Planning Today: Getting There and Getting Through

How retirement income-adequacy is being redefined

by David Laster

Of the myriad financial risks related to retirement, top of mind for many clients is the risk of outliving their wealth. A recent Society of Actuaries survey found that nearly two in three pre-retirees expressed concern over the prospect of depleting their savings in retirement.

This apprehension reflects an erosion of the “three-legged stool” of retirement: Social Security, employer pensions and private savings.

• Social Security faces growing stress as the ratio of workers paying into the system to retirees collecting benefits continues to decline. Cost may be contained in the future by reducing benefits, raising the retirement age or further taxing benefits.

• Recent accounting rule changes make traditional defined benefit plans more expensive for employers, hastening their disappearance.

• The two devastating market sell-offs of the past 15 years have sharply reduced the life savings of many retirees.

Faced with these challenges, Baby Boomers must manage their savings to last a lifetime and perhaps to leave something for the next generation. Many clients find this a daunting challenge.

Longevity risk

Living longer presents tremendous personal opportunities for our clients, but also heightens their longevity risk – the risk of outliving their wealth. While it is well known that people today are living longer than ever before, few appreciate the magnitude and implications of this trend. For a couple, both age 65, there is a 50-50 chance that at least one spouse will live past age 92 and an appreciable chance they may live far longer (Figure 1). Prudence dictates that clients should not plan to averages. Many will be living to age 90 and well beyond.

Longevity risk can be particularly challenging for two reasons. First, it amplifies other risks. The longer clients live in retirement, the longer they will be exposed to the risks of ongoing increases in healthcare costs, a serious healthcare event resulting in the need for long-term care services, inflation and market turbulence. Second, longevity may catch many clients by surprise. Retirees are far more likely to underestimate life expectancy (62%) than to overestimate it (19%). This may be because people commonly estimate their life expectancy based on how long their parents or other close relatives lived. Life expectancies have grown markedly from one generation to the next, so using relatives as a benchmark can lead people to underestimate their own life expectancy.

Addressing longevity risk

While clients cannot eliminate longevity risk, Financial Advisors can help them mitigate the risk. Here are some practical steps advisors can take to help clients address concerns about their retirement finances:

Make a retirement plan
Clients nearing retirement can benefit from a well thought out retirement plan. Planning can offer direction and comfort to clients on track to retire, and guidance on how potentially to improve retirement prospects to those who are not. With a strategy in place, clients can make prudent decisions on such matters as when to retire, how much they can afford to spend, and when to start receiving Social Security. Many find that the very process of developing a retirement plan can offer a heightened sense of well being.

The need for a retirement plan
One of the greatest threats to a secure retirement is the failure to plan. Most retirees need income from their retirement savings to fund living expenses, making it crucial to have a sound plan. Yet, remarkably, only 44% of workers surveyed report that they or their spouse have tried to calculate how much money they will need to live comfortably in retirement. Planning is one area where Financial Advisors may add substantial value.

Diversify and spend sustainably
Having a well-diversified portfolio is important for retirees, as for other investors. But what is especially critical is a clear sense of just how much they can afford to spend, while allowing this spending to grow with inflation. Our research indicates that it is overly simplistic to recommend, as some do, a single spending rate for all retirees. Sustainable spending rates depend critically on a client’s age, gender and risk tolerance. Table 1 shows our estimates of sustainable spending levels for retirees seeking a moderate level of confidence (90%) that they will not outlive their wealth.

For women retiring at age 65 the sustainable spending rate is 3.9%, very close to the four percent benchmark commonly used in the industry. But in general a 75-year-old can safely spend at a 5.2% rate, and a 55-year-old – who may have many more years to live – should spend at a more modest 3.2% rate.

Men, because they have shorter life expectancies, can in general safely spend a bit more than women of the same age. But couples, who should plan over the lifetimes of both spouses, should spend a bit less than singles.

Finally, it is important for clients who may live another 20 years or more to view themselves as long term investors. This means keeping part of their portfolio in equities, which over the long term have outperformed fixed income investments. Holding a portfolio comprising only bonds and cash may feel “safe” to some retirees but, depending on market and interest rate conditions, can actually elevate their risk of outliving their money. The appropriate allocation to equities will depend on a client’s time horizon, risk tolerance, liquidity needs and specific investment objectives.

Help clients carefully consider when to claim Social Security

The choice of when to claim Social Security is among the most important financial decisions that clients will make. Recent Merrill Lynch research finds that the lifetime expected value of Social Security benefits can exceed $700,000 for many families and that waiting to claim Social Security can potentially boost clients’ expected lifetime benefits by as much as $60,000 to $150,000.

People routinely claim Social Security when they retire, but many stand to benefit from separating the decision of when to retire from that of when to claim Social Security. So even if a client retires at age 62, it may make sense, if feasible, to wait until age 66 or beyond to claim benefits. For example a 56-year-old today, claiming at age 67 instead of age 62 will raise their monthly benefits by one third.

Financial Advisors can add value by helping clients identify an opportune time to claim Social Security benefits, a determination that varies widely among retirees in different circumstances. Some guidelines to consider:

• Those who (due to poor health or other reasons) have relatively short life expectancies should consider claiming benefits at 62, the earliest possible age.
• Unmarried people whose life expectancy is average should consider waiting until age 69 or 70 to claim. Doing so boosts expected lifetime benefits by an estimated 14-18% as compared to claiming at age 62.
• Many married couples stand to gain from coordinating when they claim benefits. Waiting until age 70 to claim can boost a couple’s expected lifetime benefit by over 20% as compared to both spouses claiming at age 62. Since individual circumstances differ, it may make sense for a non-working spouse to claim at 66, not 70.

Allocate assets, where appropriate, to a lifetime income annuity

In preparing for retirement, a key question for clients to consider is whether their guaranteed lifetime income from Social Security, pension and annuities will cover essential living expenses. If not, they should consider whether buying a lifetime income annuity may help them to close the gap. Suppose, for example, a client will be receiving annual pension and Social Security income totaling $40,000, but will need $50,000 to cover essential expenses. The client might consider an annuity that would pay, in regular installments, $10,000 per year for the rest of their life. Annuities are the only financial products available today that can offer a lifetime income regardless of how long a person lives.

The advantages that annuities offer must be weighed against their relevant costs and risks. Variable annuities are subject to Mortality & Expense fees, surrender charges, market risk and credit risk. The funds used to purchase an immediate annuity usually cannot be accessed after the annuity is purchased except through its periodic payments. And buying an immediate annuity might come at the expense of not being able to leave a bequest from the funds used to make the purchase.

What does research on annuities suggest? After studying hundreds of research articles on annuities, Professor Moshe Milevsky concluded that:

Most financial, public and insurance economists would agree (something that is rare) that life annuities, longevity insurance and guaranteed pensions have an important role to play in the optimal retirement portfolio… [A]ll of these researchers agree that life annuities are a legitimate and core product for the optimal retirement portfolio.

And a U.S. Government Accountability Office report notes:

Experts we interviewed tended to recommend that retirees draw down their savings strategically and systematically and that they convert a portion of their savings into an income annuity to cover necessary expenses.

Conclusion

Many of your clients and prospects are concerned that they might outlive their wealth. You can help to alleviate these concerns by being their go-to guide on: retirement planning; spending and investing sustainably; claiming Social Security and lifetime income options. Helping clients with these concerns will help to solidify your position as their trusted advisor. ◊