THE BENEFITS OF GUARANTEED INCOME
J. Michael Agan

J. Michael Agan is Assistant Vice President of AXA Distributors, LLC's Advanced Markets Group. The material discussed herein is the opinion of the author and is not the opinion of AXA Distributors, LLC, AXA Equitable, or any of its affiliates.
 
 
 

IF YOU ARE a financial advisor, you may be forgiven for missing an event that could well impact the way your business is conducted for the rest of your career. In October 2007, the Social Security Administration received the first ever application for retirement benefits by a Baby Boomer, making it perhaps one of the quietest ‘big events' in the financial services industry.

However, while historic today, it will become extremely commonplace as it re-occurs more than 77 million times over the next two decades. As this unprecedented wave of the U.S. population transitions from work to retirement, you, as an advisor, will be presented with many opportunities to advise Baby Boomers on retirement income planning and the benefits of guaranteed income. To capitalize on this demographic situation, however, you may need to re-tool a significant portion of your practice from a focus on wealth accumulation to that of wealth distribution.

So what is retirement income planning? It is a process in which the practitioner seeks to provide a client with the stability and security of monthly paychecks, while managing withdrawals and assets that are intended to last throughout the client's lifetime. This article may help you take the first steps in retirement income planning with your clients and arm you with useful information that can be readily and easily shared with them. In addition, it will specifically address retirement risks that your clients face and suggest ways to help them meet many of these challenges.

Getting started

The first step in retirement income planning is to understand your goals for your client. First, adequate income must be provided for life and protected against retirement risks that can jeopardize the stability and duration of income streams. Second, you should familiarize yourself with the two basic methods of producing cash flows:

• Systematic withdrawal plans (SWPs)
• Guaranteed living benefits

SWPs enable a client to ‘self-fund' retirement income by allocating assets to stocks, bonds, and cash instruments, and then liquidate them systematically to supplement other guaranteed sources of income, such as Social Security and pensions. The advantages of this approach include control, ability to monitor costs, and greater access to assets. In addition, the client's investments may have greater growth potential as a hedge against inflation. The disadvantages include exposure to longevity and market risks, as well as the potential complexity of managing various investments and distribution strategies.

Guaranteed living benefits, such as variable annuities (VAs), invest in a portfolio of stocks, bonds, and cash instruments. Those with living benefits, such as guaranteed minimum income or withdrawal benefits, may provide a minimum income stream for the life of the owner. Additionally, the owner may receive some downside protection in the event of volatile markets. This additional layer of protection is provided at an additional cost and is subject to limitations (which are detailed in the prospectus). The advantages of these guaranteed living income benefits include protection against both longevity risk and market risk by acting as a safety net for the owner. Disadvantages include limited liquidity, control, and cost. From a cost perspective, however, it is important to remember that the fees associated with VAs pay for benefits that might not be available in other investments, such as a guaranteed income stream, and living and death benefits.

A man at age 65 has a 46% chance of living to age 85 and a 24% chance of living to 90. A woman at age 65 has a 56% chance of living to age 85 and a 35% chance of living to 90.

Once you are familiar with SWPs and VAs, you will learn that the two are not mutually exclusive. In fact, in many cases, the best overall strategy may well include leveraging components of both to provide retirement cash flows for clients.

Understanding, communicating, and limiting risk

The three largest risks most of your client will face in retirement are:

• Longevity risk,
• Market risk, and
• Inflation risk.

Longevity risk is the challenge faced when a client or spouse lives significantly longer than anticipated or planned for. To help clients understand that they may be underestimating their life expectancy, simply ask them how long they think they will live. They might be surprised by the actual statistics. A man at age 65 has a 46% chance of living to age 85 and a 24% chance of living to 90. A woman at age 65 has a 56% chance of living to age 85 and a 35% chance of living to 90.

Market risk is the possibility that the downward movement of the capital markets will have a significant and adverse effect on a securities portfolio that your client is relying on to produce retirement income. To help your client understand this and why their retirement portfolio must be different, you can introduce the 'paycheck effect.'

When Baby Boomers were accumulating their nest eggs, they probably didn't pay attention to every fluctuation in the capital markets. When the stock market went down, it probably had little effect on the paycheck they received from their employers. Therefore, they could ride out market fluctuations that did not impact their immediate lifestyle. However, things change when we rely on the income and perhaps even the principal generated by retirement savings. In other words, our ‘retirement paycheck' can be significantly impacted by the market.

Subsequently, market risk is increased and the ability to mitigate risk through diversification is limited. Traditional long-term strategies can be problematic, because they are geared to provide an average return that is sufficient to meet future goals. A retiree needs income each year; therefore, what the market does in any given year or sequence of years is generally the greater determinant of success. To illustrate this, let's examine a hypothetical situation.

Suppose you have a client with a $1 million portfolio at retirement. It is determined that they need $35,000 per year in income, indexed to inflation, to supplement other guaranteed sources. You have projected that this is attainable with a modest 5% average rate of return. The life expectancy (length of retirement) of your client and spouse is 30 years.

The average return for both scenarios A and B is 5%; however, the market declined for the first three years in retirement under scenario A, resulting in a dramatic difference in how long the money lasted and how much was left over after 30 years.

Inflation risk reflects the eroding effect that increasing costs have on retirement income streams. The following table illustrates the purchasing power of a $1,000 cash flow value over time in different inflation environments. Imagine telling your clients that they could lose almost half of their purchasing power in just 15 years.

Living benefits and insurance against risks

Longevity, market, and inflation risks are the Achilles heel of even the most thorough retirement income plan. Therefore, part of a comprehensive retirement income plan should provide for certain assurances of income, while insulating the client's portfolio from threatening risks.

Variable annuities with guaranteed withdrawal or income benefits may provide some protection against longevity and market risks by providing guarantees to protect against these risks. These guarantees, however, are different from typical guarantees you might purchase. Generally, a guarantee is a type of safety net that catches you when something goes wrong. In the case of longevity guarantees, you are not guaranteeing against something going wrong, but rather guaranteeing for something that most people feel is very desirable—living a long and prosperous life.

The available downside market protection can provide some insulation from market risk and can help some investors feel better about participating in equities if they know that there is a safety net of sorts. Conversely, without a safety net, investors who rely solely on a SWP to produce income may be less inclined to participate in equities. This may result in a decreased return over time, based on historical averages.

Retirement income planning is a lengthy and time-intensive process. It calls for a great deal of knowledge on the part of the financial advisor, and generally requires the combination of both systematic withdrawal plans and guaranteed living income benefits to help provide holistic solutions for clients. It also requires an understanding of the largest retirement risks—longevity, market, and inflation—so you can help clients understand and avoid the dangers by mitigating the risks whenever possible.