Retirement income webcast: Turning clients’ dreams into reality

The following is an edited transcript of a webcast held May 11 in New York. InvestmentNews deputy editor Evan Cooper was the moderator.
InvestmentNews: We will begin by asking each panelist to give a recap of their talk at the 2010 InvestmentNews Retirement Income Summit in Chicago. Charlie, your session was titled “Income Producing Assets as an Annuity Alternative.” Tell us how to provide retirement income without using annuities.

Mr. Farrell: The core of my presentation was about looking at the securities that many advisers use every day from an income perspective as opposed to a price perspective. If you look at the price of a stock over the last 10 years, the markets in general have been very volatile. But if you look at the income that you can generate from certain types of equities, it actually is amazingly stable. And it’s the same with the bond market. While bond pricing might move dramatically, if you actually focus on the income component in the bond market and you combine that with a healthy and growing dividend stream, you can produce a stable and growing income stream through-out someone’s retirement by using a lot of the securities that are right there in front of us but that we don’t normally view from an income standpoint.

InvestmentNews: Is your approach to replace or to supplement annuities?

Mr. Farrell: It really depends on what you value. We value owning and controlling the assets, so we try to think of securities that our clients can own directly but that will actually produce income comparable to the income they would achieve from an annuity. That’s not going to be the right approach for everyone, and annuities do provide an easy way to secure an income stream.

If you’re 65 and interested in purchasing a lifetime income stream, a single-premium immediate annuity is like a private pension. It’s a fixed-income stream for the next 25 or 30 years, or however long you last. If you go out in the bond market and you look at long-term-bond yields and the yield to maturity on bonds that are comparable in credit rating to the insurance companies that you would buy the annuity from, or even on the bonds from some of those insurance companies, the yield is pretty comparable to the income stream you could generate from the annuity. So it is not really a question of which one is better; it’s really an issue of what you value. And I value controlling and owning the assets, which we think is important for clients. Others may like the simplicity and straightforwardness of an annuity. Both can produce guaranteed income.

InvestmentNews: Jack, at the summit, you spoke about new paradigms in retirement income products. Tell us what you see on the horizon and some of the products that financial advisers may be using.

Mr. Morrone: I use traditional managed mutual funds for the most part, but my approach in analyzing them is different from most advisers’. About six years ago, I was introduced to a tool, BetaVest, which helps me build financial plans. Basically, it is a different form of Monte Carlo simulation. Because my clients may have a mistrust of computer-generated numbers, I tell them, “I have tested your plan 3,000 times.” Since they have vivid memories, I am able to take their concerns about being able to afford living 35 years in retirement and show them what would have happened to their money over every 35-year period that ever existed. They can relate to that, and it helps them understand the planning process. They understand that I don’t know what will happen to them in the future but that I am able to have a discussion with them about their odds of success.

I can stress that for every possible time period, I was able to dollar-cost-average out of their funds and end up with a successful outcome. Then I compare that information to the results from other funds. As a result, I work with funds that I believe are highly likely to support a systematic-selling program and not erode the original principal.

InvestmentNews: Kevin, you speak to a lot of advisers around the country. What is the state of adviser readiness for retirement income?

Mr. Seibert: Many advisers are thinking that they still have time because our first baby boomers just turned 64 and became eligible for Social Security benefits a few years ago. We now have 18 years of baby boomers coming through the pipeline.

But you can’t wait for those baby boomers to begin hitting the shore; you have to be out in your boat right now helping them think about retirement income management and what is different about it. You have to help them identify the risks they face during the retirement years that they didn’t have during the accumulation years. And certainly, in terms of opportunity for advisers, it’s all about the consolidation and repositioning of all the client’s assets. You can’t do a good job of retirement income planning unless you do that. And frankly, if I had a practice today, I would certainly be focusing on retirement income management. For that, the key is training and finding a program that focuses on a process.

Mr. Farrell: A lot of it comes down to getting into a business structure where you can effectively deliver a higher level of service. When you have someone 40 or 45 in the wealth accumulation stage, the amount of service they need is much less in many ways than someone who is 65 or 70 and needs to live off his money. Older investors have monthly distribution issues and tax issues. So in order to do a good job, you have to have a good sense of where they are in their complete financial picture, what risks they face, what expenses they have, what debts they carry, what assets they have available to produce income and how much risk they want to take.

Without having access to the bulk of their portfolio or their entire portfolio, it is hard to give good advice. It’s also hard to profitably give clients the level of service they are going to need at that point in their life.

Mr. Morrone: Something else to consider is risk. There is a misunderstanding of the definition of “risk,” especially among a whole contingent of people coming through an 18-year wave of thinking about risk versus reward. While they’re thinking of balancing equities and bonds, the risk I care about is the risk that they will run out of money.

The only way that I can build something that has a chance of becoming their income stream for life is if I know how their asset base is constructed. My analogy is to the sign at the pharmacy desk that says, “Tell your pharmacist about other drugs you are taking.” I need to know what else is happening, and I’d rather know it real time rather than get a statement every quarter or once a month or having to chase it down.

InvestmentNews: Charlie, how do you answer clients when they ask, “How much can I take out?”

Mr. Farrell: One of the easiest ways to think about how much an investor can take out is to think of it like running a business where you have a base distribution, or a draw. A lot of advisers who have their own practices have a draw that they think they can meet every month and can comfortably cover, and then a bonus. If you view the 4% as the draw and anything above that as the bonus, that’s a good way to envision what your retirement distribution rate might be. There will be times when the markets are tough and equity prices are down that you are going to need to be at 4%. So I think investors need to be prepared to live on a 4% draw.

But there are other cycles that will support 5% and cycles that will support 6% — and even a few that would have supported 7%. So it’s probably unrealistic to think that a client can or will have one distribution rate for a 25- or 30-year retirement. Depending on the cycle and the year, you are probably going to have multiple distribution rates, probably somewhere between 4% and 6%.

As a result, the role of the adviser is to help the client understand when they need to be at 4%, when they can go to 4.5% or to 5%, or even 6%. And again, it is like a business — a base and then a bonus.

InvestmentNews: Jack, what is your reaction?

Mr. Morrone: I agree with that, although I think the beginning number is closer to 5%, but that is probably for someone in their early 60s. If the client is in their mid-50s, I suggest they take less than 5%. And if the person in front of me is 78, I don’t really have a problem with a number in excess of 5%.

Most retirees start at one rate and rarely change it, which actually increases the chances their money will last, because they rarely ask for an annual raise. It’s not unusual to find that three, five or even eight years go by, and clients have somehow managed to keep their same income stream. That’s been helpful because they are not compounding a bad year by saying, “It’s January — give me more.” Whenever one of our clients has a withdrawal rate in excess of the high 4% range, I start getting worried — and I tell the client they should be worried.

Mr. Farrell: If you go back to the concept of running a business, I like clients to consider their cash reserves. If a client tells you about having to repair a roof, for example, or to help a child that needs care, you must get a sense of how much that would cost, and park an adequate amount of cash in a reserve account that they could spend down without having to liquidate securities at the wrong time.

InvestmentNews: Kevin, could you discuss your conversion from being an annuity hater? Is there anything about annuities that is different, and what made you change your mind?

Mr. Seibert: What I didn’t understand about annuities is that you get actually more income from an annuity safely than you can from that 4% to 5% withdrawal rate from a systematic-withdrawal plan. The other issue with systematic-withdrawal plans is that even if your Monte Carlo simulation gives you a 90% or 95% chance of success, if things go bad, they can go very, very bad, very, very quickly.

I definitely would not put everything into an annuity, but from an income or product allocation perspective, it is another form of diversification.

Mr. Morrone: I agree with that. Success means you don’t run out of money, which begins with an understanding that black swans have happened before.

You can’t always count on good years. They might come two or three in a row before you hit a bump, or even longer. From the late “70s to 1999 or 2001 — depending on your perspective on when things started to go wrong — there was a 20-plus-year period where all that happened was good. If you go back to earlier patterns, you just didn’t see year after year of only good results. There might be two good years in a row and then one bad, or two bad years in a row and then a good year.

That’s why it’s important to have a process in place with your client that involves educating them about the expectations they should have for how investments behave. If you have that process, you are setting them up so they won’t be disappointed when investment results aren’t up to expectations.

InvestmentNews: Do you see a high-quality variable annuity with a guaranteed-minimum-withdrawal benefit as a draw-income element for providing a base level of income?

Mr. Morrone: I do. Sometimes the terminology is different and there are reasons why some insurance companies position theirs as an income benefit, while others position it as a withdrawal benefit, but some kind of guaranteed-minimum-withdrawal benefit is important in retirement in order to make sure that some cash flow is guaranteed and that it will never be zero. That plays an important role in many retirees’ plans.

Mr. Farrell: I agree that you have to figure out a way to secure a base income stream. Some people may want to use immediate annuities; others may want to use a variable annuity with a guaranteed-minimum-withdrawal benefit. We do it a little bit differently. We don’t use generally either one of those products but basically different types of assets.

InvestmentNews: How much of a portfolio would you put into an annuity? What are the factors you consider?

Mr. Seibert: A lot of companies are working on tools to help optimize a portfolio from an income allocation perspective, including incorporating an annuity. Those tools and resources are just around the corner, but you want to keep it as simple as possible. For many clients, it may be as simple as going over essential and discretionary needs. If there is a gap between what those lifetime-income sources like Social Security and pensions provide and what those essential needs are, then that is one place where you can look to fill the gap through an annuity. Discretionary needs would be met with a systematic-withdrawal plan.

Mr. Farrell: Because an annuity’s income stream is fixed, that often presents a lot of challenges to individuals who retire at age 65 and calculate they need X amount to purchase an annuity that will cover their fixed expenses. By the time they reach 75 or 80, their fixed expenses may be much different. Since inflation-adjusted annuity payouts are around 4% to 4.5%, you can produce almost the same types of distribution rates by maintaining ownership of your assets.

If you crank down your distribution rate to 4% or 4.5%, you have a pretty high probability of not only inflation-adjusting it but having it last your lifetime — and a lot of times having multiples of what you started with.

InvestmentNews: Is it a fair characterization of the investing public — or your clients, perhaps — that a significant number really have no idea about the reality of retirement income?

Mr. Farrell: That is probably a fair statement. Most people don’t have a sense of how much in financial assets they are going to need to support themselves. And it’s a Catch-22. They are underfunded when they start retirement, because they have been spending too much, and then they move into their retirement years and think they can take out 6%, 7%, 8% or something like that. It is a real problem because the expectations are so out of whack with where most advisers would agree they need to be.

InvestmentNews: How do you tell them that what they have in mind can’t work?

Mr. Morrone: In our practice, I do the analysis and probability piece of the plan in front of the client. It’s a way of showing them that I am a mechanic for all their assets and that I have accounted for how it is currently constructed. I show them their Social Security stream of income and their pension, and then show them how those leave a void or a gap. Then we discuss ways to fill the gap.

InvestmentNews: Do you go over their spending patterns?

Mr. Morrone: Yes, I give them homework. I ask them to tell me how they are going to spend their money. I want them to at least represent what they are currently spending and what they think they will spend in retirement. I tell them that the way they live in retirement probably will change a bit, so I am not going to hold them to a specific number, but it’s a place to begin our analysis. Then I push the start button on our analytical tool and show them that in 50 iterations, their spending plans work only 69% of the time. Given those odds, they face only two or three alternatives — retire a bit later, spend less or invest in a way that might provide a better chance of having the money last.

They see it right there with me and are engaged in the process and follow along pretty well.

InvestmentNews: Which is more difficult, being a retirement adviser and trying to meet people’s unrealistic expectations or being an accumulation adviser?

Mr. Farrell: The retirement income part is more difficult because there is so much more at risk. You don’t have a do-over, which means there is more liability for the adviser. Once clients stop working and they have a fixed pool of capital to work from, they may push you into taking more risk than you are comfortable with, or into letting them take out more distributions. In five or 10 years, if they are not where they think they should be, you face a much more difficult issue because they are out of options. Because there is a lot more at risk in the retirement income area, you have to be selective about who you are willing to work with just from a business risk management standpoint.

Mr. Morrone: I agree that be-cause there is more risk and the work is harder, it is clearer when the client is not a good fit. When that’s the case, it’s best to tell the prospect or the client that they would be better off with a different adviser.

InvestmentNews: What is the most important goal for people between 50 and 60, cash accumulation for retirement income, retiring existing debt or planning for long-term health care needs?

Mr. Seibert: I don’t know that you can really look at one mutually exclusive of the others. It is all part of the plan, and what makes it more complex is that there are lots more moving parts and trade-offs to consider. Not only must you look at the long-term-care plan, you also need to make sure that you try to reduce debt at the same time. It all depends on where the client is in relation to his goals; one objective isn’t necessarily more important than another.

InvestmentNews: With limited funds available, what should go first?

Mr. Farrell: In my experience, the people who enter their retirement years with debt have the hardest time. While you should plan for long-term health care expenses, which are a real risk, a lot of people may not run into that. So if someone chose not to plan for it and gets lucky, they can go through their retirement years without ever having a significant health care ex-pense. Debt seems most problematic because in periods like this when you have low interest rates and declining asset values, having to keep feeding the bank every single year can just destroy your retirement savings. If people don’t have to pay anyone, they can live very happily on less because they control their lifestyle.

Mr. Morrone: I would agree that eliminating debt should be a priority. But I would only prioritize it if the effort actually accomplished something. If you’re trying to pay down a 30-year mortgage, for instance, and you only manage to shave off a year, it may not be worth it. If extinguishing debt can actually happen, make it a priority. But if you aren’t going to reduce your debt to zero at retirement or soon thereafter, maybe the effort isn’t worth it.

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