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“De-Risk” Your Retirement Income

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This is the first generation that does not have a defined-benefit plan to fall back on.  We’ve gone from defined-benefit plans where the employer made all the decisions and took all the risks to where employees make all the decisions and take all the risks.  We had this big transition from defined-benefit to defined-contribution plans and we are discovering that these 401(k) plans aren’t working very well.

The industry buzz word for the actions that companies are doing is called, “de-risking” as they rid themselves of future risk and liabilities. But the risk doesn’t just disappear; it’s transferred from shareholders and executives to employees and retirees, who often are poorly equipped to handle it.  Companies have been able to shift longevity risk to retirees, as well as investment risk, interest-rate risk and inflation risk.

Investment risk is very real as a market downturn is “inevitable.”  If retirees haven’t rebalanced over the past six years during the bull market, then it’s very possible that they could be relying too heavily on equities.  Recovering from financial losses can be extremely difficult in the retirement years. In many instances, this problem forces people to withdraw retirement savings to cover their living costs

One standard rule of thumb for asset allocation is to subtract your age from 120 to determine what percentage of your portfolio to put in stocks.  If you are 60, that would mean 55% in stocks.  One thing we learned from the last recession is that having too much stock, based on your target retirement age, in your retirement account can expose your savings to unnecessary risk.  That’s a recipe that could spell disaster for some Boomers.

Today’s defined contribution pension pots tend to be seen in the terms of the fund size – often running to many thousands of dollars – giving a distorted sense of wealth when not put into the context that it must provide income for as many years or decades as it is needed.

As traditional pensions disappear, retirees are stepping up their purchase of annuities, which promise pension-like, lifetime income.  A blend of life annuities and withdrawals from an investment portfolio is recommended as the best policy for individual retirees.

One explanation for greater interest in annuities is the increase in life expectancy.  Longevity risk relates to not knowing how long a given individual will live.  With life expectancies now moving into the 80s and, in quite a few cases, the 90s, retirement assets still need to be invested for the long-term – even if you’re retired.  As ninety becomes the new seventy, the risk of running out of retirement savings becomes all too real.  Longevity risk is one of the key risks that can be managed effectively by an income annuity.

Investment and sequence risks are also alleviated through the more conservative investing approach for the underlying annuitized assets. Sequence risk relates to the amplified impact that investment volatility has on a retirement-income plan sustaining withdrawals from a volatile investment portfolio. This amplified investment risk also forces a conservative individual to spend less at the outset of retirement in case their early retirement years are hit by a sequence of poor investment returns.

People with defined contribution pensions (401K’s) can choose whether and how much of the fund to convert into a guaranteed income.  In order to “self-annuitize,” a retiree has to spend more conservatively to account for the small possibility of living to age 95 or beyond while also being hit with a poor sequence of market returns in early retirement.

The regular payment received in return for a lump sum offers a shield from market volatility, fixing the return rate regardless of what equities and other investments do.  The insurance-company annuity acts just like an old-fashioned company pension, providing a steady, lifetime income stream.

The income annuity supports a higher spending rate and a license to spend more from the outset of retirement.  Income annuities support longevity through risk pooling and mortality credits rather than through seeking outsized investment returns. Do you want to shoulder all of the risk, or do you want to transfer some of the risk?   Annuities are contractually guaranteed transfer-of-risk products.

Much like a defined-benefit pension plan, income annuities provide value to their owners by pooling risks across a large base of participants.  An income annuity also avoids sequence risk because the underlying assets are invested by the annuity provider mostly into individual bonds, which create income that matches the company’s expenses in covering annuity payments.

Retirees could probably “maximize their utility” by holding a mix of investments and annuities.  A combination of annuities and investments could give many retirees the most income and the most peace-of-mind in retirement. Surveys of retired readers show that having a pension — guaranteed income — correlates with satisfaction in retirement.

Income annuities are a form of insurance. They provide insurance against outliving one’s assets. In the same vein, someone who purchased automobile insurance might wish they had gone without if they never had an accident. But this misses the point of insurance. We use insurance to protect against low-probability but costly events. In this case, an income annuity provides insurance against outliving assets and not having sufficient remaining income sources.

Annuities are effectively an insurance policy against living beyond expectations. You just have to hope you live long enough to not regret it.  This is an incentive to commit at least part of your retirement portfolio to an annuity, as it provides some guaranteed income regardless of longevity and the risk of outliving your retirement savings. This may also alleviate anxiety over the rest of the portfolio, which can be given a higher-risk investment profile.

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Friday, August 7th, 2015 Wealth Management

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