plans becomes the rule. As a result, many retirees will need financial guidance from skilled financial professionals to help them navigate and plan for the various risks they will face in retirement, including growing health and long-term care costs, market volatility, inflation risk, longevity risk and overspending risk. The need to address these risks, along with the sheer number of boomers entering retirement, has put pressure on the financial industry to create new product solutions that will help provide sufficient retirement income. Choosing the right strategy can make the difference between a secure retirement and one of uncertainty and limitations.
Retirement Income Solutions
Below are five possible retirement income solutions available to retirees today, including one that may be the insurance industry’s best-kept secret. All of these solutions may have a place in a client’s overall retirement portfolio.
- Certificates of Deposit (CDs) – CDs and other safe investments are some of the more straightforward financial solutions for creating retirement income. Each year when a CD comes due, retirees can withdraw the interest and rollover the principal into another CD at the current interest rate. CDs are stable, insured and a client knows exactly what income will be produced for the term of the CD. However, if the interest accrued from the investment doesn’t provide enough income to cover their expenses, retirees will then need to dip into their principal, depleting their income-producing assets. CD rates are also not guaranteed from year-to-year and will always vary based on current market conditions. As a result, retirees risk renewing their CD or similar investment at a lower interest rate, providing less income.
- Systematic Withdrawal Plans (SWPs) – Systematically withdrawing a certain percentage or dollar amount from a mutual fund portfolio or other asset account is another method for providing retirement income, and is often recommended by financial professionals. This option offers the advantage of participating in the equity market to help increase a retiree’s overall portfolio and attempt to hedge against inflation. There are, however, no guarantees that the market will perform well, and due to market fluctuations your asset pool could become depleted more quickly than expected. However, these plans do offer some tax advantages under current law, as any long-term gains are paid at a lower tax rate. In order to hedge many of those risks, financial professionals typically recommend that retirees withdraw no more than 4 to 5 percent of their funds each year. However, how many of us could successfully manage our expenses on that amount of interest? Further, to ensure a higher probability of success, retirees would need to either decrease their withdrawal rate below 4 to 5 percent, or start with a larger pool of funds to draw down from, which isn’t an option for many. This leaves open the real possibility of retirees outliving their assets.
- Variable Annuities (VAs) – VAs were developed by the insurance industry as long-term investment vehicles to help pre-retirees save and accumulate assets while participating in the equity markets on a tax-deferred basis. In recent years, there has been an onslaught of “living benefit” options added to VAs, such as guaranteed minimum withdrawal benefits (GMWBs). This option provides a withdrawal provision that can be used to create a guaranteed retirement income stream, regardless of market performance. However, some VAs with GMWBs have been criticized in the media and by financial professionals for having numerous costly fees associated with them, which can eat into the asset. It’s important to note that all VAs have fees, expenses and risks associated with them. All guarantees, including the death benefit payments, are dependent on the claims-paying ability of the issuing company. Assets allocated to the investment divisions are subject to market risks and will fluctuate in value. Withdrawals and surrenders may be taxable transactions subject to ordinary income taxes, and if made prior to age 59 and six months, may be subject to a 10 percent IRS penalty.
- Managed Payout Funds – The mutual fund industry recently created these funds as their answer to the retirement income dilemma. The funds are professionally managed, typically low-cost and convenient. However, the payments are not guaranteed, the income levels can change based on market fluctuations and the fund may dip into principal to provide income, all of which may present a problem to retirees who are looking for a fixed income stream to fund expenses in retirement.
- Single Premium Immediate Annuities (SPIAs) – SPIAs, also known as income annuities or payout annuities, may be the industry’s best kept secret. They provide the most appropriate option if the retiree is looking to optimize income in retirement. SPIAs were designed exclusively to provide retirees with a guaranteed income stream for life, while most of the aforementioned techniques are derived from asset accumulation strategies. Immediate annuities also offer a unique trait called risk pooling. A recent study conducted by two Wharton professors demonstrated that due to this characteristic, an income annuity can generate the same income as a traditional portfolio of stocks and bonds with 25 to 40 percent less money. This is a tremendous benefit for investors who want to maximize the income they can derive from their retirement assets. The primary appeal of a SPIA is that it re-creates the risk pooling advantage found in defined benefit pensions, by allowing retirees to shift some of the risk burden of outliving their assets onto an insurance company. The guarantee is dependent on the claims-paying ability of the issuing company, so the strength of the insurance company you select is important.
The SPIA product has been updated with many new features, such as cash refund and cash withdrawal, which address the legacy and liquidity concerns of the past. In addition, several companies now offer SPIAs that provide inflation protection and interest rate resets to help guard against eroding the purchasing power in retirement. SPIAs are an important tool to help investors meet their basic needs in retirement. This solution helps provide them with peace of mind, knowing that the money will always be there to cover their basic expenses . It can also be shown that guaranteed lifetime income has a place as a new asset class within anyone’s diversified portfolio. By including SPIAs as an asset class, individuals can reduce some of the risks discussed above and reallocate the remainder of their portfolio to optimize value over the long run.
As you can see, one of the best answers for today’s retirees is a familiar product whose time has come. According to the Wharton study referenced previously, there is no other financial product that can provide the combination of benefits that a retiree can enjoy with an income annuity. It may be time to take another look at this “best kept secret” and put it to work for you.
This article was written by David E. Wirsing, a financial adviser with New York Life Insurance Company in Annapolis. It is for general informational purposes only. He can be reached at 410 573-1122.
Individuals should evaluate their personal situation and needs before making decisions regarding their retirement.