By Philip Lubinski, CFP
Genesis of a new strategy
Early in my career as a financial adviser, I provided corporate retirement planning seminars for several large employers in the Denver area. In 1984, one of these employers offered an early retirement incentive to their employees who were at least 55 years old and had enough tenure to be eligible to begin receiving monthly income from their defined benefit pension plan. Although their pension income would be reduced and the earliest they could claim Social Security benefits was age 62, the company offered an attractive cash bonus to the employees who decided to take advantage of this incentive.
Several of my clients who were employed by this company were eligible for this incentive and asked me if they could afford to fully retire. They did not want to accept the incentive only to find out that their income would not be adequate, and they would need to return to work. For those I determined had enough assets to take the incentive, their next question was, “How do we convert our assets to income?” I had no answer for them because our focus had been on accumulating enough savings to retire and I had not given a lot of thought to a retirement income strategy.
As I did research on retirement income strategies and listened to presentations from several mutual fund companies, the messaging was consistent. The fund companies’ presentations would always do a comparison of two individuals, Client A and Client B, who had the same amount of savings and needed the same amount of income. Client A left their money in the bank and Client B invested in the fund company’s growth fund. After drawing income from their savings for 10 years, Client B always had a bigger ending balance than Client A. The presenter would show 10-year rolling periods of time that included market losses. What was oddly consistent across the presentations was that the losses were always in the middle or end of those 10-year cycles. Which begged the question, “What would happen to Client B if they experienced a market loss at the beginning of a 10-year cycle?”
Keep in mind, this was 1984 when sequence of returns risk (discussed in Part 1 of this series) was not a hot topic and I had never heard of it. As I researched 10-year rolling periods in the U.S. market, I didn’t have to look very long to find one that began when the market had experienced losses. Just 10 years before, in 1973, the U.S. stock market had a 10-year period that began with two declines with combined losses of 40%, similar to the decade beginning in 2000. Even using a safe withdrawal rate, I discovered that at the end of the first two years, the retiree’s account would have dropped by nearly 50%. Granted, by the end of the 1973-1982 decade the account would have recovered even if the retiree continued drawing the same income. But was it realistic to think that someone who retired in 1973 and had lost half their savings in the first two years of their retirement would have the courage and faith to leave their savings invested in the market, no matter how many probabilities analyses you might have shown them?
You may think the answer to this problem is simple – just avoid investing retirement savings into products with market risk such as stocks. It is true that a retiree could confidently draw a level income for the rest of their lives by investing in bonds alone if not for inflation. But inflation is a fact of life and it is one of the most significant risks retirees face. Consider our individual who retired in 1973 and lost 50% of their savings in their first two years of retirement. According to the U.S. Bureau of Labor Statistics, they would have faced a 10.5% inflationary increase between December 1972 and December 1974, and a 14.8% inflationary increase just in the 12-month period between March 1979 and March 1980! For a retiree’s income to keep up with inflation, they need their savings to grow and therefore must introduce growth asset classes into their portfolio and accept market risk.
What was also fascinating to me at the time was that there had never been a 25-year time period where small-cap stocks did not outperform large-cap stocks, large-cap stocks outperform bonds, and bonds outperform cash. The challenge was clear. I needed to develop a retirement income strategy for my clients that offered them a combination of growth and guarantees, and, would give them the courage to stay in the growth-oriented portion of their portfolios during periods of market declines.
I determined the solution was a segmented-time horizon driven-asset allocation ladder, and I called the strategy “Time Segmentation.”
How the strategy works:
The key to the success of time segmentation is to never draw income from an account invested in a growth asset class and always have the growth portfolios re-investing until needed for income. The strategy quickly evolved into a 25-year income plan that would divide the retiree’s life into five 5-year time horizons. Having broken the retirement into separate time periods, I could easily determine how much income my client needed during each of those time periods, i.e, years 1-5, years 6-10, and so on. Then I could allocate their savings appropriately and position them in products that had the best chance of delivering that income when that particular segment’s time horizon was completed. We would also incorporate other sources of income into the plan such as Social Security benefits, pensions, rental income, and part-time work. (As I pointed out in Part 1, annuities with income riders did not exist at this time.)
Here is an illustration of strategy:
The savings that were needed to deliver income during years 1-5 (Segment 1) were placed in cash, a money market, laddered CDs or a similar product with no market risk. Personally, I prefer to use a 5-year period certain single premium immediate annuity (SPIA). The savings that wouldn’t be needed for income until years 6-10 (Segment 2) would be invested in a mid-term bond portfolio, a very low equity managed portfolio, or a 5-year multi-year guaranteed annuity (MYGA).
For the savings that would not be needed for income until years 10 and beyond, I would build three separate model portfolios. These portfolios would range from a mix of 50% equity/50% fixed income (Segment 3) to a mix of 80% equity/20% fixed income (Segment 5). In doing so, I would create what is sometimes called a “rising equity glide path.” Basically, the longer the time you have until you need to use your savings for income, the more market risk you can take. This idea is similar to how target-date funds (TDF) are constructed in retirement plans; the farther away from retirement a plan participant is, the more aggressive the allocation of their TDF.
Segments 2 through 5 would re-invest and grow over their designated time horizons after which, one by one, each segment’s assets would be moved to a “no risk” product (like Segment 1) that would deliver income over its designated payout period. Additionally, I would always create an extra segment (Segment 6/Legacy Segment) and invest some of the savings into a portfolio whose goal was to grow back to the client’s original savings amount by the end of the 25-year plan. This was particularly attractive for clients who were concerned that if they lived longer than 25 years, they would not have any more savings to provide income. If they didn’t live longer than 25 years, they liked the idea that they could pass on a legacy to their children.
Here is another way of illustrating time segmentation, which clearly shows the growth and income distribution periods of various segments over 25 years, as well as the legacy segment balance available at the end of the plan:
Most importantly, time segmentation is structured to provide inflationary increases along the way. It was a simple story and one that my retiring clients wanted to hear, ”My strategy will provide you with inflation-adjusted income for 25 years and at the end, you’ll get all your money back.” Obviously, because some of their savings would be invested in the market, I would provide disclaimers that would address the risks and volatility of the markets.
Although the strategy made sense to my clients, the primary question clients would ask is whether they should be putting a large part of their total savings into low risk/low growth portfolios (it takes about 40% of a retiree’s savings to cover the first 10 years of income). My standard response was, “Would you rather focus on getting a higher return on your investments (the ROI of accumulation) or focus on the reliability of your income (the new ROI of distribution)?” In most cases, my clients would quickly say they were more interested in having a reliable income paycheck in retirement rather than chasing returns. Although this seems intuitive it is a change in focus for both retirees and their advisors that is often difficult to make.
Addressing Retirement Risks
In Part 1 of this series, I touched on sequence of returns and inflation risk when discussing the problems around the systematic withdrawal (SWP) and annuitization approaches, but there are additional risks that retirees face. Below I list how time segmentation addresses each of these risks in ways that can be clearly communicated to retirees:
Sequence of returns risk
By always drawing income from a cash equivalent account that has no market exposure, retirees never run the risk of having their current income negatively impacted by normal market downturns. They have a buffer between their current income stream and market volatility. The portfolios in later segments that are impacted by market losses will not be needed for income for years, and most likely will recover prior to being needed for income.
By investing a sizable portion of their savings, i.e., approximately 60%, for ten years and more in growth portfolios, i.e., partially allocated to equity investments, their income will have the opportunity to keep up with inflation over the 25 to 30+ years of retirement.
Loss of principal risk
The retiree’s savings that are exposed to market losses are only those invested in portfolios that will be held (and reinvested) for ten years or longer, thus minimizing the risk associated with shorter-term investing. According to the Ibbotson SBBI Yearbook, there have only been four 10-year periods of time since 1926 that U.S large-cap stocks experienced a loss (using January 1 through December 31 annual returns). In other words, 96% of the time investors in U.S. large caps would not have lost money if they stayed invested for at least 10 years. Today, if you assume the portfolios funding the 10-year and beyond segments are allocated across multiple equity classes and fixed income, the probability of loss decreases even more.
By putting some of the savings aside in a legacy segment (Segment 6) and investing it over the 25-year retirement, there can be money available at the end of the plan to continue income, if needed. These legacy segment assets can either be more aggressively invested in a high equity portfolio, or the longevity risk can easily be transferred to an insurance company through the purchase of longevity products like DIAs, QLACs or deferred annuities with income riders to produce a lifetime guaranteed income stream. Some advisors will purchase a life insurance product with these legacy segment assets that can guarantee a tax-free legacy to their heirs.
Although everyone has a different tolerance for risk, dealing with risk in retirement is much different than dealing with risk while working. Time segmentation has been deemed by experts in the industry to be excellent at helping retirees manage their natural, human emotions and fears. This has been my personal experience with the strategy, as well, over the 30+ years I have spent as a financial advisor working with retirees. By always positioning those portfolios that are subject to market volatility 5-10 years away from the time they are needed for income, and always delivering a retiree’s current income from a product with no market risk, a risk-to-income buffer is created which gives a retiree the confidence to remain invested, even during the worst of market swings.
Additional Benefits of the Strategy
Beyond addressing the risks in retirement, time segmentation provides the following additional benefits to the client:
· The advisor and client can decide on the appropriate mix of growth-to-guaranteed product usage based on the client’s risk tolerance, income needs, and asset balance.
· The advisor and client can create a customized plan that supports that client’s varying income needs throughout retirement, as well as outside goals. The slope of the spending curve will be unique for every retiree even though the investment strategy is consistent.
· The compartmentalization of assets into segments is extremely intuitive to clients as they know exactly where their savings are invested and why, as well as what accounts will be providing income throughout each phase of retirement. This is often called “mental accounting.”
· The advisor and client are free to use different products. A segmented plan can utilize a combination of insurance, bank, and investment products and does not force the client to sell all their current investments to fund the strategy, such as a portfolio with significant unrealized gains. This portfolio could be positioned in the legacy segment and, under current tax law, receive a stepped-up tax basis at death.
· With segmentation, the advisor can develop a tax-efficient liquidation order, using different registered accounts to fund different segments of the plan based on their time horizons.
· Segmentation results in liquidity. As retirement progresses, changes in markets, tax laws, and (most importantly) a retiree’s income needs and goals will require modifying the plan and it is critical that investments are liquid and can be moved to accommodate those modifications.
· Last, but not least, time segmentation creates a WRITTEN PLAN, not just a probability of success.
Time segmentation is not a “set it and forget it” strategy. A time-segmented plan needs to be monitored throughout a retiree’s life. Like all things in life, unplanned things happen that will require the plan to be modified. Also, by focusing on the reliability of the income (the new ROI), segmentation can utilize a “pension focus.” Just like a pension Board, the retiree should only take the amount of market risk needed to provide their income goals. By monitoring the performance of each segment, the advisor and client can take advantage of cycles when the market is doing well to “de-risk” the underlying portfolio to protect the retiree’s income. It is a need-based, not greed-based strategy.
Plan management allows the retiree to get updates on their plan and know whether their individual segments are over- or under-performing and by how much. By having this information, they can make sound decisions with their advisor around plan changes and protecting their income. This gives retirees confidence and peace of mind, knowing they have permission to spend and fully enjoy their retirement
About the author: Philip Lubinski, CFP®
Philip Lubinski, CFP® is co-founder and head of Retirement Income Strategy for WealthConductor LLC. Phil has spent over 30 years as a financial advisor and planner, serving almost exclusively retirement income planning clients. He originated the time-segmented or bucketing approach to retirement income planning and has trained thousands of advisors from around the country on his strategy. Phil has been the intellectual foundation to the development of several income distribution software tools spanning back to the 1990s. He currently helps drive the development of IncomeConductor™ while providing expert case consultation support to its users and creating educational material to benefit advisors focused on retirement income generation for their clients. Learn more at IncomeConductor.
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