Delivering consistent retirement income results

The following white paper, “Sustaining Income Through Retirement: Four Strategies for Retiring Clients,” was published by Principal Financial Group in Des Moines, Iowa, and is reprinted with its permission.

Over the next 15 to 20 years, baby boomers are expected to reallocate nearly $8.4 trillion in retirement assets from investment products that support wealth accumulation to those that will support spending needs through retirement (Boston Consulting Group, 2006). Fortunately, today’s retirees have access to a much wider range of strategies for turning personal savings into reliable streams of income than their predecessors had. But for most, awareness and a thorough appreciation of these strategies will occur only with the guidance of a financial professional.

For financial professionals, this monumental shift in both client objectives and in invested assets represents a tremendous opportunity to extend their relationships into their clients’ next life phase.

The objective of this paper is to add to a financial professional’s knowledge base by discussing and contrasting four strategies for turning retirement savings into a sustainable retirement income stream for their clients.

To accomplish this, we will look specifically at the use of mutual funds with automated income payments, variable annuities with guaranteed-minimum-withdrawal benefits, income annuities, and combinations of mutual funds and income annuities.

As we do so, we will examine the pros and cons of each strategy, which might include:

• Access to account balance.

• Market risk.

• Growth potential.

• Guarantees.

• Inflation risk.

• Income predictability.

What is unique about this analysis compared with other research currently available is that wherever possible, we have maintained common assumptions among the four strategies presented. This approach allows for a fairer comparison.

It is our expectation that by delving into the nuances of these four strategies, financial professionals will find themselves better-equipped to help their clients make informed decisions and select a retirement income strategy that best meets their unique needs.

It has been well-reported throughout the media that baby boomers face an uncertain financial future as they transition from full-time employment into their retirement years.

As with prior generations, baby boomers face the twin retirement savings challenges of keeping up with inflation while protecting against losses due to volatile market swings. Baby boomers also face an increased risk of outliving their savings, thanks to increased longevity.

Moreover, as the uncertainty of having enough retirement income has escalated, so has a retiree’s share of the financial responsibility for securing a comfortable lifestyle. Unlike the prior generation, fewer baby boomers can rely on employer-provided pension plans for sufficient retirement income and health care coverage (Department of Labor, Pension Benefit Guarantee Corp., Internal Revenue Service, Department of Commerce, Employee Benefits Research Institute, Bernstein and Mercer Human Resources Consulting estimates). Meanwhile, Social Security will provide proportionately less income replacement than it did for prior generations.

But fortunately for today’s retirees, there has never been a more diverse range of strategic alternatives available for turning personal savings into retirement income. Helping baby boomers identify the best of these strategies and navigate their way through them represents a tremendous opportunity for financial professionals.

This paper is offered as a means of helping financial professionals deliver consistent and insightful guidance in this area. It may also be used as a framework for comparing some of the numerous alternatives available for converting wealth into retirement income so that financial professionals may refine their guidance to serve each of their retiree clients’ specific situations better.

MAINTAINING INCOME

During the wealth accumulation phase, saving — and then saving even more — is the best strategy an individual can follow to improve his or her chances of accumulating adequate retirement funds. Similarly, in the distribution phase of a retiree’s life, the rate at which money is spent is the most important factor in maintaining sufficient retirement income for the rest of his or her life. When deciding on a withdrawal rate, many retirees mistakenly overestimate the return they can consistently achieve in the market. As a rule of thumb, a retiree can withdraw 4% to 5%, adjusted annually for inflation, and still retain a high probability that his or her savings will last through a 25- to 30-year retirement.

While saving more and spending less are the key drivers in establishing and maintaining a secure retirement income, retirees may also improve their income flow by employing thoughtful asset allocation strategies and utilizing innovative retirement products throughout their retirement years (diversification/asset allocation is not a guarantee of future benefits).

Financial experts offer a variety of approaches for generating adequate income in retirement. However, there is no one-size-fits-all solution. For this reason, retirees need education, guidance, appropriate product selection and continuing communication with their financial professional to create and maintain personalized retirement income plans.

FOUR INCOME STRATEGIES

In an effort to help financial professionals provide valuable guidance for their clients, we will explore the differences among four strategies for turning retirement savings into a sustainable retirement income stream. By comparing the strengths and weaknesses of each option, financial professionals can help clients make an informed decision about which strategy best meets each client’s needs.

The four retirement income strategies we will discuss are:

1. Mutual funds with automated income payments.

2. Variable annuities with guaranteed minimum withdrawal benefits.

3. Income annuities.

4. Combinations of mutual funds and income annuities.

Strategy 1. Mutual funds with automated income payments are designed to automatically provide a steady, inflation-adjusted monthly payment, much like some income annuities. But where an income annuity turns a lump sum investment into a stream of payments, a mutual fund with automated income payments still offers access to the underlying account balance. Also, the income distributed by these mutual funds is not guaranteed to be steady — predictable from year to year — or to keep pace with inflation.

Graph 1 shows an inflation-adjusted 5% annual withdrawal rate being taken from a hypothetical retirement mutual fund and represents what the investor is looking for — a steady, inflation-adjusted withdrawal.

But with a mutual fund, if an investor withdraws that desired amount, he or she will have no longevity protection. Once the mutual fund is depleted, the investor can no longer receive income from it. Also, while the potential for investment growth with a mutual fund is appealing, the investor receives no protection against market losses. This means the investor may outlive his or her retirement savings.

Despite these risks, a retiree’s worst-case scenario — outliving his or her income — may not be as probable when mortality is factored into the estimation. As an investor ages, his or her chance of running out of retirement savings increases. And as the chance of running out of retirement savings increases, the chance of the investor being alive decreases.

Investment option fluctuations and longevity are important factors for an investor to consider when considering a mutual fund with automated income payments.

Types of mutual funds with automated income payments. Mutual funds with automated income payments come in two forms: endowment-style and self-liquidating. Each form works in a different way to help control the risk of an investor outliving his or her savings.

• Endowment-style mutual funds. These are designed to last throughout the investor’s lifetime. The in-come payments are linked to account performance. Consequently, in the event of market volatility — be it a rapidly rising or falling stock or bond market — the amount of each distribution check could vary widely from year to year. The potential for such volatility makes it difficult for the investor to consistently budget his or her retirement expenses. So, while this strategy technically does provide longevity protection by providing some income for life, that income may not be sufficient to meet the retiree’s needs.

• Self-liquidating mutual funds. These are designed to completely liquidate over a predetermined time horizon. The investor agrees to that time horizon when purchasing the mutual fund. Instead of spreading out assets to last a lifetime, these mutual funds are designed for the assets to last through the predetermined date. Income is tied to account performance, so income payments may be unpredictable. Typically, investors who select a self-liquidating mutual fund have other assets set aside to cover their fixed expenses in case they outlive the money in the self-liquidating mutual fund.

While mutual funds with automated income payments do fulfill a retiree’s need to generate income, they lack the ability to provide full income for life and the income predictability of other retirement income strategies.

Strategy 2. A variable annuity contract with a guaranteed minimum withdrawal benefit rider is a distribution choice for retirees concerned about maintaining a minimum retirement income. As a variable annuity, the product allows the owner to stay invested in the market, similar to Strategy 1. And the GMWB rider provides a minimum level of income through guaranteed benefit payments.

By opting to receive income payments at a fixed percentage rate for life, a retiree is protected against outliving this particular income stream. The guaranteed portion also establishes an income “floor,” which cushions the retiree against market risk. This means that, regardless of fluctuations in the value of the investment options that make up the variable annuity contract, the retiree will continue to receive a guaranteed minimum income payment for life.

The payment rate that is guaranteed for life differs from product to product and from company to company, but generally ranges between 3.5% and 7%. The older an owner is when he or she begins receiving income from the product, the higher the payment will be.

Benefit withdrawal base. It is important for owners to understand that the guaranteed income payments and fees associated with GMWBs are based on an amount called the “benefit withdrawal base,” not the actual account value.

If income payments are taken immediately after purchasing the GMWB, the benefit withdrawal base is equal to the actual or market account value. For example, if $500,000 is invested in the GMWB, the initial benefit withdrawal base will be $500,000. And while the benefit withdrawal base determines what the withdrawal and fee amounts will be, those withdrawals and fees are deducted from the actual account balance.

The effect of market gains. Be-cause this is a variable annuity product, the benefit withdrawal base has the ability to “step up” in response to market gains in the account value (In addition, some companies include what are called “sunset” provisions on the GMWB, which would terminate the option to step up when the retiree reaches a certain age or after a specified number of years). This step-up enables the owner to receive higher guaranteed income payments. While not modeled in this paper, individuals also have the option of delaying receipt of income and may enjoy step-ups in the benefit withdrawal base until income payments begin.

The effect of market losses. The primary benefit of the GMWB is its guaranteed income payment. This does not, however, mean that the owner’s actual account balance is guaranteed. The actual account balance can decrease due to poor market performance, which can lead to a lack of future step-ups in the benefit withdrawal base. Still, despite this risk, income payments will not decline below the guaranteed level. This is because the payments are based on the benefit withdrawal base — not the actual account value — and the benefit withdrawal base cannot decline due to market losses. Even if the actual account balance declines to zero, the retiree will continue to receive income payments from the insurance company based on the amount of the current benefit withdrawal base. And since the account value is zero, there will be no further GMWB fees.

While the guaranteed income may provide retirees with some assurance, it comes at a price — the GMWB fee. Remember, the GMWB fee is based on the benefit withdrawal base and is providing income protection, so market losses that decrease the owner’s actual account balance will not affect the GMWB fee that he or she will pay. Therefore, if the owner’s actual account balance decreases, but the GMWB fee remains the same, the owner is paying higher fees in proportion to the actual account balance.

Fees associated with the GMWB are the price retirees pay for the assurance of knowing they will always receive a minimum income (Guarantees are based upon the promises and claims-paying ability of the issuing insurance company).

A hypothetical retiree. Given the complexity of the GMWB, it may help to take a look at an example of how it might perform for a hypothetical retiree.

Comparing the GMWB product with the owner’s needs, it is clear that the GMWB generally is not expected to meet retirees’ needs for long-term inflation-adjusted income.

Ideally, a retiree would like a reliable income that increases a little each year to offset the negative impact of inflation. However, any growth in the payments from the GMWB is dependent on account performance. To have any increase in the monthly payments, even just to make up for inflation, the account balance must grow enough from investment returns to exceed the benefit withdrawal base and prompt a step-up.

Annual fees can add up to more than 2.75%. Assuming inflation is 3%, the investment would have to earn a 5.75% return just to make up for the eroding impact of fees and inflation. In order to allow income to step up on a regular basis after withdrawals start, the annual return would need to be at least 10.75%, due to the 5% annual withdrawal.

Given that the account is unlikely to achieve a 10.75% return year after year, by taking just the allowable income for life — even without excess withdrawals — the returns to the portfolio are not likely to offset the income and fees coming out of the actual account balance. Absent a rising account value, the beneficial future step-ups will not occur, making it very difficult for the retiree’s spending power to keep pace with inflation over the long term.

Graph 2 illustrates that a conclusion that can be drawn from this scenario — although many GMWB owners will benefit from occasional step-ups and in-creased income payments soon after purchasing the product, the account balance will eventually decline.

Investment options. Generally, the owner has a specific set of investment options or portfolios to choose from. To maintain consistency, this paper uses a lifecycle asset allocation that starts with 70% equity and gradually grows more conservative. However, some GMWB providers are starting to offer a portfolio with 80 percent equity as the most aggressive investment option. The set of available investment options prevents an owner from being overly exposed to market volatility. Such restrictions are intended to limit the volatility in the underlying portfolio’s market value and reduce the risk that the actual account balance will be diminished by market losses.

The combination of liquidity, equity market exposure and income guarantees that a variable annuity with a GMWB offers is designed to appeal to the risks and fears faced by today’s retirees. However, it is important for owners to understand that these benefits — the income guarantees and step-up values — come at a price: extra fees. Those fees will reduce the account value, and since annual payment increases are tied to account value performance, they can hamper the ability of payments to keep pace with inflation.

Strategy 3. Income annuities turn a lump sum of retirement savings into a regular stream of income. That income stream can be guaranteed for life, protecting a retiree against the risk of outliving his or her savings. Income annuities have no risk from market exposure and maximize spending for an individual. Retirees can also select additional features with this product that will address the risk of their income not keeping pace with inflation or not paying the remainder of their investment upon an early death.

With relatively low fees and fully guaranteed payments, income annuities are generally considered a cost-effective strategy. But, as with all retirement income products, there is a tradeoff.

Chief among the drawbacks owners encounter with income annuities is a loss of control. Once an annuity is purchased, the owner cannot surrender the contract for the cash value. More recently, some income annuities have introduced options that allow a partial level of cash liquidity after the initial purchase. However, when exercising this liquidity option, future payments are reduced proportionately to reflect this return of purchase premium.

Other concerns can be addressed through the selection of additional features, but adding features will reduce the income payment received. Still, the cost may be worth it if those features address key owner concerns, such as:

• The risk of dying before the owner has received much value from the annuity. This risk can be reduced through a refund option, which entitles the beneficiaries of the owner’s estate to either a lump sum or a payment stream equal to the remaining value of the initial premium.

• The risk of the owner’s spouse not being covered after the owner’s death. Owners can choose to base the annuity payments on their life expectancy and that of their spouse. This ensures that either spouse will continue to receive an income payment should the other spouse pass away.

• Inflation risk. This can be controlled by purchasing an annuity linked to the consumer price index. The annuity’s payments increase with the government’s regularly reported increases in the CPI. Another option that addresses inflation risk involves adding a fixed annual increase feature. This gives the owner an annual “raise” based on a predetermined rate.

Although income annuities can create cost-effective, inflation-protected income that is guaranteed for life, they are not a complete solution to retirement income. Retirees need some liquidity to pay for unexpected costs in retirement, especially those that arise in health care. Retirees also need flexibility in spending, as retirement could last more than 30 years and, over the course of time, spending needs are likely to change.

Strategy 4. The income annuity becomes a more effective solution when combined with other investment options, such as mutual funds. By combining retirement-appropriate mutual funds with income annuities, a retiree can enjoy the advantages of each product. While the mutual fund provides market exposure, control, liquidity, and flexibility in spending, the annuity provides a baseline of guaranteed income.

Assuming a retiree has a 30-year retirement, adding a slice of income annuity to his or her portfolio can actually create a higher and more predictable income versus an investment solely in mutual funds. Three investment scenarios, all of which involve the annual withdrawal of a 5% inflation-adjusted income, can better show how this works.

The first scenario uses a portfolio composed entirely of mutual funds. The second has 30% of its value allocated to an income annuity and 70% to mutual funds. The last portfolio has allocated 85% of its value to an income annuity and only 15% to mutual funds. (Note: It would be rare for a retiree to annuitize 85% of his or her portfolio, as it would leave too little flexibility to cover large, unexpected expenses. It is used here simply to paint a clearer picture of the income annuity’s benefits.)

Under these circumstances, the 85% income annuity portfolio generates its entire withdrawal from the annuity, leaving the mutual fund to grow untouched. As the 85% income annuity portfolio demonstrates an annuity can actually help create a higher and more predictable account balance over a long retirement.

Retirees can reap some of those same income annuity benefits by annuitizing 30% of their assets. Doing so provides the owner with a balance between receiving a floor of guaranteed income and maintaining some flexibility against unexpected expenses.

By combining traditional investments, a retiree can generate retirement income that adequately meets all of his or her retirement needs at a low cost. However, this solution is not for everyone. Consider the example of a retiree entering his or her drawdown phase with a significant portion of guaranteed income from a combination of pensions and Social Security. In such cases, retirees may be better equipped to face the unexpected costs in retirement by forgoing an annuity purchase and keeping their remaining savings liquid.

Also, income annuities are typically not appropriate for individuals in poor health, as longevity protection is not the primary concern.

CONCLUSION

After evaluating multiple alternatives, it is clear that no single product or withdrawal strategy is always the right answer for every retiree and every situation. Financial professionals can best help their retiree clients by working with them to understand which features are most beneficial to them given their circumstances, and then help them select the strategy that will best meet their needs.

As the population of baby boomers enters retirement, financial guidance will be an imperative component of this generation’s success in shifting from wealth accumulators to wealth consumers. By assisting retirees with education and guidance, financial professionals can help make the daunting responsibility of planning for retirement more manageable.

Financial professionals can offer solutions to help improve the odds that their clients will receive adequate income during retirement, no matter how long that retirement may be or the extent of the re-sources available to fund it. Fortunately for financial professionals, a multitude of options now exists for providing clients with such guidance, including the four strategies examined in this paper.

Noelle E. Fox is an investment and product analyst, and Drew A. Denning is vice president of income solutions in the retiree services group at The Principal Financial Group.

STRATEGIES To see the white paper and additional graphs, visit investmentnews.com/income.