In my book: Retirement: Congratulations You Have been Promoted to CEO! The Habits of Highly Effective CEOs that are Necessary for Retiring Healthy, Wealthy and Fulfilled, ( https://www.retirement-ceo.com/ ) I go into detail on the pieces of an effective retirement plan that include Health, Wealth and Legacy. In this second of three articles, I will cover wealth.
A worry-free retirement should ideally start with “replacing” your regular paycheck. After all, why chip away at savings or other assets – which could eventually be depleted – when you can instead use assets as a “golden goose” of sorts and generates income for an indefinite period of time?
Retirees Live on Income, Not Assets
When you retire, how do you plan to pay your living expenses (as well as pay for any of the “extras,” like travel, fun, and entertainment)?
If you have (or you will have) a pile of money that you’ve saved, do you intend to draw on those funds each month to cover your housing, transportation, and personal expenses? If so, it could get a bit nerve-wracking if the stack of cash starts dwindling, but you’re still in good health and you have a lengthy life expectancy ahead of you.
De-cumulation Matters Far More than Accumulation
Planning for retirement should ideally have two components – accumulation and decumulation (or distribution). Many financial advisors only focus on the accumulation of assets, though, and they neglect to consider how and when those assets need to be converted over into an ongoing, reliable stream of income when it is needed.
You’ve likely seen ads on TV or via the Internet that ask whether or not you know your “number.” But these ads (and the financial services companies that run them) are missing the point of “planning” ahead for retirement, because retirees don’t live on assets or net worth, they require income – and without knowing how long they’ll be around, that income needs to flow in regularly for an indefinite period of time, regardless of how long that may be.
Why NOT to Solely Rely on an Employer Pension for Your Retirement Income
If you participate in an employer-sponsored pension plan, you are one of the remaining few. These plans that were at one time offered by many employers from coast to coast have been quickly disappearing over the past couple of decades.
A defined benefit plan is what we commonly refer to simply as a “pension.” As the name suggests, defined benefit plans pay out a set (or “defined”) amount of income benefits to the recipient.
While it might sound strange, a pension plan is not a retirement plan. Rather, it is just one piece of a much bigger puzzle that can include other income generators, such as:
- Social Security
- 401(k) plan
- 403(b) plan
- 401(a) plan
- IRA (Individual Retirement Account)
- Other financial investments
The amount of the benefit from a defined benefit pension plan is determined by a specific formula that is set forth by the plan’s sponsor. This formula includes factors such as the employee’s salary history and his or her duration of employment.
In this type of plan, each individual who is involved does not have a separate individual account, but rather all funds are kept in one single account from which retirement benefits are paid out to participants upon their retirement.
In a defined benefit plan, all of the investment risk – as well as the management of the portfolio – are up to the sponsoring company, and the plan’s income payouts are primarily dependent upon the return of the invested funds in the plan.
Therefore, should the investment returns fall short of the company’s estimates, the company may be required to dip into its earnings and/or other funds in order to pay their retirees’ benefits. This differs from defined contribution plans.
For instance, in a defined contribution plan, the benefits that are accrued are directly attributed to the contributions that are made into the employee’s individual accounts – plus any of the gains on those funds, and minus any expenses and investment losses.
With these types of plans, the funds that are contributed can come from the employee’s salary deferrals (up to a certain annual maximum limit), as well as from employer contributions and / or employer “matching” contributions (which is also up to a set maximum amount).
Defined Benefit versus Defined Contribution Plans
|Defined Benefit Plans||Defined Contribution Plans|
|Advantages: Set amount of income paymentGuaranteed lifetime income for retireesLower fees||Advantages: Tax-deferred contributions (on traditional plans)Larger maximum contributions for participants age 50 and overTax-deferred growth of funds in the accountEmployee may receive matching contributionsEmployee may borrow funds from the planEmployee may take hardship withdrawals|
|Disadvantages: Plans are not portable (i.e., the employee cannot take it with them if they leave the employer)Must be vested Benefit amount may not increase over time (which can erode retiree’s purchasing power)||Disadvantages: Employee/retiree is responsible for converting funds into a retirement income stream Unknown amount of income in the future Participant is subject to market and/or low interest rate risk|
The Impact of Inflation on Your Retirement Portfolio
Inflation can have a huge impact on Even with an average inflation rate of just 3.22%, your current income would have to double in 20 years in order to give you the same buying power you have presently. So, for instance, if your income today is $4,000 per month, it would need to increase to $8,000 per month in order to just keep pace with your current lifestyle.
Therefore, in terms of the actual dollar amount, inflation can cost retirees a great deal – especially over a long period of time. According to the LIMRA Secure Retirement Institute, if a retiree has expenses and income of $1,341 per month (or $16,092 per year), over a period of 20 years, even a 1% inflation rate could have a significant impact on their purchasing power.
Source: LIMRA Secure Retirement Institute, 2016.
Given increased longevity, a retirement that lasts for 20 or more years is becoming more of the norm than the exception. So, taking inflation into account is an essential component of your overall retirement income plan – and you won’t likely find this if you rely primarily on retirement income from a defined benefit pension plan.
Who Should Help You Create Your Retirement Income Plan?
While most financial advisors are happy to provide you with advice on investing in and growing assets, few are income specialists who can provide you with a detailed “map” for the next step in your retirement journey.
This entails taking the assets that you have and developing a strategy for turning them into an ongoing income stream for the remainder of your life (as well as your spouse or partner’s life, too). Find an advisor who is focused on Retirement Planning. Advisors with the RICP (Retirement Income Certified Professional) is a good place to start. 401(k)s and Other Defined
Contribution Plans are Not a “Replacement” for True Pension Income
With a defined contribution plan, the benefits that are accrued are directly attributed to the contributions that are made into the employee’s individual account, plus any gains, and minus any expenses and investment losses.
Participants in a 401(k) or other defined contribution plan can defer a certain amount of their income into the plan – up to an annual maximum. These pre-tax contributions that go into a traditional defined contribution plan can reduce the employee/participant’s taxable income for the year.
Unfortunately, though, because there is little guidance with regard to choosing the investment options, defined contribution plan participants can oftentimes end up putting the wrong financial tools in their plan, which can impact whether or not they will be able to reach their future retirement goals and objectives.
Risks and Limitations Faced with Defined Contribution Plans
In addition to the potential for choosing the wrong investments, employee/participants in defined contribution plans can face other risks, too. For instance, because the stocks and mutual funds in the plan can be tied to market performance, there is the potential for loss.
On the other hand, if participants lean towards “safer” alternatives, like bonds or bond funds, the painfully low interest rates of today can also be detrimental because they aren’t able to meet, much less beat inflation. This, in turn, can impact the employee’s future purchasing power.
Also, the employees’ overall returns can be reduced by a plethora of management and administrative fees that are typically charged by the plan each year. So, even if the underlying investments in the defined contribution plan perform well, the plan participant could still come up short.
Planning Ahead for Retirement Income Risks
We’ve all heard sayings like, “No pain, no gain,” or “No risk, no reward.” Unfortunately, these don’t just pertain to working out in the gym. Rather, they are oftentimes associated with saving and investing for retirement.
There are actually a number of risks that can cause you to have financial “pain.” This is the case, even with “safe” investments that don’t lose (or gain) value based on the movement of the stock market.
Risks can come in a variety of different forms – and they don’t necessarily always hinge on the rising and falling of the market, or even the overall economy. So, knowing where your retirement risks can arise – and planning ahead for them – can make a significant difference in your financial future.
Regardless of whether it’s a dollar in a defective vending machine or six-figures in a stock market correction, no one likes to lose money. But unfortunately, many investors – and their financial advisors – think that more risk equals more reward.
If you had money invested in the stock market during the 2008 recession, and/or in early 2020 when the Coronavirus pandemic struck (along with the corresponding market drop), you know first-hand how nerve-wracking a volatile stock market can be.
For some, there may be time to “make up” for market-related losses. But what if you had planned to retire in 2020 when the market was at an all-time high in February, only to watch it drop by roughly 30% within just a few weeks’ time? Do you really want to postpone your retirement date by 10 or even 20 years because of a stock market correction?
Low Interest Rates
Many investors feel that investing in “safe” financial vehicles like bonds and CDs can “protect” their principal. Unfortunately, though, given the historically low-interest rates that the U.S. has seen for the past dozen years won’t even come close to meeting, much less beating, inflation.
For instance, the 30-year Treasury rate is the yield that is received for investing in U.S. government-issued treasury securities that have a maturity of 30 years. The 30-year Treasury yield is included on the longer end of the yield curve and is important when you are looking at the overall United States economy.
Historically, the 30-year Treasury yield reached upwards of 15.21% in 1981, when the Federal Reserve raised benchmark rates in order to contain inflation. The 30-year yield also went as low as 2% in the low rate environment after the Great Recession.5
As of mid-2020, the 30-year Treasury rate stands at just 1.32%. That means if you invested $500,000 for retirement income purposes, you would earn a whopping $6,600 – or just over $500 per month.
Given our longer life expectancy today, inflation is another component that needs to be considered when creating a retirement income plan. Technically, inflation is defined as the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling.
Inflation can play a big part in how and how well you live in retirement. For instance, if you plan to retire at age 65, the odds of having a retirement that spans for ten, fifteen, or even twenty years are good.
If your retirement income does not keep pace with inflation, there are some things you may have to do in order to ensure that you can still pay your bills – and none of these things are very appealing.
Healthcare and Long-Term Care
As we discussed in the health section of the book, prices are rising rapidly in this economic sector. It is anticipated that a couple who retires today at age 65 will spend somewhere in the range of $295,000 in healthcare expenses throughout the remainder of their lifetime.
But this figure doesn’t include long-term care. Depending on where you live and the type of care you may require, you could find that these costs alone can exceed $10,000 per month – just for one person.
But, what if both you and your spouse require care?
If you have not planned ahead for long-term care needs, where will the money come from to pay for it? Which assets will you deplete – if any?
Sequence of Returns
On top of the actual returns, you attain on your investments, a relatively unknown – but serious – the risk is the order in which you receive those returns. This is particularly the case as you get closer to retiring.
Consider the following hypothetical investment scenarios for Mr. Green and Mr. Brown. Both of these investors began with a $1 million portfolio at age 65. Both also averaged 6% annual return that grew to the same value over 25 years. However, they experienced their annual returns in inverse order from each other.7
In this case, the sequence of investment returns had no bearing on portfolio values because the average annual rate of return was the same and no distributions were taken from the account. But take a look at how the sequence of returns can impact a portfolio when taking distributions.
Mr. Green and Mr. Brown still start out with an initial $1 million investment portfolio. But in this example, they begin taking 5% withdrawals (of the initial value) beginning immediately at age 65.
Here, Mr. Green begins taking withdrawals in an up market, giving him the optimal environment to maintain his portfolio value long-term. Unfortunately for Mr. Brown, he starts taking income in a down market and ends up depleting his entire portfolio before he reaches the age of 83.8
With that in mind, it is important to ensure that your money is not only growing, but that your principal is safe, and that it is not participating in major losses, especially in those last few years before retirement.
Taxes are one of those “necessary evils” that we deal with nearly our entire lives. For many people, sharing a portion of your income with Uncle Sam will continue after you retire, too. And unfortunately, no one has control over what tax rates will be in the future.
But what if federal income tax rates go up by 20% during your retirement. This could make a significant dent in your net spendable income.
While taxes can potentially take a significant portion of your retirement withdrawals, as you invest for future income there are some things that you can do in order to essentially “move taxes out of the way” so that your income-generating savings and investments have the opportunity to grow more.
One way to do this is to invest in tax-deferred and tax-free vehicles. In doing so, the gain each year on your investments will either be postponed (tax-deferred) until the time of withdrawal or possibly even eliminated altogether (tax-free).
According to the Social Security Administration, the average woman who is 65-years-old today will live to be 86.6 years old. A man of 65 today will live, on average, to be 84.3. But, these are just averages, meaning that some people won’t live that long, and others will live longer. For instance, 25% of all Americans will live to be 90 or older – with one in ten surviving to 95.
Living a nice long life can certainly have its advantages. But it must also be planned for from a financial standpoint, because the longer you live, the longer you will need income to support your expenses.
Longevity is often referred to as a “multiplier” of all other financial risks. This is because you’ll need to face these risks for a longer period of time. This is a key driver of the biggest fear on the minds of retirees today – running out of money when it is still needed.
How to Create Your Own Personal Pension Plan
As the CEO of your retirement, then, it is necessary to make wise financial decisions regarding how and where your savings are invested, and to make sure that you will have at least a certain amount of income that you can count on for paying your expenses going forward.
One way to ensure that you’ll have an ongoing income stream is to add an annuity (or more than one annuity) to your retirement plan. Not all annuities are exactly alike, though, so it is essential to know how these financial vehicles work, and whether or not they will be right for you.
What are Annuities and How Do They Work?
An annuity is a financial vehicle whereby in return for either a lump sum contribution or multiple contributions over time, an income stream can be paid out, either for a set period of time – such as ten or twenty years – or even for the remainder of your lifetime, regardless of how long that may be.
While annuities have existed in their present form for just a few decades, the idea of paying out a stream of income to an individual or a family actually dates back to the Roman Empire, where individuals would make a contribution and then receive an annual payment each year.3
Today, annuities are offered through insurance companies, and they are designed using a mortality table that provides an estimate for an annuity purchaser’s life expectancy. This gives the insurer a better idea of how much risk it is taking on in terms of paying out a future income benefit.
One of the biggest benefits that can be garnered from an annuity is the ongoing income that it can produce. This, in turn, can help to reduce the worry about running out of income in retirement.
Other Benefits Offered by Annuities
In addition to the generation of a reliable income stream and tax-advantaged growth, annuities can provide you with a myriad of other enticing benefits, too. These may include:
- Death Benefit – Many annuities will include a death benefit as a part of the contract. In this case, if all of the annuitant’s (i.e., the income recipient’s) contributions have not yet been returned at the time of his or her death, a named beneficiary (or beneficiaries) will receive the remainder of these funds. (It is important to note, though, that unlike the death benefit on a life insurance policy, annuity death benefits are not typically received income tax-free).
- Limited liquidity. Most deferred annuities will allow you to access a certain amount of the account value every year without penalty. (In many cases, this amount is 10% of the contract value). However, if more than that is accessed while the annuity is still in its surrender period, a penalty will usually be incurred. Surrender charges generally range from two or three years up to a dozen or more years, and the percentage of the charge will typically be reduced over time, until it eventually disappears.
- Long-term care waiver. Some annuities will allow penalty-free withdrawals – even during the surrender charge period – if the annuitant must reside in a long-term care facility for at least a minimum time period, such as 90 days.
- Terminal / chronic illness waiver. Likewise, if the annuitant has been diagnosed with certain terminal and/or chronic illnesses, some annuities will allow penalty-free access to some – or even all – of the contract value.
Don’t Go it Alone: Build a Wealth Team
Your team of wealth professionals should ideally include the following members:
- Financial / Insurance Advisor
- Estate Planning Specialist
- Attorney / Legal Advisor
- Accountant / CPA / Tax Specialist
- Trust Company
- Other Specialists
- Family Members
Keeping the Whole Team on the Same Page
In addition to having knowledgeable professionals on your wealth team, it is important that they all communicate with you, as well as with one another to better ensure that everyone is moving in the same direction. While your wealth plan may be extremely detailed, it is definitely not a “set it and forget it” endeavor. Today, with the ease of virtual meetings, having regular calls – ideally every six to twelve months – can be highly beneficial.
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