Planning for the Phases of Retirement

Will the Income from Your IRA Last Two Lifetimes?

by Brandon Buckingham, JD, LLM

With nearly 10,000 baby boomers turning age 65 each day,¹ more Americans than ever before will be transitioning from the accumulation phase of retirement planning to the distribution phase of retirement planning.

Since most retired couples can no longer solely rely on retirement plans such as Defined Benefit Plans or Social Security to provide guaranteed monthly income, they will have develop a retirement income plan that will transform their retirement accounts, such as IRAs and 401(k) plans, into a steady stream of income that will last two lives.

When approaching retirement age, couples will need to determine the investments, withdrawal rate and order of withdrawals that will create the most sustainable income stream. Retirees who incorrectly structure their retirement assets could face a reduction in retirement income, possibly later in life when only one of the spouses is still alive.

Longevity Risks

Once a healthy married couple reaches age 65, there is a nearly 50 percent chance that one of the two spouses will live to age 92.² Accordingly, most baby boomers need to plan for 30 years in retirement. To plan for that longevity, financial experts suggest withdrawing no more than three or four percent of retirement assets annually.

However, the Required Minimum Distribution (RMD) rules for IRAs and 401(k) plans will eventually require annual withdrawals in excess of four percent. Per the IRS distribution tables, the initial RMD withdrawal rate is 3.65%. As the account owner ages, the RMD withdrawal rate quickly climbs, exceeding 4% by age 73, 5% by age 79, 6% by age 83, 7% by age 86 and 8% by age 89.³

Market Risks and the Variability of Returns

Additionally, IRA owners over age 70 1⁄2 may find that they are required to begin taking distributions at a time when the IRA has had poor performance. Market trends are one of the most important factors to portfolio longevity, perhaps second only to the withdrawal rate. Investors typically spend decades saving for retirement. Systematic investing in a fluctuating market coupled with historically rising trends has helped many savers build sizable retirement accounts. However, when people retire and stop contributing to and start withdrawing from retirement accounts, they become much more susceptible to market risks.

Chances are most retirees will have to live through at least one bear market. In fact, the average retiree will likely face 3 to 5 such bear markets in retirement. Since 1945 there have been 20 market corrections of greater than 10% and 12 bear markets with losses that exceed 20%. The average bear market lasts 14 months with a loss of 33%. Assuming no withdrawals are taken from their retirement savings, it will take the average investor 25 months to recoup those losses. But if withdrawals are taken during a down market, it may be harder or take longer to recoup those losses. This is sometimes referred to as the “sequence of returns” risk.⁴

During the accumulation phase of retirement planning, the sequence of returns do not matter. It’s the average rate of returns that do. Assume an investor had a million dollars in a retirement account and it grew an average annual rate of return of 5%. After 10 years the account would grow to about $1.5 Million. It makes no difference if the investor started saving in the beginning of a bull market or bear market. The sequence of those market returns has no affect on the portfolio while saving for retirement. But the average rate of return does.

However, the sequence of returns matters greatly during the distribution phase of retirement planning. If the investor is forced to take Required Minimum Distributions in the beginning of a bear market as opposed to a bull market the depletion of the retirement account could be accelerated.

Risks of Spousal Impoverishment

In an effort to protect retirement plans, Congress has passed a variety of legislation designed to provide retirement income for both the retiree and the surviving spouse. The Retirement Equity Act was passed due to the “inequitable” possibility that the surviving spouse would receive “no survivor benefits under the plan even though the participant had accrued significant vested benefits before death.”⁵

The concern of Congress was even more acute when the spouse was a homemaker without assets of his or her own.⁶ To remedy this, Congress required all defined benefit plans, and most defined contribution plans, to provide a default payout option of a Qualified Joint and Survivor Annuity (QJSA).

However, the vast majority of plan participants choose to waive their QJSA rights and roll the retirement assets to an IRA because they want the increased liquidity, growth and control of the retirement assets. Unfortunately, IRAs generally provide few guarantees and many clients retirement accounts could be at subject to market and longevity risks.

To help address this concern, some insurance companies have created an annuity product that provides the spousal protection the government has been trying to provide, albeit unsuccessfully, for the past 30 years. Some annuities will offer certain protective riders, for an additional fee, that can address the market, inflation, longevity and timing risks inherent in all IRAs, as well as provide guaranteed income over the lives of both spouses.

For instance, a Guaranteed Minimum Withdrawal Benefit (GMWB) with a “spousal” rider could guarantee a withdrawal rate beginning at age 65 over the lives of both spouses. The withdrawal rate is guaranteed regardless of market performance and regardless of how long the IRA owner and his or her spouse live. Furthermore, some GMWBs “spousal” riders are “RMD friendly” meaning that at any time the RMD exceeds the rider’s allowable withdrawal rate, the annuity will permit such withdrawal without adversely affecting or reducing the guarantee. In other words, the IRA owner and his or her spouse will be assured to receive the greater of the guaranteed withdrawal amount or the RMD each and every year for the rest of their lives.

When considering an annuity for use in an IRA, it is important to note that there is no additional tax-deferral benefit, since these accounts are already afforded tax-deferred status. Thus, an annuity should only be purchased in an IRA if some of the other features of the annuity are of value, such as access to specific portfolio choices, the ability to have guaranteed payments for life and other guaranteed benefits, and you are willing to incur any additional costs associated with the annuity to receive such benefits. The guarantees are backed by the claims paying ability of the issuing insurance company.

Another popular feature of some GMWBs is an automatic “step-up” feature that locks in potential market gains periodically, sometimes daily. These step-up features help IRA owners keep up with the inevitable increase in the cost of living.

Finally, some GMWBs also offer a deferral credit feature that increases the guaranteed withdrawal balance each year a withdrawal is not taken during the initial years. Should the IRA perform well, future step-ups could increase the IRA owner’s guaranteed withdrawal balance and since the deferral credits and step-ups work together, any available credits could be based off of the higher stepped-up amount. This annuity strategy may allow IRA investors to maintain a structured withdrawal program while addressing the longevity, timing, market and inflation risks faced by many retirees. Most importantly, this protection continues even after the first spouse dies.

Before making any election regarding retirement distributions, make sure consideration is given as to how the election could affect the surviving spouse’s standard of retirement living. ◊

Endnotes
1. The Baby Boom Cohort in the United States: 2012 to 2060; Colby and Ortman; May 2014; United States Census Bureau;
2. U.S. Annuity 2000 Mortality table, Society of Actuaries
3. (Source- IRS Publication 590 Section III).
4. Bloomberg Financial, January, 2016
5. S. Rep. No. 98-575, 98th Cong., 2d Sess. 12 (1984)
6. Id.
Prudential Financial, its affiliates, and its financial professionals do not render tax or legal advice. Please consult your tax and legal advisors for advice concerning your particular circumstances.
The Prudential Insurance Company of America, Newark, NJ and its affiliates.