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Overview Of Retirement Income Planning – Part One

Strong disagreements exist about how to position a retiree’s assets to best meet retirement goals. Two fundamentally different philosophies for retirement income planning—which I call probability-based and safety-first—diverge on the critical issue of where a retirement plan is best served: in the risk/reward trade-offs of a diversified and aggressive investment portfolio, or in the contractual protections of insurance products.

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On the one side are investments-centric approaches of the probability-based philosophy that rely on the risk premium from the stock market. This is the idea that stocks will outperform bonds over sufficiently long periods, and this investment outperformance will provide retirees with the opportunity to fund a higher lifestyle. Those favoring investments (the probability-based approach) rely on the notion that while the stock market is volatile, it will eventually provide favorable returns for most retirees and will outperform bonds. The upside potential from an investment portfolio is viewed as so significant that insurance products are not needed. Investment approaches are probability-based in the sense that they will probably work. My book How Much Can I Spend in Retirement? A Guide to Investment-Based Retirement Strategies provided a detailed analysis for these probability-based investment approaches for retirement.

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An alternative school of thought for retirement income is the safety-first approach. Safety-first advocates are generally more willing to accept a role for insurance as a source of income protection to help manage various retirement risks. For investments-only strategies, retirement risks are generally managed by spending less in retirement, as longevity risk is managed by assuming a long life, and market risk is managed by assuming poor market returns. But insurance companies pool these market and longevity risks across a large base of retirees—much like a traditional defined-benefit pension—allowing for retirement spending that is more closely aligned with average, long-term, fixed-income returns and average longevity. This could support a higher lifestyle than what is feasible for someone self-managing these risks by assuming low returns and a longer time horizon.

Safety-first advocates recognize that risk pooling can be a more effective way to manage retirement risk because it allows retirees to spend as though they will experience average outcomes; those with average lengths of life and average market returns will have paid an insurance premium that is transferred to those who experience a more costly combination of a longer retirement and poor market returns. This can allow everyone in the risk pool to spend more than they may otherwise feel comfortable spending without this protection in place, or to otherwise earmark a smaller asset base to fund their lifestyle in retirement.

The income protections provide a license to spend assets because the retiree knows that subsidies (or insurance benefits) will be received from the risk pool if risks manifest that otherwise threaten the sustainability of an unprotected investment portfolio. Income protections manage longevity risk and calibrate the planning horizon to something much closer to life expectancy. Those who fall short of life expectancy subsidize the income payments for those who outlive it. Those subsidies are known as mortality credits. While receipt of those subsidies clearly benefits the long-lived, arguably both groups can benefit by enjoying higher spending while alive because they have pooled the longevity risk. Their spending can be based on averages, and they do not have to self-manage the risk by planning for an overly long retirement.

Income protections through insurance can also provide peace of mind for retirement lifestyle that leads to a less stressful and more enjoyable retirement experience. Overly conservative retirees become so concerned with running out of money that they spend significantly less than they could. A dependable monthly check from an annuity can provide the explicit permission to spend and enjoy retirement and can simplify life for those with reduced cognitive skills or for surviving spouses who may be less experienced with financial matters.

As for legacy, a death benefit can be created with life insurance to provide a specific legacy amount. Additionally, an annuity supporting lifetime income dedicates assets specifically toward the provision of income, allowing other assets to be earmarked specifically for growth. This can allow for a larger legacy, especially when the retiree enjoys a long life and more of his or her income is supported through the annuity’s mortality credits.

This article is part of a series; click here to read Part Two.

This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon.

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