Lifelong retirement income: the zone strategy

One of the difficult decisions that must be made at the start of retirement is how to create lifelong income for your client. There are several choices: You can generate income from an investment portfolio, you can buy life annuities or you can try the variable annuities with guaranteed pay for a specified term.

How do you decide what strategy to follow and which products to use?

What works for one client may be disastrous for another. So, to start, you need to evaluate two critical factors: a client’s emotional capacity, and his/her financial capacity. Only then can you select the correct strategy.

If a client’s emotional capacity is high enough, she can hold a portfolio of fluctuating equities, so the degree to which a client can tolerate volatility can be one of the limiting factors in financing his retirement. But more importantly, you need to evaluate the client’s financial capacity.

Before you can talk about your client’s dreams—or the wisdom of asset allocation, or the virtues of investing large cap or small cap—you must first determine if your client has the means to finance retirement. If she doesn’t, then no amount of emotional capacity and risk tolerance will improve the outcome.

Determining the financial capacity can be easy, so long as you convey to your client what retirement planning is: providing realistic solutions and strategies that ensure his or her capital lasts a lifetime. It is not plugging some average numbers into a retirement model—the averages don’t cut it. For proper retirement planning, you must base your retirement solutions and strategies on potential adverse outcomes and worst-case scenarios. Using the Monte Carlo simulators is a step in the right direction, but most fall short of reflecting historic market realities.

Drawing Income

The Sustainable Withdrawal Rate (SWR) is the largest periodic income that can be drawn from an investment portfolio without depleting the assets and is based on market history. For an investor to be deemed to have sufficient cash, not only must she have the ability to finance her retirement, she must also be able to finance the time value of fluctuations in her portfolio (these being defined as the losses created by long and short-term market fluctuations and inflation in distribution portfolios).

Ideally, the SWR indicates a 0% percent probability of portfolio depletion. For practical purposes, combined with proper annual reviews, we can accept a more liberal probability of depletion. For our purposes, we’ll assume the SWR means a maximum of 10% probability of depletion at the age of death.
When it comes to retirement income, there are three significant risk factors for the retiree:

• Longevity: living too long;
• Market: the portfolio running out of money prematurely; and
• Inflation: the inability to maintain purchasing power due to inflation

A retirement plan must cover all three factors to be considered well designed.

Special attention must be paid to longevity risk. Don’t use the average life expectancy to calculate a client’s retirement plan, because that’s merely the age by which half of the people will die, but after which the other half survives. In other words, if you use average life expectancies to determine the age of death in your retirement plans, at least half of your clients will run out of money during their lifetimes. Not a good track record for an advisor.

Some financial planning software tries to go a bit further by calculating an average life expectancy based on a list of questions, such as “How much do you drink?” or “How many speeding tickets did you get in the last two years?” It compares the person’s answers to averages and then spits out a number. But unless you are an insurance underwriter, these questions are useless. These averages don’t mean anything. Clients are individuals and responses are subjective.

The proper way to handle the longevity risk is to review the mortality tables. They indicate the percentage of survivability for each age, and the age of death in a well-designed retirement plan should be high enough that the probability of survival won’t exceed 15%.