The Evolution of Income

Navigating your clients through the turbulence of retirement

by Herbert K. Daroff, J.D., CFP

Mr. Daroff is a contributing editor to LIFE&Health Advisor, and is affiliated with Baystate Financial Planning, in Boston. Connect with him by e-mail:

As I write this article, the DJIA is up over 16,000. Many investors who ran to variable annuities for protection from down markets are experiencing buyer’s remorse. “Why am I paying for an income base that is now lower than the fair market value of my account?” Client memory is so short!!

They are questioning why they are paying for any investment advice at all. “Why not just buy the index? Why do I need you?” Clients are so fickle!!

We show them the many periodic tables of what’s been up and down over the past so many years, and they begin to flash back to why they hired us in the first place and why they took our advice. How many of you create an Investor Policy Statement for your clients? An investment policy statement is a signed understanding of the basis for investment advice. In its simplest terms it spells out the client’s:

  • Investment Objective — what is the purpose for this money? (education, retirement, etc.)
  • Time Horizon — when will this money be needed? (10-years, 30-years, etc.) and over what period of time will it be used (5-years, 30-yesrs)
  • Risk Tolerance — how do you feel when your investment values go down

Ask any search engine for sample investment policy statements. All of the information is on your broker/dealer or investment advisory firm’s paperwork. Google has 7.42M choices. Financial Planning Association (FPA) on its website recommends a book written by two people with whom I have served on industry committees, “Creating an Investment Policy Statement: Guidelines and Templates” by Norman M. Boone, MBA, CFP® and Linda S. Lubitz, CFP®.

Ask any search engine for a risk tolerance questionnaire. Google has 1.61M choices. My favorite single question is,

“If you bought a stock for $10 and sold it for $12, but then it went to $15, did you MAKE $2 or LOSE $3?

  • Conservative investors (1,2 or 3 on a scale of 9) answer “Made $2”
  • Aggressive Investors (7,8, or 9) answer, “LOST $3”
  • Moderate Investors (4,5, or 6) don’t answer right away, they are weighing both


Don’t be surprised if you are working with a couple and one answers “MADE $2” and the other answers “LOST $3”. Or the same answers from two separate business owners.
These tools are defensive in nature. They help you explain why you did what you did. But, they also lay a proper foundation for the work you are about to begin and continue on their behalf.

Our focus should always be R.O.I. — but, those letters mean different things at different points in investing:

  • During Contribution, they mean Regimen of Investing, when clients start setting aside dollars for the future, how much they set aside, and how often.
  • We have all seen the “cost of waiting” — if you want $1,000,000 at age 65 and you start at 30, you need to invest $10,544.48/year for 35 years at 5%
  • But, if you wait until 35, you need $14,334.70/year for 30 years — that’s a 36% increase in the amount needed annually
  • And, if you wait until 40, then you need to save $19,994,72/year for 25 years — that’s nearly twice as much as needed if you started 10-years earlier
  • During Accumulation that’s Return on Investment, with a focus on Sequence of Returns and Net Returns (after taxes, inflation, fees, and expenses). The so-called “red zone” of retirement (the five years before and the five years after a client’s retirement date) is a crucial time for investment management. Retiring into a down market requires hedged portfolios, which is also part of distribution planning.
  • During Distribution, that’s Reliability of Income.

What portion of your retirement income will be reliable? How reliable? Will Social Security be there for you? Do you have a company pension plan? Will that plan stay intact for all of your retirement? What if the sponsoring company (your former employer) goes out of business?

Our parents’ three legged stool was a combination of employer pension, Social Security, and private savings. And, retirement was a period under 20 years. Today, retirement can last well over 30 years and most all of our sources of retirement income are from our own savings. Qualified savings is mostly in our own 401(k) plan. Should we be setting aside all of our 401(k) dollars in pre-tax savings or should some be after-tax dollars in a Roth 401(k)? What tax bracket will you be in for each and every year of retirement? Without knowing the answer (and, of course, we cannot, then we need to manage the risk by having some of each). But, with either 401(k) or Roth 401(k), where’s the reliable income?

“If you bought a stock for $10 and sold it for $12, but then it went to $15, did you MAKE $2 or LOSE $3?

So, what are the sources for reliable income (in varying degrees or reliability)?

  • Pension plans from a strong employer
  • Annuities (fixed, indexed, or variable with the proper living benefits) from a strong insurance company
  • Social Security from a strong government
  • Life insurance cash value (in fixed products or variable products with guarantees) from a strong insurance company
  • What else? Anything? — Maybe home equity, as a last resort.

Everything else produces UNRELIABLE income.
So, what is your client’s ratio of RELIABLE to UNRELIABLE income?

If their goal is $100,000/year and Social Security produces $30,000/year with 401(k) savings and traditional after-tax savings producing the other $70,000/year then their ratio is:

– Reliable: 30%
– Unreliable: 70%

How do you feel about that? How does your client feel about that?
Wouldn’t you and your clients prefer:

– Reliabvle: 70%
– Unreliable: 30%

So, how do you go about increasing the amount of RELIABLE income:
Step #1: Identify fixed and discretionary expenses in retirement. Determine what amount of income net after taxes in today’s dollars will be needed, using reasonable assumptions;
Step #2 Project guaranteed retirement income from Social Security, Employer Pensions, Annuities, and Cash Value based on reasonable assumptions
Step #3: Project non-guaranteed retirement income from qualified and non-qualified investments
Step #4: Re-position non-guaranteed investments into guaranteed sources

Remember, the goal is to generate income measured in today’s dollars to provide for the client’s lifestyle during retirement, net after income taxes and net after inflation. Fixed Income mandates a declining standard of living during retirement, if we experience any inflation.

Positioning for retirement income, therefore, requires having the right buckets of investments from which to draw retirement income in years with HIGH income tax rates or LOW, as well as with HIGH investment markets or LOW.

For years in retirement with LOW income tax rates and HIGH markets,

  • the traditional retirement savings 401(k), 403(b), IRA, SEP, SIMPLE work
  • along with traditional non-qualified savings and investment accounts

What percentage of all the years in retirement will fit this category? What do you do for the rest of the retirement years?

For retirement income when tax rates are HIGH and markets are LOW, you need “hedged” accounts:

  • hedged against income tax rates like Roth IRA, Roth 401(k), and Roth Look Alike (cash value)
  • as well as hedged against market performance like annuities with the proper living benefits and by placing protective puts, covered calls, stop/losses on investment accounts, but note:
  • mutual funds cannot be hedged
  • individual security accounts can be hedged, but can be expensive if you hold many different securities
  • exchange traded funds and notes (ETF and ETN) can be more economically hedged

Some investors invest for safety instead of paying a fee (options and annuity lifetime benefits) for safety. How do you invest for safety? It used to be that you would allocate more to bonds and cash. How safe are bonds once interest rates begin to ratchet up? Cash may be safe, but it certainly doesn’t work very hard in today’s interest rates. With today’s rates, will bond investments and cash savings maintain a client’s standard of living during retirement?

– For retirement years with HIGH markets and HIGH tax brackets, use the “Roth” accounts and the traditional investment accounts.
– For years with LOW markets and LOW tax brackets, use the traditional retirement accounts and the “hedged” investment accounts/annuities.

Your clients need all four buckets, not just the traditional two. That’s asset LOCATION coupled with asset ALLOCATION.