Understanding the Tools in Your Retirement Income Toolbox

Wade Pfau, Ph.D., CFA

by Wade Pfau, Ph.D., CFA

April 7, 2016

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You should be familiar with all of the tools in your retirement income toolbox. Retirement plans can be built to manage varying risks by strategically combining the following retirement income tools in different ways.

Total Return Investment Portfolios

Making systematic withdrawals from a well-diversified investment portfolio is a common way to obtain retirement income. Systematic withdrawals do not protect a retiree from longevity risk or sequence-of-returns risk, and may only protect from inflation risk when asset returns can keep up with inflation.

The benefits of this approach are that it provides potential to keep your nest egg growing and leave a large inheritance, as well as provide a sense of technical liquidity that could become true liquidity if markets perform well. A total returns approach is particularly vulnerable to declining cognitive abilities as it requires complex financial decision making to manage distributions and investments.

Individual Bonds

Leaving behind the purely total returns perspective, another viable option is to hold fixed income assets to their maturity to guarantee upcoming retiree expenses. Often, this will be done to support short and/or medium term spending, with a more aggressive investment portfolio with higher expected returns to be deployed for expenses in the long term.

Holding bonds to their maturity can avoid selling them at a loss, which can help to alleviate sequence of returns risk. Individual bonds do not provide longevity protection, however. And while they may provide technical liquidity, selling them early to use for other contingencies could result in capital losses as well as the loss of assets that had been earmarked to cover future spending. Traditional bonds will be exposed to inflation risk, but Treasury Inflation-Protected Securities (TIPS) can be used to lock-in the purchasing power of money in real terms.

As for the risk of declining cognitive abilities, managing the bond and investment portfolio may still be complicated, but the bonds can provide additional behavioral benefits. Knowing that income is accounted for over the next several years does help retirees to stay the course and not panic after a market decline by selling off their stock positions. Retirees can take comfort in the knowledge that there will be time for their stocks to recover before they must be sold.

By using bonds to provide income for a fixed number of years, it may also be easier for retirees to understand why the overall asset allocation is what it is. Individuals may not be clear why their portfolio has 60% stock funds and 40% bond funds, but if they instead think in terms of how building a bond ladder with 40% of their assets allows for eight years of income, for instance, then the nature of their asset allocation choice may be clearer.

Income Annuities, Traditional Pensions, and Other Annuity Types

Partially annuitizing your assets can also provide an effective way to build an income floor for retirement. Income annuities, as opposed to individual bonds, provide longevity protection by hedging the risks associated with not knowing how long you will live. Fixed annuities can be real or nominal, and the initial payments can begin within one year (single-premium immediate annuities or SPIAs), or be deferred to a later age (deferred income annuities, or DIAs). Traditional defined-benefit pensions some employees still offer can also be treated as an income annuity. Though income annuities only represent about 4% of total annuity sales, they are the type of annuity that is of the utmost importance as a retirement income tool.

Deciding on whether to annuitize, on an appropriate age to annuitize, how much to annuitize, and whether to build a ladder of annuities over time are all important questions. Annuities protect from longevity and sequence-of-returns risk, and they can protect from inflation risk if a real annuity is purchased. Because income continues automatically, they also provide protection for cognitive decline.

David Laibson, a professor at Harvard University, refers to income annuities as “dementia insurance.” They help manage many risks, but they do not provide any growth potential and life-only versions will not support an inheritance by themselves. In general, they are also not liquid if more funds are needed for unplanned contingencies. However, partial annuitization combined with investments can be an effective way to create true liquidity on the balance sheet.

Income annuities represent only a small percentage of total annuity sales. There are countless types of annuities that can serve many different types of purposes.

Fixed deferred annuities can act as an alternative to CDs or savings accounts; investment-only deferred variable annuities can provide a source of tax-deferred savings during the accumulation phase; and fixed indexed annuities (a newer name for equity indexed annuities), immediate variable annuities, and deferred variable annuities with guarantee riders can all provide various combinations of guaranteed income, liquidity, and upside growth potential. Related non-annuity investment options include the ability to have an income guarantee rider on an investment portfolio, and using financial derivatives to generate the same types of outcomes as some types of annuities on your own.

Social Security

Social Security is the ultimate form of an income annuity, and it is generally one of the largest assets on the household balance sheet. For a high-earning couple, the present value of future Social Security benefits could exceed one million dollars. Social Security provides inflation protection, longevity protection, protection from sequence of returns risk, and survivor benefits. Retirement benefits can begin as early as age sixty-two, but the benefits grow as one waits up to age seventy.

If you view lost benefits from ages sixty-two to sixty-nine as a premium to buy a larger annuity starting at seventy, delaying Social Security can be viewed as the best annuity that money can buy. It offers a better deal than any commercial providers. Because Social Security income continues automatically over time, it also provides protections for cognitive decline. The only risk that Social Security does not help to manage is spending shocks, as you cannot borrow against your future benefits to obtain greater liquidity today.

Housing Wealth

The other major asset for most households outside of their investment portfolios and Social Security is home equity or housing wealth. Housing wealth can be used in a variety of ways in retirement. If care is taken to choose housing that will allow for aging in place, then housing can provide inflation protection and some protection for the uncertain costs related to long-term care.

With cognitive or long-term care needs, housing could be used to live comfortably outside of an institution for a longer period, and then housing wealth could be redeployed to cover the costs of institutional living when it becomes necessary. With a reverse mortgage, home equity can become a liquid buffer asset which can help serve to reduce exposure to sequence of returns risk, or to cover unexpected contingencies.

Long-Term Care Planning

One of the largest spending shocks facing a retired household is the need for ongoing long-term care. A retirement income plan must account for this, and various tools are available to help control the impacts of long-term care costs on family wealth.

The four main options for meeting long-term care needs include:

  • self-funding,
  • Medicaid,
  • traditional long-term care insurance,
  • and new hybrid insurance products that combine long-term care coverage with an annuity or life insurance.

Planning in advance for long-term care needs can help control the impact of spending shocks and cognitive decline.

Other Assets, Insurance, and Income Sources

A hodgepodge of other retirement income tools can also be a valuable source of support for retirement. Decisions made about Medicare or other health insurance can help mitigate the risks of large health care spending shocks throughout retirement. Part-time work, to the extent that it is feasible, can help support a more fulfilling lifestyle while also providing as source of income to help mitigate risks related to market returns. An active mind may also help to limit the onset of cognitive difficulties.

Another source of support is social capital: the ability to obtain help from family members, the community, and the social safety net. Access to these opportunities can help mitigate harms related to the various retirement risks. Other potential assets that are less exposed to market risk and may be available to support retirement goals include life insurance, business holdings, and rental income from real estate.


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