Retirement Income for Life
There was a time when a retiree didn't need to worry about balancing the need to leave an inheritance with the need to have guaranteed income for life with the need to enjoy a decent standard of living.
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That's not the case anymore. Now those on the cusp of retirement and those already living in retirement need a better mousetrap. Today, they need to look beyond their traditional mix of stocks and bonds to building a portfolio that consists of all their sources of capital.
What's more, they may need to incorporate some of those not-so-well-understood products, such as longevity insurance or single-premium immediate annuities or variable annuities with guarantees, into their portfolios. Or at least, they should if they want to be prudent.
Now, we've written about this in the past, when it was part theory and part test model. But now the concept of constructing a portfolio designed to accomplish multiple goals, including not outliving your assets, is more of a reality. There are companies building and selling software designed to help you manage and allocate your capital in ways that take into account what are often conflicting goals. There's an endless amount of new research on the subject. There are even new self-help books.
So what's the latest thinking on how to integrate all these new products into your portfolio? Here's what experts had to say.
Retirement risks
For starters, you can't build a retirement-income portfolio without taking into account all the risks that retirees face in managing their investments, according to Michael Henkel, a managing director of Envestnet PMC, which sells a retirement-income software program to firms in the financial services industry.
Those include longevity, the risk of living longer than expected and running out of assets; inflation, the risk that you lose purchasing power over time; sequence of returns, the risk of experiencing (as many did in 2001 and 2008) bad market returns early in retirement and suffering losses from which it's difficult to recover; and volatility of returns, the risk that is typically associated with investing in stocks and bonds.
Many products, similar objectives
The next order of business is to get a sense of the universe of retirement-income products that you can use to address those and other risks.
There are at least nine broad categories focusing on retirement income, according to Ernst & Young. Those include target-date funds, life insurance, variable annuities, fixed annuities, long-term-care insurance, payout funds, fixed index annuities, combination products (annuities plus long-term-care insurance, or life insurance plus long-term care), and payout annuities.
To Henkel, there are four large groups: systematic withdrawal, which is what most retirees use today; single-premium immediate annuity; variable annuity with guaranteed lifetime withdrawal benefits; and single-premium immediate variable annuity.
But no matter how many retirement-income products there are, a few things are certain. Henkel said these products all have their strengths and weakness and none are silver bullets; none of them completely address all retirement risks. "There is no one-size-fits-all solution," Henkel said.
What's more, some of these retirement-income products might accomplish similar goals, but work very differently. For instance, payout funds — mutual funds designed to pay out a certain amount of income to retirees — are similar in some ways to payout annuities. They are, however, very different in other ways, including the fact that annuities are more expensive than mutual funds, while payout funds have no guarantees but annuities do.
Which retirement-income product you add to your portfolio might depend more on the adviser you're working with and what regulatory body oversees that person (state insurance departments, FINRA, or SEC) and what business model they use (fee, or fee-plus-commission, or commission only) than anything else.
Measures of success
According to Henkel, would-be retirees and retirees need to determine the best product mix in ways that accentuate the strengths of the various products and offset the negatives. And the best way to do that is to understand how those products stack up against these three measures:
• The probability of retirement success. This is the probability that the retiree will not run out of money while still alive. That depends on two things: the random returns of the retiree's investment portfolio and the random time of death.
• The magnitude of retirement income. This is the projected amount of total retirement income over the life of the retiree.
• The expected discount bequest. This is the present value of any inheritance that the retiree wants to leave.
Assessing how all those products perform against those measures of success isn't easy for the average Joe. It requires a little bit of computing power, but getting a sense of whether the retiree will or will not run out of money is the most important measure, Henkel said.
But it's also important to put that measure into perspective. If one product or strategy gives you a 75% probability of success and the magnitude of the failure is just a few thousand dollars and another strategy or product gives you an 80% chance of success but the magnitude of failure is $100,000, then it becomes clear which product you might choose, all else being equal.
The big trade-off
Moshe Milevsky, author of the just-published "Pensionize Your Nest Egg: How to Use Product Allocation to Create a Guaranteed Income for Life," says the single most important trade-off that "retirement transitioners" have to get comfortable with is the relationship between legacy and sustainability. Do you want your money to last or do you want to leave an inheritance to loved ones? That's it.
"The legacy value is an estimate of what you want to leave for the next generation, while sustainability is about securing an income that you can't outlive with high probability," said Milevsky, whose work is incorporated in Envestnet's software. "There is an economic trade-off between the two."
So, for example, products like single-premium life annuities, with no refunds or certainty periods, create high sustainability value, but will kill the bequest or inheritance, he said.
In contrast, life insurance will increase the legacy value but will create a drain on the portfolio, Milevsky said. There are premiums to pay and the opportunity cost of the cash value. That, in effect, reduces what he calls "income sustainability."
"Any sort of structured product — such as a guaranteed lifetime withdrawal benefit or an equity index annuity — will create greater sustainability, but has some expense to the legacy value," Milevsky said.
"What people have to do, therefore, is decide where they want to live on the retirement-income frontier, and then select the appropriate product allocation," Milevsky said.
The optimal retirement product mix
Understanding those trade-offs is indeed helpful. But the key to building the optimal retirement portfolio requires that you take into account gender, health concerns, longevity, retirement age, risk tolerance, bequest desires, and the desired annual income as a percentage of wealth.
When all those factors are added into the mix, things get a bit trickier. Take, for instance, a husband and wife, both 65 years old, who don't want to leave any bequest and who plan to withdraw 4% from their portfolio. That couple could put the bulk of their assets into a single-premium annuity and maybe some into the capital market (stocks and bonds).
But if that same couple wanted to leave a bequest of 30% and withdraw 6%, the mix would change. In that case, the couple would invest 100% of their assets in stocks and bonds and nothing in a single-premium annuity.
Ultimately, Henkel said building the optimal retirement portfolio is a bit like the experience one has when going to the eye doctor. The eye doctor shifts around various lenses asking "Which is better? This or this?" ultimately narrowing down the prescription to the one that's just right. Getting to the right prescription is a time-consuming exercise. But it's an exercise well worth the effort.
Robert Powell is editor of Retirement Weekly, published by MarketWatch.
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