Rethinking Retirement Income

Transcription

1 Rethinking Retirement Income I Annuities Rethinking Retirement Income New strategies for an uncertain world A 10/24/13 FOR PRODUCER/AGENT INFORMATION ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC.

2 Charlie Gipple, CLU, ChFC National Director of Index Products, Genworth Financial Based in Des Moines, Iowa, Charlie joined Genworth in December 2012 as National Director of Index Products. In this role, Charlie directs the sale of index products for Annuity and Life. Prior to joining Genworth, Charlie was employed by ING for 11 years where he held the roles of Regional Vice President of Fixed/Index Annuities, National Business Development Vice President, and most recently, Vice President of Strategic Distribution. With 14 years of financial industry experience, Charlie has worked in retail sales, account management, employee training, product development, and wholesaling of life insurance, annuity and mutual fund products. He has vast experience in working within the IMO/BGA distribution system as well as the Broker Dealer/Financial Institution distribution system. Charlie is a student of index products, financial markets, financial legislation, advanced sales concepts, and how to position insurance products within that framework. He also has a passion for presenting these ideas to large audiences. Charlie has a BA in Finance from the University of Northern Iowa, holds a Series 7, Series 6, Series 63, and is a CLU and ChFC.

3 Chapter 1 I Rethinking Retirement Income Clients have questions. Do you have answers? Since 2000, consumers have borne witness to the S&P 500 Index dropping approximately 50% two times. 1 The volatility in 2008 was unlike anything ever recorded with the Volatility Index (VIX), often referred to as the investor fear gauge, reaching in October, a number representing a quadrupled expectation of market volatility. 2 At the same time, interest rates, as measured by the 10-year Treasury bond yield, have continued their three-decade decline since a peak of almost 16% in At the writing of this paper, the 10-year treasury sits at 2.22%. 4 Additionally, the current average rate on a five-year jumbo certificate of deposit (CD) is 0.80%. 5 The timing of this mixture of volatility and low rates could not be worse. The irony behind all of this is the 78 million-strong baby boomer population began hitting age 65 in 2011, and will continue to do so for 50% Since 2000, the S&P 500 Index has dropped 50% twice. 1 This is why there s never been a better time to fully understand the power of annuities. the next 15 years, to the tune of almost 10,000 per day. 6 1

4 Imagine the questions that might be going through the mind of someone retiring today, regardless of the amount of money they have saved: Market volatility I know the market has been up and down for the last decade, but it has averaged almost 10% over the long run. Doesn t that mean I should be safe over the long run even though the short run has been rough? Bond market risk Low Interest rates Do I put my money in bond funds as well as in stocks, and hope that rates don t spike from historically low levels to potentially have a negative impact on my portfolio value? Can I live off the low interest rates generated by traditional financial products such as certificates of deposits? Portfolio depletion If I do put my money in stocks and bonds, how much can I withdraw each year? Unpredictability Do I have other options? How else could I get a measure of predictability in an unpredictable world without sacrificing my standard of living during retirement? Clearly people have many questions and possibly misconceptions as they approach retirement, especially given the recent turmoil, low interest rates, and perceived risk in the bond market. These hypothetical questions are merely the tip of the iceberg. This is why financial professionals have never been more important than they are today. It s also why there s never been a better time to fully understand the power of annuities. 2

5 Chapter 2 I Rethinking Retirement Income Reverse dollar cost averaging and timing The question around market performance is one many consumers may ask themselves. Indeed, large cap stocks averaged a compounded annual return of 9.8% from 1926 to December Over that same period of time small cap stocks averaged 11.9%. 7 So, people may assume that because retirement is a long-term proposition and the stock market over the long run has performed well, it should be safe to use an allocation that includes the stock market in their distribution years. This is why it s important to understand the concept of timing and reverse dollar cost averaging. Reverse dollar cost averaging happens during the distribution or de-accumulation years, as opposed to dollar cost averaging, which takes place in the accumulation years. Dollar cost averaging is systematically purchasing investments with equal dollar amounts regularly over a certain period of time. In essence, you purchase more shares when the price is low, and fewer when the price is high. For example, when the purchasing price of an investment drops 25%, that same dollar amount would buy more shares, increasing your purchasing power. However, the opposite can happen during distribution. If you are withdrawing 5% of the original portfolio value, $1,000,000, and the portfolio value drops by 25%, that same $50,000 would then be effectively almost 7% of your portfolio value. A drop in portfolio value in conjunction with this increased draw down rate in that year could mean big trouble, especially if the drop in portfolio value happens early in retirement. Reverse Dollar Cost Averaging $1,000,000 5% $750,000 7% $500,000 10% Annual Withdrawal: $50,000 Reverse dollar cost averaging happens during the distribution or de-accumulation years, as opposed to dollar cost averaging, which takes place in the accumulation years. 3

6 It s all about the timing Prior to retiring, Bob amasses a portfolio valued at $1,000,000. Once Bob turned age 65, he wanted to withdraw $50,000 each year from his portfolio for the rest of his life. Illustrated is a 30-year ledger representing a 30-year retirement. As you can see, based on these hypothetical returns over 30 years, Bob was not only able to take out $50,000 per year, he was also able to accumulate almost $2 million to pass on to his heirs should he die at the end of the 30th year. Of course, as you can see, there were bumps in the road along the way. A couple major market declines occurred during his retirement journey even a 25% drop in the 30th year. However, because of the favorable timing of these declines, Bob was able to make it to his destination: the highly coveted 30-year retirement. You might think Bob achieved his goal because he earned and average return of 6% over the 30-year period of time, which was more than the 5% of initial value that he was withdrawing. The 6% average helped, but it was not the major factor in this scenario. Timing was his friend as well. Bob s Retirement Ledger: Year Hypothetical Return Withdrawals Investment Value 0 $1,000, % $50, ,330, , ,408, , ,561, , ,708, , ,824, , ,862, , ,758, , ,015, , ,260, , ,232, , ,920, , ,245, , ,480, , ,357, , ,653, , ,838, , ,094, , ,283, , ,523, , ,855, , ,967, , ,359, , ,193, , ,272, , ,044, , ,193, , ,186, , ,200, , ,688, , ,978, Average 6% Return Success Success These scenarios are hypothetical and used for illustrative purposes only. 4

7 The effective timing of returns To further illustrate the affects of timing, consider Jim s experience (also hypothetical and purely illustrative). Jim had the same 30-year retirement horizon as Bob. Jim also achieved the exact same average return. However, the timing of Jim s annual returns was the exact opposite of Bob s. As you can see in this chart, we inverted the timing of returns that were used in Bob s example to represent Jim s retirement. The annual returns were the same and the average return of 6% over the 30 year retirement was the same. The only difference was that Jim encountered problems early in his journey, and Bob encountered them later. As you can see, it ended badly for Jim, with the depletion of his retirement savings in the 22nd year. Early declines can be severe Many people look at the market, whether the stock market or bond market, and think favorably of the robust averages experienced throughout history. This is an accumulation mindset, in which the actual sequence of returns does not matter. With accumulation, an average of 6% will get you the same ending value regardless of how the actual returns played out. For example, in both of the scenarios above, if you started with $1 million and accumulated based off the year by year returns, assuming no withdrawals were made, you would have ended up with $4,233, But this is not the case in the distribution years. With distributions one cannot assume that an average return will happen in a linear fashion. If the average returns experienced were the same every year, then the calculation of retirement savings and income would be much simpler. However, returns are not likely to be the same every year. The severity of any declines is further multiplied if they occur in the early years of retirement distributions. Jim s Retirement Ledger: Year Hypothetical Return Withdrawals Investment Value 0 $1,000, % $50, , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , Average 6% Return Failure Failure 5

8 The study that started it all In October 1994, a financial planner named William Bengen published an article in the Journal of Financial Planning entitled Determining Withdrawal Rates Using Historical Data. Based on research Bengen had done on stock returns and retirement scenarios over 75 years, this industry-changing article caused the financial world to remember that life is not linear. Even though at that point in time large cap stocks had averaged 10.3% per year since 1926, and Intermediate Treasury Bonds had averaged 5.1%, 8 this study provided there was more to de-accumulation than averages. Through the use of back-testing hypothetical retirements starting every year since 1926, Bengen set out to determine the annual safe withdrawal rate from retirement portfolios. He wanted to answer one of our hypothetical client questions: If I do an asset allocation strategy of stocks and bonds, how much can I withdraw each year? In his back-testing he assumed a portfolio of 50% large company stocks and 50% intermediate term treasuries. From 1926 through 1976 he plugged in this 50/50 portfolio, rebalancing every year, and asked this question: based on the actual performance (not averages) of this portfolio The 4% rule Over a 30 year retirement, a 4% withdrawal rate was successful 100% of the time. allocation, how long would a client s retirement money have lasted at a 4%, 5%, or 6% withdrawal rate of the initial portfolio value? He also adjusted the withdrawals for inflation/deflation. (Note: There were no investment/management fee assumptions included in his study). In the end, Bengen determined 51 different hypothetical retirement scenarios for each of the three withdrawal rates. With a 4% initial withdrawal rate, 100% of these retirement scenarios lasted at least 30 years. In fact, 33 years was the shortest duration the money lasted with a 4% withdrawal rate adjusted for inflation. Thus, Bengen was able to prove, based on the allocation and assumptions, the success rate was 100% for a 30 year retirement utilizing a 4% withdrawal rate. The 4% Rule was born. In 1998, three professors from Trinity University in San Antonio set out to answer the same question: What is the safe withdrawal rate to sustain a 30 year retirement? Their conclusion confirmed the 4% rule. Trinity s research did, however, suggest an optimal asset mix of 75% stocks and 25% long-term corporate bonds. 9 6

9 Chapter 3 I Rethinking Retirement Income Changing times: The demise of the 4% rule Clearly the financial landscape is different today than it was in the mid-90s when Bengen conducted his study. Investors have experienced two major bear markets in 13 years, three decades of dropping interest rates, and an environment in which many believe there is a bond bubble that might be ready to burst. 10 To recalibrate the safe withdrawal rule to this new reality, David Blanchett, Head of Morningstar Inc. s Investment Management Division recently coauthored a new study with Michael Finke, a professor at Texas Tech University, and Wade Pfau, a professor at The American College. This study tested the likelihood of success of a 40% stock and 60% bond portfolio, with a 4% initial withdrawal rate adjusted annually for inflation. The research showed that the initial 4% withdrawal rate would only lead to a 48.2% success rate over a 30-year retirement. Plus, the model assumes a 5.14% return on the bond allocation and a 9.89% return on the stock allocation over 30 years: quite generous in the current landscape. What has caused the success of a 4% withdrawal rate to drop to 48.2%? Simple: Current interest rates. Even though the authors assumed interest rates would eventually return to long-term averages, they accounted for the current low interest rate environment within the first 5 to 10 years of the hypothetical retirement. In fact, the team used an initial interest rate of 2.5%, based on the Barclay s Aggregate Bond Index Yield available as of the writing of the paper. 48.2% Today, the 4% rule is successful over a 30 year retirement only 48.2% of the time. 10 When it comes to shortfall risk, those first five to ten years are extremely important. Michael Finke 7

10 90% success likelihood with 2.8% withdrawal rate over a 30 year retirement. 12 As the study would show, the impact of adverse rates is multiplied when it happens in early retirement. The first five to 10 years are extremely important for retirees because low rates erode returns on the bonds. However, rising rates will consume the value of the bonds. When it comes to shortfall risk, those first five to ten years are extremely important, said Finke, one of the study s authors. 11 The new safe withdrawal rate proposed by Blanchett, Finke, and Pfau: 2.8%. Using a 2.8% withdrawal rate using the same assumptions as above, the results of the study shows a 90% success likelihood over a 30 year retirement. Of important note, the Blanchett/Finke/Pfau study did take into consideration a 1% fee to account for investment costs and/or advisor fees. This is one important component not taken into account in the Bengen study. 8

11 Investment management or risk management? Even William Bengen himself acknowledged that times had changed. On March 5, 2012, he told the Wall Street Journal, Retirees whose withdrawals lately have gone up to 5.5% or 6% of the current value of their account should consider taking steps to protect their nest egg. Consumers will likely ask, If an individual investor can t reduce portfolio risk themselves through investment management then how can an insurance company do it? The answer: risk pooling. Risk pooling is not so much as taking money and putting it into a pool as it is taking different risks from a certain population and averaging those risks together. Essentially, risk pooling allows an insurance company to pool contract owners life expectancies, contract funds, and potential payout amounts to help offset an overabundance of risk. As Jack Marrion states, in his book Index Annuities: A Suitable Approach (published 2010) Retirement income planning isn t really an investment problem; it s a risk management problem. Risk management typically encompasses risks such as death, disability, house fires, car crashes, etcetera. Many would argue that a retirement shortfall is just as serious as these risks. People buy insurance on their lives, their houses, their cars, and even their animals to help offset risks. So it may make sense to use insurance to help offset retirement shortfall risk too. Retirement income planning isn t really an investment problem; it s a risk management problem. Jack Marrion Index Annuities: A Suitable Approach 2010 Insurance companies pool premium payments from consumers into their general account and invest them, so the company has funds from which to pay claims, cover expenses, and make a profit. More importantly, the insurance company has potentially millions of clients over which to spread any potential risk. 9

12 Putting it into practice: Creating sustainable retirement income strategies Returning to our hypothetical retiree questions, one concerned alternative strategies for boosting predictability in an unpredictable world. Utilizing the safer withdrawal rate of 2.8%, let s look at another hypothetical story. This story consists of two examples: one with an annuity and one without. EXAMPLE 1: 40/60 Portfolio of Stocks and Bonds Mary, age 63, is two years from retirement and has a 40/60 portfolio of stocks and bonds worth $1 million. She asks you what kind of income she should expect from this portfolio two years from now. She claims that she will need at least $25,000 per year to cover her essential expenses in retirement. Social Security will take care of her discretionary spending. You discuss with her that with the rates on the bond component of her 40/60 portfolio are about 2.5% per year and, assuming a 10% annual growth on the stock portion, she should have a value of around $1,120,000 in two years. Or, a blended return of close to 6% per year. You then suggest that if this scenario were to play out to her plan, Mary should take $31,360 (2.8% times $1,120,000) per year adjusted annually after year one for inflation and deflation to follow the 2.8% rule. This amount is more than enough to cover Mary s essential expenses. With the above strategy there is a risk, however. What if the portfolio actually drops by 20% to $800,000 over the next two years? In this scenario, once Mary hits retirement two years from now, for her to abide by the 2.8% rule she must limit her initial withdrawal to $22,400 (2.8% x $800,000). This won t be enough money to cover her expenses. 40/60 Portfolio of Stocks and Bonds Portfolio: $1,000,000 Ó Market performance Value Annual 2.8% withdrawal amount Annual needs met After 2 years, assuming 10% annual growth $1,120,000 $31,360 $6,360 excess Ô After 2 years, assuming 20% decline $800,000 $22,400 $2,600 shortfall 40% Stocks 60% Bonds A 40/60 portfolio may protect your retirement needs, but it is vulnerable to the market fluctuations. 10

13 Chapter 4 I Rethinking Retirement Income Mary, age 63, 2 years from retirement Retirement needs: $25,000 per year EXAMPLE 2: 20% Allocation to Fixed index annuity with an optional income rider An alternative strategy would be to allocate 20% ($200,000) of her retirement savings into a fixed index annuity with an optional income rider. Using this strategy, in two years Mary would be guaranteed a $232,000 contract benefit base assuming an 8% simple rollup. Because of the optional income rider, when Mary turns 65 she could begin taking $11,600 (5% of the benefit base of her contract) for the rest of her life, guaranteed. The remaining $800,000 she had invested in the 40/60 allocation of stocks and bonds can provide additional income. If the $800,000 dropped by 20% as in the previous example, Mary would have $640,000 at retirement. (Not withstanding her annuity benefit base value of $232,000). At that point Mary could take $17,920 (2.8% x $640,000) per year from the stock/bond allocation. Between the annual income provided by the fixed index annuity with an optional income rider and the income provided by the allocation of stocks and bonds, Mary would have a total annual income of $29,520 ($11,600 +$17,920), covering her essential expenses. By using this combined strategy you can couple the power of the guaranteed income stream generated by the index annuity with the ability to adjust the withdrawals on the asset allocation model upward with inflation. Adding an annuity with a Guaranteed Lifetime Withdrawal Benefit in the second example allowed Mary to shelter 20% of her retirement savings from shortfall risk. 20% Allocation to Fixed index annuity with an optional income rider Portfolio: $1,000,000 Allocation Value after 2 years Annual withdrawal or income Annual result Ó Ô $200,000 to a fixed index annuity with optional income protection rider $800,000 in 40/60 stock / bonds split $232,000 $640,000 $11,600 $17,920 $29,520 = $4,520 excess plus added protection 20% Annuity ] 80% Stocks & Bonds (40/60 split) Including an annuity with an optional income rider into your portfolio can help make annual income more predictable. Assumptions, Age 63, $200,000 contract purchase; income withdrawal payments beginning after year 2. The benefit base is used only to calculate the rider income withdrawals and is not a representation of the contract value or surrender value. 11

14 Adapting to a changing landscape Much has changed since William Bengen recorded his findings on an annual safe withdrawal rate. In today s ever-changing times, consider including a fixed index annuity as part of a client s overall portfolio to provide: Opportunities for more predictable growth Opportunity to create guaranteed income for life Protection of principal Protection from Index declines and the impact of interest rate risk Tax deferral until withdrawals or income payments begin* In other words, there has never been a better time to talk to your clients about the power of annuities. * NOTE: There is no additional tax deferral benefit for annuities purchased in an IRA, or any other tax-qualified plan, since these plans are already afforded tax-deferred status. The other benefits and costs should be carefully considered before purchasing an annuity in a tax-qualified plan. 12

15 ENDNOTES 1 S&P 500, finance.yahoo.com, accessed 10/03/13, time periods 03/20/ /30/2002 (48% drop) and 10/08/ /02/2009 (56% drop) 2 June CBOE Interest Rate 10-Year T-No, finance.yahoo.com, 10-year bond Sept 21, 1981, accessed 10/03/ interest-rates/pages/textview.aspx?data=yield, 6/10/13 5 bankrate.com, 06/11/13 6 AARP, June Ibbotson SBBI Ibbotson Associates Stocks, Bonds, Bills and Inflation as published in AAII Journal, Feb CNN Money, Bond bubble finally bursting? Rates creep up. 08/19/13 Investment News, The magic withdrawal number in a low interest rate environment? You ll be surprised. February 7, Ibid. 12 Ibid. 15

16 Annuities Issued by Genworth Life and Annuity Insurance Company, Richmond, VA SecureLiving Index annuities with market value adjustment and optional index interest crediting are issued by Genworth Life and Annuity Insurance Company, policy form series GA , GA301R-0312, ICC12GA301R, GA , ICC11GA3002, and ICC11GA3001 et. al. Products and/or riders may not be available in all states or markets. Features and benefits may also vary by state or market. All guarantees are based on the claims-paying ability of Genworth Life & Annuity. The discussion of tax treatments in this material is Genworth s interpretation of current tax law and is not intended as tax advice. You should consult your tax professional regarding your specific situation. Withdrawals may be taxable and a 10% federal penalty may apply to withdrawals taken before age 59½. This is a brief product description. Consult the annuity contract for a detailed description of benefits, limitations, and restrictions. The contract terms and provisions will prevail. The S&P 500 Index is a product of S&P Dow Jones Indices LLC ( SPDJI ) and has been licensed for use by Genworth Life and Annuity Insurance Company and Genworth Life Insurance Company hereinafter referred to as Licensee. Standard & Poor s, S&P, and S&P 500 are registered trademarks of Standard & Poor s Financial Services LLC ( S&P ) and these trademarks have been licensed for use by SPDJI and sublicensed for certain purposes by Licensee. Licensee Index Universal Life Product(s) are not sponsored, endorsed, sold or promoted by SPDJI, S&P, or their respective affiliates, and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability for any errors, omissions, or interruptions of the S&P 500 Index. Although the contract value may be affected by the performance of an index, the contract is not a security and does not directly or indirectly participate in any stock or equity investment including but not limited to, any dividend payment attributable to any such stock or equity investment. Insurance and annuity products: Are not guaranteed by a bank or its affiliates. Are not deposits. May decrease in value. Are not insured by the FDIC or any other federal government agency Genworth Financial, Inc. All rights reserved.