Tuesday, April 3, 2012

The Retiree Toolkit

Developing a retirement income strategy is an individualized process which uses building blocks from a retirement toolkit. No single approach or product works best for everyone. But crafting together these various pieces can help result in a strategy to obtain a sustainable income for the remainder of one’s life. I’ve taken to calling this the retiree toolkit and “building blocks” for the toolkit. Recently I read an article by Steve Vernon describing  the same basic idea, and he calls it the retirement income menu.

The way I see it, the basic building blocks for a retirement income strategy are:

1. Social Security: Social Security provides an inflation-adjusted annuity with income for the remainder of one’s life. Retirement benefits can begin as early as age 62, but the benefits grow as one waits up to age 70. Often it is worthwhile to spend down other assets in order to preserve the start of Social Security until age 70. Getting this decision right is quite important as the income floor provided by Social Security is a fundamental building block of retirement income. (Any other defined benefit pensions could also be grouped in with this category if it is thought of more broadly as social capital).

2. Part-time work: I’ve heard it said that the concept of retiring completely in one’s 60s is a unique circumstance of the late 20th century. To put it bluntly and to generalize, before this time people did not live long enough to have to worry much about funding their retirements, and now people are living too long to be able to save enough to drop completely out of the workforce. Continuing part-time work, or maintaining the option to return to the work force is also an important building block for retirement income.

3. Bond ladders: An important retirement income strategy is to dedicate specific assets to fund future planned expenses. This can be done most safely with a portfolio of bonds designed to mature and provide the desired income at specific future dates.

4. Single Premium Immediate Annuities (SPIAs): Partially annuitizing one’s assets can also provide an effective way to build an income floor for retirement. These fixed annuities can be real or nominal, and the initial payments can be deferred to a later age. Deciding on an appropriate age to annuitize, how much to annuitize, and whether to build a ladder of annuities are all important decisions. Annuities protect from longevity and sequence-of-returns risk, and they can protect from inflation risk if a real annuity is purchased. But they do not provide any growth potential or potential to leave an inheritance, and in general they are not liquid if more funds are needed for an emergency. Also, there are concerns about the long-term viability of the insurance companies providing the annuities.

5. Systematic withdrawals from a volatile portfolio: Withdrawing income from a portfolio of stock and bond funds is another option, and the research about safe withdrawal rates refers to this strategy. This approach doesn’t protect from longevity risk or sequence-of-returns risk, and it only protects from inflation risk if asset returns can keep up with inflation. The benefits of this approach are that it provides potential to keep one’s nest egg growing and leave a large inheritance as well as providing liquidity. Fitting into this category include different approaches such as investing for total returns, using a bucket approach which is combined with bond ladders, and drawing income from dividends and interest while attempting to preserve the original principal.

6. Variable Annuities with Guaranteed Lifetime Withdrawal Benefit riders: These are a mix between annuities and systematic withdrawals from a volatile portfolio.  When markets are down, these provide a guaranteed return.  When markets are up, these share some of the upside, but not the full amount due to the expenses of providing the downside guarantee.

Other honorable mentions for this list include reverse mortgages, long-term care insurance, and life insurance.

That’s the basic list. Now it is just a matter of fleshing out the details for each of these building blocks, quantifying their pros and cons, and considering how to best combine them to help individual retirees to best meet their goals.