In the popular television sitcom "Home Improvement," Tim Allen's character, Tim "The Toolman" Taylor, went to his neighbor Wilson for advice on many subjects. Usually, Wilson had good advice. When it comes to finances, many turn to their own personal "Wilson." Usually, that advice centers around what rate of return they believe a particular product will produce. But when it comes to retirement income distribution planning, it is not all about rate of return.
Unlike any time in our history, the American investor is continually inundated with financial advice from sources such as CNN, Jim Cramer, Dave Ramsey, Suze Orman, MSNBC, brokers, family, friends, financial institutions and even the cabbie making airport runs. Sadly, the same person who relies on conflicting sources is also the same client who has developed a financial opinion on his or her own, attempts to be his or her own advisor and then focuses on the internal rate of return at every move.
That client usually invests heavily in equities in the hopes of a return that may never pay out, or worse yet, he or she intentionally subverts professional advice, further undoing all the careful planning that was already done. Clearly, the consumer with the lack of coordination and proper strategic modeling is often vulnerable to potential pitfalls that may be ahead.
There are two distinct phases which need to be considered for an upcoming retiree: The remaining accumulation and distribution phases. In the accumulation phase, rate of return is romanticized, but is often not the most important issue. In the distribution phase, there are four methods: Annuitization, Withdrawal Method, Withdrawal Method with a Lifetime Income Protector, and the Time Segmented Method. This article will primarily focus on why internal rate of return is often not the most important issue in the distribution phase.
1. Annuitization
The Society of Financial Services Professionals (SFSP) first released the concept of four categories in a video training conference released in February 2008, entitled "Personal Financial Planning Using Employer Sponsored Benefits and Tools."
The first method, which is Annuitization, uses the technique of annuitizing a lump sum of money in return for the money being systematically distributed back to the retiree over a period of time, generally over one's lifetime. This option may provide an effective high rate of return, when not taking inflation into account over time and based on the value of the original sum of money in the calculation.
The annuitant turns over control of the asset to an insurance company in exchange for the guarantee of an income stream he or she cannot outlive -- a contractual obligation of the insurance company. These guarantees are subject to the insurer's claims paying ability. However, often this also is the biggest concern for retirees. It is the loss of the original asset, which cannot be passed onto heirs. Perhaps, the most effective use of annuitization is earmarking a portion of assets to be annuitized when a retiree lives past his or her life expectancy and other sources of income have been exhausted under the time segmented planning method.
2. Withdrawal
The second method called Withdrawal uses the concept of withdrawing either a fixed or adjusted percentage from a portfolio that is predetermined at the time of retirement between 4% and 5%, or as a predetermined fixed dollar amount.
According to Dick Weber's presentation at the 2009 SFSP Annual Meeting entitled, "Feeding the Income Stream: Strategies for Sustainable Income in Retirement," the withdrawal method is what approximately 50% of Americans choose to do, because it's a simple and appealing strategy. But, "Remember it's not all about rate of return, Tim." The order in which rates of return are applied to a portfolio, as long as the same rates are applied to two different accounts, has no effect on an account value during the accumulation phase. In other words, two accounts with the same rates of return, but in different orders, will have the exact same value at the end of the accumulation phase.
On the other hand, the order in which rates of return are applied has a dramatic effect on account values in the distribution phase. It is for this reason that there is so much concern over the volatility of an account when withdrawals are being made. It also is perhaps why so much time and energy has been devoted in the industry, especially with financial planning. Monte Carlo after Monte Carlo assimilations testing iterations have been conducted. Such iterations are based solely on historical and bootstrap performance. Yet, in the end, nobody can predict the future.
If no other strategic or proper planning has occurred, and if the client is using the withdrawal method, the portfolio, in addition to providing an income stream will then have to serve the purpose of providing a source of emergency funds, also known as a safety net. A means of estate transfer at death will also be necessary. Given this, it's no wonder we are so concerned about what the portfolio will do. If a portfolio serves multiple uses, it is imperative to do the research and look at how it may perform under a variety of circumstances and environments.
But this method also is inefficient from a tax perspective. If, for example, a retiree is drawing a 4.5% income stream on a taxable portfolio in a 30% tax bracket (25% Federal and 5% State), this equates to only a little more than a 3% after tax rate of return. Add in an inflation rate of 3.5% over 20 years, and the effective rate of return on a retiree's spendable income after 20 years is less than half of what he or she started with.
It is my personal experience that the withdrawal method is often accompanied with the philosophy that the client and perhaps his or her planner have been applying for years: "I will buy term insurance for a period of time, and as soon as my portfolio is large enough to support me, I will drop the insurance because I don't need it anymore." That approach can leave the retiree with fewer planning options if his or her desire is to transfer wealth or if the retiree is concerned about the portfolio being depleted for any number of reasons. Again it forces the portfolio to serve as an estate transfer tool. Regardless, great care must be taken for the retiree not to "outlive" the portfolio.
In addition to using permanent life insurance as a wealth transfer tool, it can be positioned to provide a backup source of revenue if other assets are depleted. The "buy term philosophy" eliminates the use of portfolio spend-down techniques. An example of a spend-down technique would be: Use a single premium immediate annuity (SPIA) over a 5- to 10-year period, with non-qualified assets, to produce an income stream. This allows the retiree to receive income distributions on a regular basis which are made up of both cost basis and interest therefore taking advantage of the exclusion ratio. This technique may have implications on the total tax paid by the retiree and may affect other things such as his or her marginal tax rate and the taxation of Social Security benefits. If the retiree is open to charitable gifting, the "buy term philosophy" diminishes other planning options which could also assist with tax planning and various forms of income creation.
The bottom line: Many techniques which can create tax-efficient sources of income cannot be considered when the life insurance element of a retiree's portfolio is no longer present.
From a wealth transfer perspective, in many cases the income tax-free death benefit from life insurance can be a much more tax-efficient tool than the investment portfolio itself. For example, if the retiree has accumulated significant assets in any tax-deferred or tax-deductible accounts (IRA, 401(k), TSA, etc.), these do not act efficiently as an estate transfer vehicle at death.
First and foremost, the income tax must be paid at some point by someone. In the case of death it will be paid eventually by the retiree's heir. Second, if the retiree's estate is large enough that the estate is responsible for estate taxes, this must be considered. The income tax-free death benefit can be a much more efficient means of transferring wealth to the next generation.
When we look at the "buy term philosophy," more than likely, this planning technique also did not take into consideration the tremendous "lost opportunity cost" created from the premiums expended on the term insurance, which can never be recaptured into the retiree's total net worth. Sadly, very few investors ever meet with an insurance or financial planner for analysis, research, or advice, because they simply believe that achieving a high rate of return on the portfolio will produce the income desired.
3. Withdrawal Method with a Lifetime Income Protector
The third method (Withdrawal Method with a Lifetime Income Protector) is generally provided through variable annuity contracts with income withdrawals guaranteed for life. This method permits an investor to participate in the upside investment potential, yet is guaranteed as an available income stream, even if the portfolio does not perform as expected once the withdrawal phase begins. This guarantee continues, even if the underlying investment value of the annuity diminishes to zero.
In an article published by Moshe A. Milevesky, Ph.D., he expressed great concern about these types of products being underpriced for what is ultimately guaranteed to the investor. ("Confessions of a VA Critic," Research Magazine, Jan. 2007). In this article he stated, "...some insurance companies are not charging enough in pure M&E fees, or that they are not using those fees to properly hedge and protect themselves."
With the recent increasing cost for insurance companies to hedge against risks in the marketplace, in addition to increased population longevity, perhaps Milevesky was right as evidenced by many carriers who have stopped offering this feature. In a more recent article titled, "What is the Guaranteed Rate Really Worth?" (Research Magazine, Aug. 2009) he states that the true rate of return the annuity owner is receiving for the guaranteed income stream is, in fact, skewed unless a thorough analysis of the accumulation phase and the distribution phase are analyzed separately. He demonstrates, for example, that when these two phases are analyzed separately using the Guaranteed Lifetime Income Benefit variable annuity, the following would be the actual rate of return: A 7% stated growth rate in the accumulation phase and 5% guaranteed withdrawal rate works out to a meager 2% rate of return.
To make this calculation, the planner must determine what lump sum of money is required to purchase a single premium immediate annuity at the proposed retirement age vs. the assumed value of the account, based on the proposed guaranteed growth rate. This number will be significantly lower than the accumulated value illustrated by the marketed growth rate. Use this number to determine what growth rate would have been necessary to accumulate the sum of money equivalent to the sum of money necessary to purchase the SPIA. This is the true value of the growth and withdrawal rate combination. That percentage rate should be understood and evaluated in comparison with other financial strategies.
The real question still has to center on what was the achieved and real effective rate of return by using this method. Additionally, the withdrawal guarantee may have financial ramifications, similar to an immediate annuity where the annuitant may not have the ability to pass on this asset to the next generation.
4. Time Segmented Method
The fourth method (Time Segmented Method) is where assets are segmented into portions. The first portion is used to produce an income stream for a certain number of years. Then, income is replaced with another income stream later from certain funds, specifically designated for various timeframe accumulation periods. Each of these earmarked funds is then later converted into an income stream.
There are several advantages to this method. First, it allows for asset diversification, based on the timeframe in which the asset is needed for conversion to an income stream (a portfolio tends to be more weighted toward equities the longer the time horizon). Second, stocks are not required to produce income as assumed with a balanced portfolio (stocks/bonds) when the withdrawal method is being used. Third, funds earmarked for certain time segments can also be converted, if desired, to guaranteed investments when they have met their target value. Finally, a potential significant advantage to this method is that certain tax planning techniques also may be accomplished, depending on the client's situation, to distribute principal and interest back to the retiree. In most situations, this also would lower the total effective tax rate and create a higher after-tax income stream.
Income streams are generated through strategic financial tools such as a 5- or 10-year SPIA, a staggered bond or CD ladder, laddered annuities, and Single Premium Deferred Income Annuities (SPDIA) known as longevity insurance. All of these financial tools have various forms of guarantees inherent with them that stocks do not possess. These time-segmented income streams also may have the added benefit of being designed to increase and offset the impact of inflation. Essentially, this could increase the effective (inflation protected) income stream by 1% to 2% over the withdrawal method. To accomplish this, competent knowledge and extensive planning should be sought by the consumer. It goes far beyond the scope of this article, but there can be many problems and difficulties with this method of distribution when it comes to potential product withdrawal/payout considerations, product penalties, product restrictions, and tax ramifications resulting from existing assets that the client owns and of course, the long-term performance of any funds set aside to accumulate for future income streams. As with any method chosen, issues such as first death, long-term care concerns and estate planning considerations should be considered.
In conclusion, one of the biggest benefits of this planning method is that certain types of assets are not asked to accomplish something where historically they have a poor track record. For a good overview of the Time Segmented strategy, I recommend CPA Paul Grangaard's book, The Grangaard Strategy (Berkley Publishing Group, 2003).
Conclusion
Is any one of these methodologies used alone really the best? Probably not. Much research, discussion and formal presenting is being done today, which is focusing more on how to use a combination of tools and techniques instead of merely focusing on the historical mindset of what rate of return "the portfolio" will earn. Various software packages are available to assist in designing a distribution method that uses more than one financial instrument. These software tools give the advisor more planning capabilities.
While various experts have differing opinions on how to best plan for retirement, the bottom line is that effective retirement income distribution planning is more about using facets of all four distribution methods and leveraging a variety of financial tools.
Many are the voices who think they know as much as Tim Taylor's neighbor Wilson. But, Wilson does not know everything, and Tim should not go to Wilson when it comes to his medical problems, let alone his finances. Instead, Tim should consult a financial professional. After all, it is to his benefit.
Daniel C. Flanscha, CFP, CLU, ChFC, is the president of Longs Peak Financial, a OneAmerica Securities general agency.
Registered Representative of and securities offered through OneAmerica Securities, Inc., Member FINRA, SIPC, a Registered Investment Advisor, Insurance Representative of American United Life Insurance Company(R) (AUL) and other insurance companies. Longs Peak Financial is not an affiliate of OneAmerica Securities or AUL and is not a broker-dealer.
