The U.S. retirement income system, Pt. 2
By Dick Duff
In last month's column, I outlined the U.S. Retirement Market (The Market) as described by the Investment Company Institute (ICI). A U.S. Retirement Income System (The System) doesn't exist... but it could. It would be micro, between advisors and clients on a one-on-one basis. It would also be macro -- with an emphasis on worldwide broader concepts. In this column, I'll touch on some micro income basics. With this background, we'll move next month into the bigger picture.
It's my view that we already have a retirement income crisis, which will only get worse. Think of casual comments about relatives and friends in their 90s -- on the way to their 100s. It seems only yesterday that these people were in their 60s or70s -- on the way to their 80s. Imagine the strains on The System and family assets as loved ones spend about 40 years spending money in retirement. And, if these funds run out, the price could be staggering as your clients live longer and become more frail.
Micro income thinking
What does it cost to have enough income in retirement? And, how do you explain this simply to your next client? For the answers, here's a refresher on basic retirement income planning. To keep things easy, we will sidestep income taxes or tax brackets. It won't be a qualified or non-qualified income, nor will it be income from Social Security or The Market, per se. Simply put, you'll explain how to build a safe and secure cornerstone program for Harry, a retiree aged 65. In this model, he'll want merely a $10,000, 20-year annual income beginning end-of-year (EOY) at age 66. As he spends (amortizes) his income capital, it will earn 5 percent interest credited over time.
Retirement income risks
To begin, you explain that Harry has a few risks along the way:
- No. 1: Investment or savings risk. These come from poor choices. If he gets frisky with his money, it could run out before he reaches age 85, the length of his payout. Without an end game, he could eventually be in trouble.
- No. 2: Longevity risk. Clients look at this as having money that lasts as long as they live. As Harry plans on a payout to life expectancy at age 85, he stands a 50-50 chance of living longer. If he lives longer, he may have to depend on other people or welfare. He probably won't want this risk.
- No. 3: Mortality risk. Let's say Harry acquires a life contingent payout annuity. If payments cease at his death, he could lose his money to the insurance company. What can he do about dying too soon?
- No. 4: Inflation risk. This equates to losing funds due to increasing prices without corresponding value. It won't be long before Harry's $10,000 income won't buy $10,000 in current goods and services. He needs to decide how to handle this probability.
- No. 5: Asset protection risk. Harry could lose to lawsuits or claimants. There could be a home foreclosure, Medicaid spend down or litigation from leftfield. Can he shield his income from those who want his money?
- No. 6: Money management risk. Paperwork, tax reporting and savings decisions can be daunting for someone who wants to play golf, tennis and bridge and be with grandchildren. How can Harry simplify his income planning?
A retirement income cost analysis
Let's say that Harry wants some cost projections for his income. The estimates should reflect the risks. Assuming 5 percent interest on money being liquidated, here's how he might look at the price of his income:
(1) Harry asks about a constant $10,000 income for 20 years until age 85, roughly his age 65 life expectancy. It will cost $125,000 -- with $8 provided for $1,000 of capital set aside. He'll receive $200,000 in self amortized payments.
Simply put, $125,000 in capital (with 5 percent interest credited on unpaid balances) will pay out $10,000 EOY for 20 years. There is a longevity risk here -- and (risk No. 1) savings/investment, (risk No. 2) inflation, (risk No. 3) asset protection and (risk No. 4) money management risks too. To improve things, Harry could purchase a fixed commercial annuity merely for a 20-year period certain. Then, he'll avoid risk No. 1 and No. 4. If annuity payments are protected from creditors in his state, he may also avoid risk No. 3.
(2) Harry exclaims, "I plan to live until age 105; what would it cost to have a fixed period payout for 40 years?" You tell him that the price goes from $125,000 to about $170,000. In other words, $170,000 earning 5 percent amortizes into total receipts of $400,000 (40 x $10,000) throughout a 40-year period. He seems interested.
Observation: If it's not possible to obtain a 40-year fixed period from a commercial annuity, Harry will have to manage this himself. And, he'll have all the risks except for dying "too soon."
(3) If Harry is concerned about living past age 85, he could purchase a $10,000 life-only annuity. The premium for $10,000 EOY at age 65 will be about $125,000 -- similar to the cost of a 20-year fixed period annuity.
Observation: As a payee gets older, the cost of a life-only income lessens due to fewer years to life expectancy. However, the cost of a 20-year fixed period income remains the same.
With a life-only annuity, Harry shifts longevity, savings/investment and money management risks to his carrier. He still has mortality and inflation risks. His asset protection risk may be shielded.
(4) Let's say Harry is equally concerned about (A) living past age 85, perhaps until age 105; and (B) dying too soon, anytime before age 85. At age 65, he could hedge both fears with a life and 20 year's certain annuity. The price is about $145,000.
Observations: For an extra $20,000 over $125,000, Harry shifts both mortality and longevity risks to his carrier. The $145,000 premium is considerably less than $170,000 -- the cost of the self amortized 40-year period payout in risk No. 2.
(5) Harry brings up the possibility of inflation. If he can hedge both longevity and mortality risks for $145,000, what would it cost to build-in, say, a 3½ percent annual inflation factor?
You explain that some carriers have cost-of-living or inflation annuity policies and the premiums vary greatly. Moreover, a $10,000 income increasing at 3½ percent annually (using the Rule of 72) will double to about $20,000 in the 20th year -- an average of $15,000 annually. This would cause a $145,000 premium to increase by 50 percent to nearly $220,000. You'll have to get a specific quote.
There are a lot of possibilities here; however, it's not difficult to have an intelligent conversation about basic retirement income planning with most anyone. With a grasp of present and future values, the Rule of 72 and life expectancies, you can describe how someone might spend their capital throughout 30 or 40 years in retirement... and you won't need a calculator or computer program, either.
Where will Harry's income come from? In next month's column, we'll look at what The System could do for him, you -- and me.
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