By Bill Broich
In 1994, amateur economist and investment manager William P. Bengen wrote his famous thesis about withdrawal rates from accumulated funds in calculating retirement income. Here is the link: http://www.retailinvestor.org/pdf/Bengen1.pdf Over the years and due to the financial meltdown of 2008, the amount of withdrawal has been reviewed by many planners as well as projecting economists. Recently Morningstar (www.morningstar.com) (2013) reviewed Bengen’s research and downgraded the percentage from 4% to 2.8%.
The fact that a portfolio must maintain a growth level of over 2.8% to keep the offset of withdrawals presents a serious problem. Most portfolios contain a blend of bonds and common stocks and some bank products, the question remains; over the length of the average retirement period (21 years according to AARP study) can the portfolio maintain itself or is principle invaded?
Suppose it doesn’t, and the retiree has to withdraw more to maintain income flow, what happens? Suppose the retiree uses up the balance of the funds? Does this sound like doomsday? Or does it only mean that planning for future events makes reality difficult? Think about the past collapses of the stock market just in recent years, such as 1987 (Black Monday), 2008. Are those the only collapses in the past 30 years, that wouldn’t have much of an effect would it? The answer is no, here are a few more events that caused the stock market to lose value since 1987:
- 1989 failed United Air Lines buyout • 1990 Iraq invades Kuwait • 1991 Japanese property value bubble burst • 1992 Black Wednesday in the UK • 1997 Asian stock market crash • 2000 Dot-Com Tech bubble burst • 2001 9-11 • 2007 Chinese stock market bubble burst • 2008 Bank failure in Iceland • 2009 Dubai debt deferment • 2010 Greek debt issues • 2011 World stock market volatility • 2015 China stock market crash.
These small (by Black Monday) crises might not seem like much, but each of them caused the American stock market to lose value. What happens to your available retirement accounts should a future crisis occur as you were withdrawing 2.8% annually?
Suppose you consider using an income rider with a 7% guaranteed growth in place of the 2.8%. I know well the argument, the company will just use a smaller factor as the income generator to offset crediting the 7%, but now with the new Morningstar research saying that 2.8% is far more prudent, an income rider quickly becomes the greater choice.
As an example, I will use $1,000,000 in a retirement account and wait 1 year to begin withdrawals. I will also assume a net return of 2.8% as an annual yield. In one year, the account would contain $1,028,000.
2.8% annually of that account would be $28,780 a year. If the account gained more, income would increase, if it earned less, income would drop.
Plus Volatility: Volatility, as described here, refers to the actual current volatility of a financial instrument for a specified period. It is instability of a financial instrument based on historical prices over the specified period with the last observation the most recent price. (Wikipedia)
Consider the option of outsourcing to a Fixed Indexed Annuity (FIA) with an income rider (7%). In one year, the income side would have a guaranteed account value of $1,070,000.
Now the tricky part and the argument over bait and switch. Many marketing advertisements offer the 7% but I the fine print they include the fact it is 7% not as yield but as growth in an account that can only be removed via income, income over an extended period of time.
I have seen the ads, and so have you, they are bordering on misleading the public, but the “devil is in the details” is it not?
So why not agree that income needed in retirement is long term? Given that fact, let’s look at the details, the factors used in conjunction with the guaranteed 7%. Our assumption is a retirement at age 65. (http://www.ssa.gov/oact/STATS/table4c6.html)
Life expectancy for males is 17.6 years, and women are 20.2 years. An interesting fact becomes evident.
“The longer you live, the longer you live.”
This means that as you age, your expected life expectancy is extended. If at age 65 (male) your life expectancy was 17.6 years (83) but at age 83, your life expectancy is now another 6.6 years, the longer you live, the longer you live. By outsourcing management of retirement income to a third source, you remove the worry and stress of financial decisions, and you answer the most important question of all: “can you ever outlive your money?”
Let’s go back to the factors used by the annuity company to determine exactly how much income can be received by a male age 65.
Lifetime income guaranteed factor at age 65 is 4.5%. If I have an income value of $1,070,000 in my FIA and the factor is 4.5 then my income for life is $48,150,00.
$48,159 versus $28, 780.
But wait a minute, the withdrawal of $28,780 allows no invasion of principle, and the FIA means you have turned over your money to the annuity company. What happens if you die prematurely? Will the insurance company keep your money? Also, what about taxes, how much is reduced by paying income taxes? Income taxes are due on earned income. If you remove 2.8% from an IRA, it will be taxed as income, the same is true with an FIA, taxes must be paid. If your FIA is not in an IRA, it can have a tax advantage over removing income.
Here is an often used method for maximizing income and at the same time leaving the entire amount TAX FREE to your heirs. The system is simple and some may not qualify for it, but using a portion of the difference between the two factors ($48,159 minus $28, 780 equals $19,379) can buy a 20 year term (or lesser) life insurance policy to provide the account value used in full as a tax-free benefit for heirs. Even paying premiums for the life policy will still provide a greater net retirement value for the user of the FIA.
With interest rates still so low, using an FIA can make solid sense for retirement planning, plus it removes stress, volatility while providing dependable reoccurring monthly income.