Why We Need a New Approach to Retirement Income Planning

In this part one of a two-part series on retirement income planning, adviser Phil Lubinski outlines the challenges facing retirees today. Part 2 will delve into the solutions.
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By Philip Lubinski, CFP®

If you are feeling nervous about funding your retirement, you’re not alone. A survey of more than 3,200 baby boomers by financial firm Allianz found that more than 6 in 10 baby boomers feared running out of money before they died more than death itself. The reason for this anxiety is that retirement has changed significantly over the past decades.

Phil Lubinski, CFP

Phil Lubinski, CFP

Due to these changes, today’s retirees are facing challenges never experienced by their parents or grandparents. Let’s review some of the challenges that have the most impact on your retirement income plan:

A lack of pensions and low pension payouts means retirees must depend more and more on their personal savings to provide income. According to the Pension Rights Center, in 2018 only 1 out of 3 older adults received income from private company or union pension plans, federal, state, or local government pension plans, or Railroad Retirement, military or veterans’ pensions.

The median private pension benefit of individuals age 65 and older was $9,827 a year. The median state or local government pension benefit was $22,546 a year. Considering that most pensions do not provide cost-of-living increases, they cannot alone meet a retiree’s expenses over a 30+ year retirement. Personal savings must be used to supplement their income. The two-thirds of Americans without a pension must rely solely on their savings to provide a paycheck in retirement.

A lack of confidence that Social Security can keep up with inflation and its long-term viability means retirees must consider that it may not provide enough to cover even their non-discretionary expenses. The Social Security Administration reported that half of all people age 65 and older in 2018 received less than $15,516 a year from Social Security. Annual increases to Social Security have averaged 1.4% over the last 10 years, although many expenses incurred by retirees have increased at a much higher rate. As one example, the net cost of prescription drugs rose over three times faster than the rate of inflation over the last decade, according to researchers from the University of Pittsburgh’s Health Policy Institute.

Although it’s good news that we are living longer than our parents and grandparents, increased longevity means retirees must generate more inflation-adjusted income and potentially higher medical expenses in later years. According to the Social Security Administration, a 65 year old male today has a life expectancy 50% longer than a 65 year old had when Social Security was enacted into law in 1935. Additionally, a married couple age 65 has a 48% probability of at least one living to age 90 and an 18% probability of at least one living to 95. As medical treatments improve, average life expectancy for both men and women is expected to increase.

Along with medical advances comes the use of additional procedures and drugs, leading to higher medical expenses especially later in retirement. We are already experiencing the devastating impacts of higher medical and long-term care expenses on retirees’ financial security. The Consumer Bankruptcy Project reported that bankruptcies for retirees over 65 years old have increased 500% since 1991, with medical expenses being a primary cause.

The low interest rate environment over the past few years is predicted to continue, forcing retirees to find alternatives to traditionally ‘safe’ investments. Although bonds have outperformed stocks over the past 20 years, today the yield on 10-year Treasuries has dropped to roughly 0.6% and the 30-year yield is down to 1.3%. This may be good news for long-term investors, but certainly not for retirees who need to generate income in the short term.

Income Planning Strategies Used Today

Despite these dramatic changes in retirement, according to Dennis Galant of GDC Research, 80% of financial advisors continue to use the same strategies today, called Systematic Withdrawal Program (SWP) and the “4% Rule”, to plan for their clients’ retirement income that they used decades ago. The only innovation in retirement income planning in nearly 20 years has been the introduction of annuities with guaranteed income riders. Neither of these solutions adequately addresses nor manages the challenges and risks faced by today’s retirees.

Problems with the SWP strategy and “4% Rule”

1. When SWP and the resulting “4% Rule” were developed by William Bengen and published in the Journal of Financial Planning in 1994, a 30-year life expectancy was used. This may have been a safe longevity assumption back then but hardly addresses the increasing longevity statistics retirees are experiencing now and future retirees will experience.

2. The SWP strategy also assumes that spending levels will remain the same throughout retirement and only be adjusted annually for inflation. Today, retirees’ spending is anything but constant. Most retirees have a spending pattern that can be best described as “U-shaped”. They tend to spend more in the early years of retirement while they are in good health, then their spending naturally slows down as they enter mid-retirement. Spending increases, sometimes dramatically, in the last stage of retirement due to higher medical, long-term care, and assisted living expenses.

3. The “4% Rule” resulting from Bengen’s 1994 analysis claimed that if a retiree were to withdraw no more than 4% from their portfolio the first year of retirement, then no more than 4%, adjusted for inflation, each subsequent year for thirty years, they would not run out of money. Bengen called his rule “Safemax”, a descriptor of the maximum amount you could withdraw each year and still say “safe.” There are problems with still using this assumption decades later.

First, Bengen’s analysis was based on historic market returns between 1926 and 1976. This period does not reflect the market volatility and inflationary periods that we have seen over the past twenty years. Individuals who retired in 2000 have experienced two of the worst U.S. stock market losses in history and three recessions, something their parents never dealt with.

Second, Bengen looked at the performance of a portfolio consisting of 50% S&P 500 stocks and 50% Treasury bonds. Today’s more diversified portfolios contain many more asset classes, including non-U.S. markets and alternatives, where performance is not necessarily correlated. Regardless of the asset allocation, Dalbar and Associates continues to show that retirees find it difficult to stay invested in the market during declines while they are drawing income from a single portfolio. Many move to safer investments at the worst possible time, i.e., when their portfolio value is at its lowest.

4. A SWP strategy can increase your portfolio’s exposure to what is called “Sequence of Returns Risk.” This risk occurs when someone is drawing income from an investment portfolio during a normal market downturn. The portfolio value can potentially drop so low that it is not able to recover when the market does and, because you need to keep drawing that income, the portfolio balance could potentially drop to zero before you die.

For example, if a retiree had retired January 1, 2000 with $1,000,000 invested in the S&P 500 index and withdrew $3,333/month with annual CPI inflationary increases, the investment balance would have dropped to $552,243 by the end of three years. Five years later, this same retiree would have experienced another 37% drop in the S&P 500. This example assumes no management fees or commissions, which would only have made the situation worse. (Source: Ibbotson SBBI Classic Yearbook: Market Result for Stocks, bonds, Bills and Inflation)

Problems with Annuitization

Before discussing the problems with annuities with income riders, we need to define the product. Prior to 2003, the only way to guarantee a lifetime income was to “annuitize” an asset where the investor would exchange a lump sum of money for a lifetime income guarantee. The problem was that to receive the highest payout, the investor had to elect an option that would stop the payment upon their death. Many retirees were uncomfortable with this total loss of control.

After the 2000 bear market, the insurance industry introduced a new type of annuity which guaranteed a withdrawal rate, many of which were set at 5%. This 5% withdrawal amount is guaranteed for the life of the contract owner and, if that owner died, there could be continued benefits for surviving spouses. Also, if there is still a balance in the annuity contract after both spouses have died, that balance could be paid to their beneficiaries.

Despite these improvements, this income strategy has its problems:

1. Although the income is guaranteed for the entire life of the contract owner there is very little probability of inflationary increases. Over a normal life expectancy, a retiree can expect their expenses to double, with some expenses increasing at a higher rate.

2. Annuities with income riders have very high expenses compared to other investment options. It is not uncommon to see internal expenses as high as 3%-4% per year.

3. To guarantee a lifetime income to your surviving spouse many income rider annuities force you to accept a lower beginning income. For many retirees the income provided doesn’t even cover their non-discretionary expenses.

4. Many annuities with income riders are illiquid and charge surrender fees should you change your mind and want to move the money somewhere else. These penalties can range from 10%-20% and last for as many as 10-15 years.

5. If both spouses live a normal life expectancy there is very little probability that the annuity will have a balance that would be paid to beneficiaries.

Old strategies and even newer “product only” solutions do not address the challenges faced by today’s retirees who would like as much guaranteed income as possible but also need market growth to meet ever growing expenses over long time horizons. The key question is how to safely position their assets using a strategy that provides both.

In summary, a good retirement income strategy must accomplish the following:

1. Provide guarantees as well as growth

2. Customize income to meet a retiree’s unique goals

3. Provide asset liquidity to support modifications as income needs, markets and tax laws change

4. Be easily understood

5. Be easily monitored along the way

6. Accommodate multiple product options

7. Be tax efficient

In other words, provide retirees with the confidence to retire, permission to spend and enjoy their hard-earned wealth and provide peace of mind. In Part 2 we will examine a strategy that meets all these requirements and is gaining traction with financial professionals today.

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. www.incomeconductor.com