Retirement is risky business. Just ask The American College of Financial Services, which recently identified 18 distinct risks that retirees face — any one of which, if not addressed with careful planning, could irreparably damage a retirement nest egg.
From longevity and long-term care to sequence of returns and public policy, the far-ranging list of risks compiled by the Pennsylvania-based American College underscores just how difficult it can be to protect a nest egg so it produces enough income to last a lifetime. The retirement income challenge is formidable enough that The American College created a professional program of study around it, with its own designation: the RICP, or retirement income certified professional.
“A person could need income for 30 years and maybe more [during retirement],” observes Chris Chen, CFP, CDFA, an advisor with Insight Financial Strategists in Waltham, Massachusetts. “That’s a long planning horizon. So you have to plan for the long run, expecting there are going to be threats [to income] along the way — some that we see coming and others that we don’t.”
In a recent survey by The American College and Investment News, more than 500 advisors who responded identified the five most difficult risks to manage in clients’ retirement income plans as:
1. Market volatility
3. Health care costs
5. Long-term care
A retirement income strategy is part and parcel of the financial, tax and estate planning you do on behalf of your clients, so it’s important to get it right. Here’s a look at some of the income protection approaches advisors are using to shield clients from the most formidable threats to retirees’ cash flow.
1. Market volatility risk
“Equity market volatility is the biggest threat by far” to retirement income and the nest egg that feeds it, asserts Stephen F. Lovell, ChFC, CLU, principal at Lovell Wealth Legacy in Walnut Creek, California.
What’s more, he notes, “When I look at many client retirement accounts, the risk far exceeds a level appropriate for someone nearing or in retirement.” With many clients, dampening that risk is a matter of shrewd equity portfolio management incorporating equity hedging strategies that emphasize managing downside risk.
To couple the upside potential of equity market exposure with downside protection, Lovell says a fixed indexed annuity or a variable annuity with an income rider may also make sense for a portion of a client’s income needs.
Tax diversification within the retirement portfolio
This is another viable strategy for mitigating market volatility risk. The goal is to build flexibility into the portfolio in terms of the types of accounts — tax-exempt (such as a Roth IRA), tax-deferred (such as a traditional IRA or 401(k)) and taxable (such as a brokerage account) — from which the client can draw income. Having the flexibility to let market conditions dictate from which account(s) income is withdrawn may help minimize the damage a market decline can cause to principal. “Ideally, you want a client to have retirement funds in all three types of accounts, so you can pick and choose where the income comes from,” explains Rose Swanger, a certified financial planner with Advise Finance in Knoxville, Tennessee, who recently earned the RICP designation.
2. Longevity risk
As lifespans increase, so does the risk of running out of money during retirement. The trouble is, other than Social Security, few income sources are guaranteed to last a lifetime. And since Social Security is rarely adequate to cover a person’s income needs, there is often a need to seek guaranteed income from other sources.
“There will be situations where you have to go out and get an annuity that gives you a high-grade source of income to last a lifetime,” says Lovell. Here again, a fixed indexed annuity or a variable annuity may make sense, as “the [pure] fixed annuity is not a good choice now,” in a low-interest-rate environment.
Both Lovell and Swanger point to a relative newcomer in the annuity mix, a qualified longevity annuity contract (QLAC) as a solution worth considering to address longevity risk. A 2014 federal government ruling opened the door for insurers to begin offering these fixed-rate deferred longevity annuities for purchase with funds from a qualified retirement account.
Held inside a qualified retirement account, the QLAC functions as an income-management tool that repurposes required minimum distributions so that the account holder, rather than taking RMDs in lump sum starting at age 70.5, can push that income out to later years, (starting as late as age 85) and spread it out over time. This will help ensure they have a steady source of income during the later retirement years. It also allows them to delay paying income taxes on lump-sum RMD amounts they may not need in early retirement, while providing greater flexibility in terms of wealth transfer to heirs. What’s more, the value of a QLAC is excluded from RMD calculations. And, Swanger notes, QLACS are likely to carry lower fees than most similar commercial annuities.
A few limiting factors to keep in mind with QLACs: The investment amount is capped at the lesser of $125,000 or 25 percent of applicable non-Roth retirement account assets. QLACs don’t carry any cash surrender value, although they may come with a return of premium or lifetime annuity death benefit option for beneficiaries. And currently, only a handful of insurers offer them.
3. Health care cost risk
A 2015 report from HealthView Services estimates that a healthy 65-year-old couple retiring in 2015 will pay an average of about $395,000 in lifetime retirement health care costs. For a 55-year-old couple retiring in 10 years, that figure rises to about $464,000. The report also notes that the U.S. Department of the Actuary projects health care inflation remaining at a lofty 6 percent for the next decade. So at least in the health care arena, inflation is a very real and immediate concern.
For retirees with access to a health savings account as part of a high-deductible health plan, Swanger recommends setting aside money in the tax-favored HSA to cover health care expenses. Not only are contributions to an HSA deductible from taxable income (up to a certain dollar amount), distributions from an HSA for qualified medical expenses — including premiums for COBRA, long-term care insurance, and Medicare Parts A, B, or D, for example — come out income-tax-free.
Purchasing Medicare supplement insurance and/or prescription drug coverage under Medicare Part D also can help control out-of-pocket health care expenses that erode retirement income, such as deductibles and copays.
4. Inflation risk
“It’s inevitable we are going to get a higher rate of inflation again,” posits Leon C. LaBrecque, CPA, CFP, CFA, managing partner at LJPR, a wealth management firm in Troy, Michigan.
To defuse inflation risk, seek out income vehicles that come with a built-in inflation protection. With its cost-of-living adjustment, Social Security is one such vehicle. So, managing the timing of Social Security payments is one way to gain a measure of inflation protection.
But for most clients, that’s only part of the solution. Bond laddering is another effective strategy to address not only inflation risk but market volatility risk, according to LaBrecque. These days, he uses bond ladders of five to as long as 20 years to emulate an income-producing annuity, minus the fees or surrender charges. Currently, he leans toward shorter-term ladders to mitigate interest rate risk (another of the 18 risks identified by the American College).
Maintaining an equity portfolio remains one of the most effective strategies to mitigate inflation risk, according to Chen. Resist the temptation to move most assets from equity to fixed accounts at retirement. Instead, he says, focus on building a diversified equity portfolio and balancing that with conservative investments in fixed-return vehicles such as CDs.
Also look to diversify with asset classes that historically serve as an inflationary hedge, such as commodities, suggests LaBrecque.
5. Long-term care risk
At least 70 percent of people over age 65 will need some form of long-term care services and support during their lifetime, according to the U.S. government. That includes an estimated 58 percent of woman and 44 percent of men who, according to a 2014 report by the Center for Retirement Research, will require nursing home care at or after age 65.
And the cost of long-term care is increasing steadily. For example, according to a 2014 study by Genworth, the national median monthly rate for assisted living is $3,500, representing annualized growth exceeding 4 percent over five years. Given those realities, “It’s really helpful to have some kind of long-term care insurance,” says Chen.
But what kind? Chen says he tends to steer clients toward traditional long-term care insurance, while others may lean toward newer so-called combination, hybrid or asset-based products that deliver a measure of long-term care protection on an annuity or life insurance chassis.
“Traditional long-term care insurance products have become more expensive and a little less generous with their benefits,” acknowledges Lovell, so it makes sense to consider the alternatives. Whatever the chosen mode, he says, “It’s a good kind of insurance to have.”
For those retirees who do have it, that’s one less risk to worry about.
Source: “Retirement Risk Solutions” by David Littell, RICP Program Director, The American College of Financial Services.