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Risk of Dying Too Late

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During retirement, people need to convert a pot of accumulated assets into a stream of regular cash flow akin to the monthly paycheck they received during their workdays. The assets you have accumulated and grew over your working life are meant to provide you retirement income.  The challenge is anticipating potential swings in the value of those investments while providing a relatively predictable level of income.

Adding to the challenge, with the increasing cost of medical needs, increasing life expectancies, as well as fewer pension benefits and Social Security benefits, retirees are finding it harder to get by on the amount of savings that they had previously thought would be adequate.

Greater life expectancy also revealed itself as a source of anxiety when investors were asked what they perceived to be the greatest risks to financial futures, with the second most popular answer being clients having to spend more than they earn.

Since the financial crisis, there’s no question that the nation’s population is concerned about their financial standing. Plenty of investors saw the huge declines in their portfolios, while others had their pensions stripped or other financial hardships.

On the heels of such events, there’s one fear that the majority of soon-to-be retirees share, the most common shared concern is living beyond their savings — a.k.a. running out of money.

However half of over-60s say they have no idea how to convert a pension pot into an income when they retire.  Retirees have depended on the 4 percent rule to help guide their future financial planning since the mid 1990s. The rule goes that if a retiree withdraws up to 4 percent from their savings every year, their nest egg should last for the next 30 years. However, it seems the rule is out of date with current economic realities of low returns.

How much retirees can safely withdraw from their retirement account each year is a mostly a function of current stock values and interest rates, which tend to predict near-term returns. And when stock market valuations are well above and bond yields are well below their historical averages, as they are today, retirees should withdraw much less than 4% of their portfolio, assuming they want their nest egg to last over the course of their household’s lifetime.

An initial withdrawal rate of 3% might be an even safer starting point. “Since there are so many variables – age and remaining lifespan, longevity, risk aversion, asset allocation, and the like, it’s hard to say anything really general except that the finding is that ‘3% is the new 4%.

Today, the choice is effectively an annuity versus income drawdown, both of which have their advantages and their faults. By offering structured payouts in the future, an annuity can give some sense of security to a retiree that’s concerned about outliving their income.

For Americans who will not be retiring with a meaningful stream of pension income, income annuities offer that potential. Because an income annuity is purposefully consuming both interest and principal to create an income stream, the individual distributions are likely to be higher than anyone could justify taking from a balanced portfolio of investments, where maintenance of the principal balance is often the goal.

The purpose of an annuity is always income, whether you need money now, or in the future.  It can be helpful to think of an annuity as being similar to other types of investment vehicles.  For instance, a CD is an investment vehicle between you and a bank, and a municipal bond is an investment vehicle between you and a municipality.  An annuity is an investment vehicle between you and an insurance company.

While overweighting a retiree’s income portfolio with income annuities may be problematic, avoiding the income solution may not be in the retiree’s best interest either. Income Annuities, while underwritten by bonds, prove to be better bonds in respect to retirement income because of their ability to pool risk. Risk pooling is combining the uncertainty of individuals into a calculable risk of large groups.

A life annuity’s main strength is that it creates a “Personal Pension” income stream by insuring the “Risk of Dying Too Late.”

Monday, December 9th, 2013 Wealth Accumulation

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