The Challenges Facing Retirement Income Planning

Brian FisherFebruary 22, 2019

Retirement Planning

Retirement is made up of three components: pensions, social security and savings. You can think of retirement as a three-legged stool. However each of the three components doesn’t support an equal amount of the total. Pensions, the first leg of the retirement stool, has always been the strongest. Pensions are retirement plans funded exclusively by employers on your behalf while you are working.  When you reach retirement age you are eligible to receive this money via a monthly pension check. Pensions, however, are being phased out by companies nationwide at an alarming rate. In fact, in 2017 only 16% of all private companies participated in a pension plan. Employers, instead, have begun to offer defined contribution plans, such as 401(k)s. Although these plans save employers large sums of money, employees are at the mercy of the stock market in terms of their retirement savings.

Social Security, the second leg of the retirement stool, is a trust funded mainly from payroll taxes. Both the employer and employee pay 6.2% of wages earned to the trust.  This money is used to pay disability, survivor and retirement benefits. Social security was originally designed as a security net for a retiree living longer than life expectancy. However the average life expectancy is longer today. As a result, the money paid annually in Social Security benefits is greater than the money being collected via taxes. Based on the Social Security and Medical Board of Trustees 2018 Annual Report, Social Security will be insolvent in 15 years as this model is not financially sustainable.

Savings, the third leg of the retirement stool, now takes on a much more significant role in supporting the stool. It is almost impossible to calculate how much of a nest egg you will need due to uncertainties, including health care costs, taxes and the performance of the financial markets. Imagine working your entire life to save a nest egg and the economy and stock market take a turn for the worse as soon as you retire. You are now wondering if your nest egg will be enough for retirement. The transition from a life of accumulation to a life of spending is a daunting shift in the mindset of a retiree.  You need to plan for retirement income as opposed to saving for retirement. This income will need to last for the duration of your retirement.

Traditional retirement savings plans use asset allocation as the main tool, which is saddled with several risks. One of these, longevity risk, is the risk of outliving your assets. With advancements in technology and healthcare, life expectancies have increased substantially over the last 20 years.  This means we are living longer in retirement, and there is a substantial risk of retirees running out of assets before the time when they no longer need them. Thus, the need to determine how to make the money last is imperative.

Market risk is another risk associated with retirement savings plans. We have all experienced market risk at one time or another.  However, during the period of employment, individuals can mitigate poor market performance with continued income.  But in retirement, negative market performance coupled with a systematic withdrawal of funds for income, can devastate an investment account.

Lastly there is interest rate risk. This is when changes in interest rates can lead to fluctuations in the value of your bond or stock investments. In general, when interest rates fall, bond prices increase. This usually happens in times of economic slowdown and poor performance in the stock market. When interest rates rise, bond prices fall. This usually happens when the economy is doing well, and stock returns are positive.

How do you alleviate some of these risks? How do you assure that you don’t run out of money? You insure your homes, cars, boats and lives, so can you insure part of your retirement? Unfortunately you can’t purchase an insurance contract on your retirement savings, but through the use of an annuity, you can guarantee income for the remainder of your life. The mention of annuities may cause you to think of complexity, big commissions and high costs. That may be the case with variable and indexed annuities but income annuities are designed to generate guaranteed income payments with no exposure to stocks and bonds. Basically it is a way to reduce savings risk. An income annuity is a contract between you and an insurance company. You make a single premium payment and the insurer will provide you a stream of income payments immediately or at some set date in the future. These income payments can be for a certain time period or can last your lifetime. You can even arrange for the payments to continue for a spouse after your death.

While annuities are not for all, they may provide a solution for some. Those retirees that have an investment only approach, with their lifestyle entirely dependent on the performance of stocks and bonds, might consider allocating some of their investments to an annuity. The annuity can provide a higher probability of not outliving your money. While you don’t have to worry about market fluctuations, it is possible that your annuity may be less than the return you could garner from a stock or bond investment. When used as part of a diversified retirement income strategy, an income annuity can help provide confidence that you will be able to pay your bills long after the paychecks end.  The decision to purchase an income annuity should be discussed with your advisor to determine whether this strategy fits in your overall financial plan.

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Social Security – A Summary of the 2018 Annual Reports
planadviser – A Mere 16% of Fortune 500 Companies Offer a DB Plan

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