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Retirement income planning is the most important trend in the financial planning industry today, and it requires a new type of qualified retirement professional who can manage income at the start of and throughout retirement for middle-affluent and middle-mass clients. This article explains a six-step retirement income management process jointly developed by the International Foundation for Retirement Education (InFRE) and Insured Retirement Institute (IRI) to help financial advisors identify and manage the risks and opportunities inherent within each unique client situation.  This is the first of a two-part article. 

“How can I make my retirement income last for my lifetime?”

Financial advisors hear this question more often today as the first wave of Baby Boomers have reached retirement age. To answer it well, advisors need to know how to guide retirees and near retirees with limited retirement resources through a maze of often-contradictory goals and trade-offs. Advisors need to be able to tailor their advice to the unique circumstances of individuals who are often at great risk of running out of money during retirement. Retirement-specific risks such as unknown longevity, rising health care costs, market volatility, and ever-changing inflation make retirement income planning a multi-faceted challenge for all but the wealthiest clients. This article provides you with an overview of our six-step process of managing retirement income for middle-mass and middle-affluent consumers, that when thoughtfully applied, will set you apart from your competitors.

The Retirement Income Management Process

Because a proper retirement income plan requires the careful consideration of many variables, identifying solutions for clients requires not only choosing financial products, but employment of a process for helping clients—and you–make informed decisions. There is no one “magic bullet” action or product that works for all situations.

The retirement income management (RIM) process identifies a client’s goals, resources, unique retirement risks, tax and estate planning opportunities, and options for closing income gaps prior to and during their retirement years. These variables are then applied to a series of income conversion considerations to optimize retirement income streams from Social Security, IRAs, employer retirement plans, taxable savings and other resources. This optimization requires the identification and prioritization of multiple trade-offs and timing decisions.

The following six steps outline a systematic method of producing a personalized plan to manage retirement income and risks. They may appear basic at first glance because they build on what you already know about retirement accumulation planning. As in many facets of managing client assets, however, the devil is in the details. Decisions made at each step influence the potential courses of action to be considered in the next. Following a prudent, suitable decision-making process such as this also provides the needed documentation for investment recommendations in today’s regulatory environment.

    Step 1: Estimate Duration of Retirement Assets

    Step 2: Identify and Manage Retirement Risks

    Step 3: Identify Distribution, Tax and Estate Issues and Opportunities

    Step 4: Identify Options for Addressing Gaps

    Step 5: Convert Resources into Income

    Step 6: Maintain and Update the Plan

Step 1: Estimate Duration of Retirement Assets

Until a client defines retirement on a holistic basis, it is difficult to determine what their total spending needs will really be. Planning for retirement is not just about money. According to the International Foundation for Retirement Education’s (InFRE) General Population Retirement Readiness Study, success or happiness in retirement for today’s retirees requires the integration of three major life areas: wealth, engagement, and health (see Figure 1 below).

InFRE Retirement Readiness Model

Figure 1 – InFRE Retirement Readiness Model

  • Wealth (the geo-financial sphere) means not only the sufficiency of the savings accumulated, but also the cost of living, access to healthcare, activities, etc. in the area of the country that the retiree lives.
  • Engagement (the psycho-social sphere) includes participation in activities that increase a personal sense of social interaction and fulfillment. Such activities could include spending time with family and friends, providing volunteer labor for a favorite charity or non-profit organization, or working part-time for the social benefits of work.
  • Health (the bio-medical sphere) includes an awareness of inherited biological characteristics and managing health and long-term care risks during retirement.

Retirement accumulation rules of thumb, such as targeting 70-85% of pre-retirement income, are based on averages and since very few individuals are “average,” these estimates should be replaced with identifying an individual retiree’s actual spending needs from a retirement-readiness perspective as defined above. Advisors can then build a plan to meet those expenses, or determine how much the retiree can afford to spend once resources are repositioned for retirement income and evaluated for sufficiency.

The figure below demonstrates a retirement income approach of ensuring essential expenses (such as food, clothing, and housing) are covered by income from lifetime sources such as Social Security, pensions from defined benefit plans, immediate annuities and other lifetime income sources. Discretionary spending needs (such as travel and entertainment) are matched to income from managed sources such as taxable accounts, personal retirement accounts (like IRAs), employment income or other managed sources. The first challenge will always be to fill Gap A to meet essential lifetime needs. If Gap B cannot be filled with other resources available, then the client must answer the following: What’s more important to you: Being retired, or the quality of your retirement? Once you understand their primary motivation for retiring, the remaining steps in the process will help you identify suitable options for closing gaps.

The Retirement Income Management Process for the Mid-Market

Figure 2 – The Retirement Income Management Process for the Mid-Market

To model how this process works, we introduce to you Susan Lewis. At age 68, she is a very conservative investor and currently has no retirement accounts. Susan has $50,000 in CDs (yielding 2%, or $1,000 of interest) and another $370,000 invested in bond mutual funds (collectively yielding 5%, or $18,500). She receives $22,500 a year from Social Security.

Susan has identified a total of $25,000 of essential expenses and $32,000 of discretionary expenses in her retirement budget (including taxes), for an overall income need of $57,000 a year.  After reducing these respective amounts by her expected Social Security benefit ($22,500) and current investment income ($19,500), Susan has a $2,500 essential gap (Gap A) and a discretionary gap of $12,500 (Gap B) annually. You can make a quick “back of the napkin” estimate during your initial meeting of how long Susan’s resources might last by conservatively assuming taxes and inflation will offset investment returns. Take the sum of her essential and discretionary income gaps (Gap A + Gap B=$15,000), and divide that total into her managed resources ($420,000) for an estimate that her assets might last for roughly 28 years. At age 68, Susan theoretically might run out of money around age 96, a point in time past her potential life expectancy.

At first glance, Susan appears to have a medium risk of running out of money before she passes away, assuming no shocks to her retirement income or assets. However, when a client is very conservatively invested as in her case, the combination of taxes and inflation will likely be higher than the returns earned on their invested assets. A basic financial concept is that for an asset to maintain its purchasing power over time, it must grow at a rate equal to or greater than the annual rate of taxes and inflation. If Susan maintains a conservative approach to investing over the next 30 years, her assets will most likely be depleted earlier than the back of the napkin calculation estimate, as the cost of living and taxes will outpace the growth of her investments.

Susan is also personally shouldering key retirement expenses such as long-term care costs that will take up an increasing share of a her budget as she progresses through the phases of retirement. Therefore, where the back of the napkin calculation can help identify where the services of a knowledgeable retirement professional–like you–can help increase a client’s retirement security, it is not meant to be a substitute for a more thorough analysis.

Step 2: Identify and Manage Retirement Risks

One of the keys to creating a successful retirement income plan for the middle market is to identify and manage retirement risks. The number of key risks in retirement are more than one might expect, and not just financial.

Some of these risks apply to all retirees, and some others may be unique to the individual. The goal of this step is to help the client identify all primary risks, prioritize their importance, and finally engage in a discussion to determine practical methods for managing those risks when implementing their retirement income plan.

The risks listed below are the primary post-retirement risks from Practice Tip #3 that most substantially impact retirement income. Most retirees in the middle market will face all of these risks to some degree. It’s the combination of these risks that, when the risk is not appropriately identified and transferred, can derail even the best laid investment plan.

  • Longevity risk (the likelihood a retiree will outlive his or her financial resources).
  • Inflation risk (the likelihood a retiree’s standard of living will decline due to inflation).
  • Healthcare and long-term care risk (the likelihood that medical expenses will consume an ever-growing percentage of a retiree’s budget).
  • Investing risk (sequence of returns risk and the likelihood that investments underperform).

Step 3: Identify Distribution, Tax and Estate Issues and Opportunities

Deferring and reducing taxes over time can have a substantial impact on how long a retiree’s assets last or how much might be available for heirs. Different types of assets have their own set of potential penalties and income tax treatments, so where an asset is located (in a taxable account or a tax-deferred account) can further complicate the retiree’s tax picture.

As a retirement professional, it is important to understand both tax and estate planning implications before converting retirement resources into income. This includes having a good understanding of how required minimum distributions rules impact both the account holder and beneficiary.

Asset liquidation order has been shown to increase the duration of a retiree’s assets. Conventional wisdom says to liquidate taxable assets first, then tax-sheltered, and finally Roth money. However, it is important to look at the assumptions involved in conventional wisdom and examine the tax treatment of the particular assets that are sheltered compared to those which are not sheltered. When distributing retirement assets, the whole process is often not as simple as conventional wisdom makes it out to be.

The second half of this article will be available in the December, 2011 issue of Retirement Insights and Trends.  A shorter version of this article was published as “Managing Retirement Income for the Mid-Market,” in the Journal of Financial Planning, September, 2010.

Betty Meredith, CFA®, CFP®, CRC®, is Director of Education and Research for the International Foundation for Retirement Education (InFRE), whose purpose is to increase the retirement readiness of the American worker through the accredited Certified Retirement Counselor® (CRC®) professional certification and continuing education. Betty oversees incorporation of research findings and best practices into InFRE’s certification study and professional continuing education programs in order to help retirement advisors and counselors more effectively meet the retirement preparedness and income management needs of clients and employees. She has almost 30 years experience in the financial services industry.

©2011, Betty Meredith. All rights reserved.