Strategies To Consider When Building An Effective Retirement Income Plan

The challenge in building an effective retirement income
plan is to use available income tools and tactics in a strategic manner to meet
the financial goals of retirement while also managing the risks confronting
those goals. The financial goals of retirement include sustainably meeting a
lifestyle spending goal for as long as one lives, providing a legacy for the
family or community, and maintaining liquidity to cover unexpected expenses and
contingencies in retirement.

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Meanwhile, the three major categories of risk for a
retirement income plan include longevity, market volatility, and spending
shocks. Longevity risk is the possibility of living longer than planned, which
could mean not having resources to maintain the retiree’s standard of living.
Market volatility is the risk that poor market returns are realized, leading to
a reduced portfolio value and a reduced ability to maintain the retirement
standard of living. Taking distributions from investments in retirement further
amplifies market risk by increasing the importance of the ordering of
investment returns. This is called sequence-of-returns risk. Finally, spending
shocks are the risk that expensive bills materialize, such as for long-term
care or health care, which require large expenditures that deplete assets and
reduce the ability to maintain lifestyle at later ages.

Retirement income planning is the field of financial planning which addresses this challenge. It is still a relative newcomer within financial services, and it continues to experience growing pains and disagreements about the best way to help retirees succeed. In reviewing existing approaches, I have identified two very distinct schools of thought for managing the finances of retirement.First, probability-based advocates generally support using an aggressive investment portfolio with a large allocation to stocks to meet retirement goals. My earlier book How Much Can I Spend in Retirement? A Guide to Investment-Based Retirement Strategies provides an extensive investigation of probability-based approaches. With these investment solutions, a higher lifestyle may be supported if one is willing to spend and invest aggressively in the hope of subsequently earning higher market returns. Should decent market returns materialize, investment solutions can be sustained indefinitely while also helping to support legacy and liquidity. Probability-based advocates are generally comfortable with the expectation that decent returns will materialize such that these approaches will probably work just fine.

However, an investments-only mind-set is not the optimal way
to build a retirement income plan. There are pitfalls in retirement that we are
less familiar with during the accumulation years. Traditional wealth management
is not equipped to handle longevity and sequence risk in a fulfilling way.
Retirees must self-manage longevity and market risk, which means more assets
are required to cover spending goals over an assumed long time horizon combined
with the possibility that poor market returns chip away at the portfolio.
Nonetheless, longevity protection is not guaranteed with investments and assets
may not be available to support a long life or legacy. For retirees who are
worried about outliving their assets and not successfully meeting their
lifetime financial goals, probability-based strategies can become excessively
conservative and stressful.

My most recent book is primarily about the other school of thought: the safety-first approach to retirement income. Safety-first advocates support a more bifurcated approach to building retirement income plans that integrates investments with insurance, providing lifetime income protections. Probability-based advocates generally view annuities and life insurance as unnecessary in retirement. They see the stock market as a straightforward way to obtain superior retirement outcomes. Safety-first advocates disagree.

Risk pooling with insurance provides an alternative means
for potentially earmarking fewer assets to cover lifetime spending goals,
effectively reducing the potential overall cost of retirement. With risk pooling,
one does not need to plan for the very expensive case of an extremely long life
combined with poor market returns. Instead, the retiree pays an insurance
premium that will provide a benefit to support spending if those risks
materialize and retirement becomes more expensive. An unprotected investment
portfolio may otherwise deplete. Insurance companies can pool sequence and
longevity risks across a large base of retirees, allowing for retirement
spending that is greater than the sustainable withdrawal rate from investments
for someone self-managing these risks. When bonds are replaced with
insurance-based risk pooling assets, retirees can improve the odds of meeting
their spending goals while also supporting more legacy at the end of life,
especially in the event of a longer-than-average retirement.

Lifetime income through insurance, whether that be annuities
or life insurance, can help to manage market volatility and investment risks,
to protect from longevity risk, to more efficiently earmark assets to cover
retirement spending, to reduce the fear and worry that many have about
outliving their assets in retirement, and to simplify the financial plan.

We walk through this thought process and logic in steps,
investigating three basic ways to fund a retirement spending goal: with a bond
ladder, with a diversified investment portfolio, and with annuities and life
insurance. We consider the potential role for different types of annuities
including simple income annuities and their various flavors, variable annuities,
and fixed index annuities. When we properly consider the range of risks
introduced after retirement, I conclude that the integrated strategies
preferred by safety-first advocates, which combine investments and insurance,
support more efficient retirement outcomes that better support spending and
legacy.

This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon.

 


Originally posted at https://retirementresearcher.com/strategies-to-consider-when-building-an-effective-retirement-income-plan/

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