THE CHALLENGES OF TRANSITIONING FROM THE ACCUMULATION TO THE DISTRIBUTION PHASE IN RETIREMENT PLANNING

THE CHALLENGES OF TRANSITIONING FROM THE ACCUMULATION TO THE DISTRIBUTION PHASE IN RETIREMENT PLANNING

Overview 1. Specializing in retirement income planning 2. Helping Clients Understand Retirement Income Planning 3. Process of building a plan 4. Choosing a retirement income strategy 5. Concluding thoughts

Specializing in Retirement Income Planning

So Many Ways to Provide Value Help clients discover goals Manage retirement budget Determine when to retire Medicare planning Tax efficient savings and withdrawals Roth conversions Using home equity Social Security claiming Executive benefits Long-term care planning Planning in case of incapacity Converting assets into income Retirement risk mitigation Distribution options from employer plans

Does Advice Help? Strategies Increase in income* Social Security Claiming 9.0% Dynamic Withdrawal Strategy 8.5% Tax Efficiency 8.2% Total Wealth Asset Allocation 6.1% Annuity Allocation 3.8% Liability Relative Optimization 2.2% Total 38% Blanchett, video discussing article Alpha, Beta and now Gamma

Helping Clients Understand Retirement Income Planning

What is Retirement Income Planning? Meeting client s financial goals Income needs Contingent expenses Legacy goals Address retirement risks Longevity Inflation Health and long-term care costs Investment-sequence of returns risk Public policy changes

What Are You (the Advisor) Going to Do? Help clients determine their needs Evaluate and maximize all available resources Determine strategies to match resources with needs Help them choose a plan that make sense to them Review and modify the plan to make sure that you stay on track Most important is likely behavioral coaching!

Maximize Resources Social Security Financial assets Medicare benefits Family support Home equity Community support Employer benefits Employment income Government resources Maintaining health

Introduction: Importance of Investor Behavior in Defined-Contribution Plans

Investing is simple, but not east -Warren Buffett

IMPORTANCE OF DC PLANS FOR RETIREMENT SECURITY DC plans have become the go-to employer sponsored retirement savings vehicle 1975 fewer than 11 million DC participants 1990 roughly 24 million DC participants 2014 over 72 million DC participants Participants now have investment control 88.6% of DC plans allow full investment control of assets Additional, 2.7% allows for some participant investment direction Roughly 9% do not allow any participant investment direction

IMPORTANCE OF INVESTOR BEHAVIOR IN DC PLANS Traditional financial theories rely on rational consumer decision making Markets are supposed to be efficient, but there is more volatility than explained by financial models alone Over time, psychology research has shown irrational decision making biases This has caused the development of behavioral finance Aligning traditional financial models and theories with real world planning Nobel Prize Winner Richard Thaler called for the end of behavioral finance as separate from traditional finance nearly 20 years ago Successful outcomes in defined contribution plans, as defined by participation, investment performance, and sufficient retirement savings are hindered by biases and human behaviors

Understanding the Human Element in Decision Making

UNDERSTANDING THE HUMAN ELEMENT IN DECISION MAKING People react to differently depending on how information is presented People are messy, overconfident, and ill-prepared for many situations The dual-self decision making Can you improve outcomes without losing freedom of choice? Nudge and creating better models

THE DUAL- SELF Daniel Kohneman s Thinking, Fast and Slow Detailed work on how people make decisions System 1 Quickly sorts through feelings and memories to make a recommendation System 2 Is slow and effortful, making more calculated and rational decisions The issue is that System 1 often wins out over System 2 Takes effort and work to allow System 2 to prevail This is the dual-self a conflict and partnership between emotional and rational

WHO IS HUNGRY? Read & Van Leeuwen Study Participants that were not hungry were given two food options They picked the health food for delivery in one week 74% of the time Participants that were hungry were given two food options for immediate consumption They picked the unhealthy food option for immediate consumption 70% of time

BEHAVIORAL BIASES IMPEDE GOOD FINANCIAL DECISIONS In daily activities System 1 performs well Essentially an evolutionary process for survival quick thinking Long-term, System 1 has flaws Tends to lead to mistakes for investors Poor at assessing risks and predicting future events Too reactive to current information Behavioral finance is essentially here to define and quantify the mistakes and biases made by System 1 thinking to improve investor outcomes

Understanding Behavioral Biases

IMPACT OF BIASES ON INVESTMENT PERFORMANCE Francis Kinniry Study (2014) Found that most important underperformance factor for individual investors was the lack of behavioral coaching Staying the course would have resulted in 1.5% of additional annualized returns David Blanchett & Paul Kaplan Developed gamma to quantify cost of poor and good decision making Found that making decisions around asset allocation throughout life and in retirement was extremely important Retirement success could be improved by better decision making

RANGE OF BIASES Anchoring Basing estimates on the first piece of information acquired o Example: People tend to rely on the first number that they see, even when it has no relevance to the matter on hand. This can drive people to irrationally believe the price of something is worth more or less than it is today. Framing Reacting differently based on whether the same outcome is presented as a loss or as a gain o Example: Talking about survival rates in medical procedures or success is viewed much more optimistically than discussing the mortality or failure rates, even when the percentages are the same.

RANGE OF BIASES PART 2 Endowment Effect Reacting differently based on whether an item is already in possession o Example: People think items that they already own are worth more. If someone is gifted property, they attach more value to it after they have it than when it was gifted. Home Bias Preferring what is most familiar o Example: This leads people to feeling comfortable investing in companies in their home town and their own company stock. This often leads to a lack of diversification overtime.

BEHAVIORAL CYCLE OF INVESTING Greed-and-Fear Cycle Buy into market at peak Sell out of market at lows Cycle Strong markets attract more money Poor markets lose money

HOW TO HELP CLIENTS Education alone is not enough Need help staying the course Need a plan and course to stay on Need tax planning and asset allocation help

Process of Building a Retirement Income Plan

Retirement Income Process Preparation 1. Create engagement and evaluate the client s current situation 2. Identify/prioritize retirement goals/expectations 3. Estimate the costs of retirement 4. Evaluate available resources (pension, savings, Social Security, life insurance) 5. Make a preliminary calculation of the client s preparedness for retirement 7. Determine the theoretical approach 8. Consider key retirement decisions and strategies 9. Address risks faced in retirement 10. Test alternatives and measure outcomes 11. Present alternatives to client and decide on a plan 12. Implement the plan Building the Plan 13. Review and revise the plan 6. Modify plan if a shortfall

Determine and Prioritize Goals and Expectations Explore retirement life Health Family Work Housing Leisure Life s purpose Legacy -- Long-term care Identify actual retirement activities What activities take on new meaning? What new activities fill the void of work? Create a calendar of a particular day Educate clients about risks and have them prioritize concerns (discuss in a later section)

Determine and Prioritize Goals and Expectations Understand the transition into retirement Is the framework of retirement even meaningful? Is retirement voluntary or involuntary? Is deferring retirement voluntary or involuntary? Is the goal a crisp end of work or phasing into retirement? Identify and prioritize financial goals/concerns Relative importance of insuring an income floor Relative Importance of possibility of increasing income Relative importance of leaving a legacy Risk tolerance Willingness to spend more now with possibility of reducing spending later Risk tolerance--tolerance of portfolio losses

Choosing a Retirement Income Strategy

Determine Approach For Meeting Client s Goals Safety first (flooring) approach Systematic Withdrawals from a single portfolio Bucket or multiple portfolio approach

Safety First Approach Based on life cycle finance theory maximize spending over lifetime, not maximizing wealth Based on utility theory goals are determined and prioritized (1) basic needs, (2) emergency funds, (3) discretionary expenses, (4) legacy goals Consider household balance sheet (financial assets, human capital (work), social capital (Social Security) Unfavorable view of safe-withdrawal rate literature Retirees cannot rely on averages Only get one opportunity for a successful retirement

Investment Strategies Assets are matched to goals (liabilities) so that risk levels are comparable Volatile assets are not appropriate for basic needs or emergency fund To ensure that basic needs are met look to low risk investments (annuities/government bonds) Lower priority needs can be met with risky assets resulting in potential for reduction/increase in spending Systematic withdrawals from a diversified portfolio Multiple portfolio (bucket) approach

Building an Income Base Choosing the amount of income Enough to meet basic needs Enough to meet lifestyle goals Other Low-risk income products Social Security Employer provided pensions Bond ladder that provides income for specified period Annuities Income annuities Variable or indexed with GLWB

Strengths/Limitations Ensures minimum needs are met Purchasing income may limit other financial objectives Income base addresses retirement risks Longevity/excess withdrawal/frailty/long-term care/elder financial abuse Annuitizing maximizes spending Spreads spending over uncertain life expectancy Retirees spend income easier than assets

Retirement Goals

Spending, Liquidity, and Legacy for Bonds, Annuities, & Stocks 65-Year Old Female $1 million at retirement Seeks Real $40,000 Spending Through Age 100 0.5% fixed real yield curve Society of Actuaries Individual Annuitant Mortality Table Life-only, CPI-Adjusted Income Annuity True Liquidity: Discretionary Wealth Not Earmarked to Meet Spending Goal 100,000 Monte Carlo Simulations for stock and bond portfolios. Bonds earn a fixed real return of 0.5%. Stocks earn an arithmetic average real return of 6.5% with a 20% annual volatility. Research by Wade Pfau

Dr. Wade Pfau s Conclusions Risk Pooling Guarantee supports income for life (protection from longevity and market risk) Less assets earmarked for spending goal Greater clarity about true liquidity availability for spending shocks Mortality credits provide unique source of returns competitive with the risk premium Lifetime spending is guaranteed Greater legacy in the long run Greater true liquidity for spending shocks Partial annuitization integrates risk pooling and risk premium Risk Premium (Investments Only) More legacy in event of short retirement Upside growth may support greater spending and legacy Self-management for longevity & market risk requires conservative spending w/o guarantee

Partial Annuitization Impact on Portfolio Sustainability Partial annuitization can have a positive impact on the sustainability of the portfolio if the annuity payout rate is more than the withdrawal rate from the portfolio If payout rate is higher, then a lower withdrawal rate can be used with remaining assets, which extends portfolio sustainability If the payout rate is lower, then portfolio sustainability may decline. However, even if financial assets are depleted, guaranteed payments will continue. This is only a partial failure

How A Partial Annuitization Strategy Addresses Retirement Risks Role of diversified portfolio o Inflation risk o Public policy risk o Liquidity o Unexpected expenses o Long-term care o Health care expenses Role of guaranteed income o Longevity risk o Frailty o Financial elder abuse o Market risk o Excess withdrawal risk o Timing risk o Loss of spouse

Wealthier People Tend to Live Longer Poorest 10% 11%-20% 21%-30% 31%-40% 41%-50% 51%-60% 61%-70% 71%-80% 81%-90% Richest 10% -2.1-1.6-1 -0.2 0.5 1.7 2.7 3.3 3.6 Change in average additional life expectancy (in years) at age 55, by wealth, between cohorts born in 1920 and 1940 1 1.4 1.8 2.4 3.1 3.9 Women Men 4.2 4.6 4.9 5.3 5.9-3 -2-1 0 1 2 3 4 5 6 7 Change (in Years) Source: Barry Bosworth, Brookings Institution Michael Finke, Ph.D. 41

Probability Based Approaches Goals not prioritized must meet lifestyle goal or have a failure Safe withdrawal rate is a floor as it always provides upside except for the worst-case scenario Investment approach can be total returns or multiple portfolio approach Focus is on financial assets failure defined as depletion of financial assets Annuitizing considered too costly for marginal increase in safety and lowers chances to fully achieve lifestyle goals Probability approaches include the systematic withdrawal approach and the various bucket strategies

Systematic Withdrawal Approach Maintain a diversified portfolio and withdraw lifestyle needs Choosing the safe withdrawal rate arguably provides a floor No guarantees risk of reduction in spending Flexible, good for legacy goal possibility of increased spending

Safe Withdrawal Research Worst case scenario using historical analysis and a 30 year time horizon Withdrawal rate based on initial portfolio value plus inflation Look to combine asset classes for best combinations of expected return and volatility 4% becomes 4.5% adding small cap stocks Withdrawal rate ties to time horizon Withdrawal rate can be much higher if you retire when asset values are low

Safe Withdrawal Research Impact of adjusting spending Flat withdrawal rate Withdrawal rate based on current values Adjustments based on investment performance Will 4% work today?* Historically, it did not work in most developed countries With today s low fixed investment environment * Pfau, An International Perspective on Safe Withdrawal Rates: The Demise of the 4% Rule? Market Expectations, Asset Allocation and Safe Withdrawal Rates, Both in the Journal of Financial Planning. (2012).

Choosing a Withdrawal Rate How is withdrawal rate defined? What is the asset allocation? What is the time horizon? How important is a legacy goal? Willingness to adjust when the market is down? Willingness to take risk (willingness to reduce spending later)? Capacity to take risk (are there other sources of income)?

Multiple Portfolio (Buckets) Mental accounting Portfolio management Liability matching Primary strength is helping the client stay on course Limitations can include No guarantees Costs associated with transactions Harder to test

Time Segmentation The three phases of retirement Phase one The client is the same as he was before retirement. This typically means the client has no limitations (fully active). Phase two The client experiences moderate limitations. Occurs at different times for different people in the relationship Relationships and interactions with others become more meaningful Phase three The client experiences significant limitations. Appropriate and regular support are needed Family caregivers may need to leave their own jobs Asset allocation Build portfolios to match time segmentations Match asset allocation with income allocation More conservative allocation for nearest time segments

Cash Reserve Cash reserve (Evansky) Investment portfolio combined with cash reserve Use cash reserve to meet expenses when the market is down Use portfolio gains to meet expenses and replenish cash reserve when market is up Consider alternatives to cash Reverse mortgage Life insurance cash value

Social Security Single largest income source for most retirees 2/3rds of retirees its more than 50% 1/5 th its all of income Provides a floor of income beats any annuity so the first annuity you should every buy is S.S. Deferral Well tested strategy is defer S.S. till 70 and spend based on RMDs

Don t Forget Home Equity Housing costs are largest for retirees Home equity also represents America s largest asset 2/3 wealth in home 1/3 other assets for average 65 couple Reverse Mortgages Non-market correlated asset Cash flow Tax benefits Line of credit

Time Segmentation Can accommodate different risks that occur in different phases of retirement Bucket approach may resonate well with clients: Stocks are for later time periods, so the client can buy and hold rather than worry about short-term market fluctuations. Without looking at a bucket approach, it is difficult to rationalize to a client why stocks should be in a retirement fund. Clients can sleep better at night. Total asset allocation may be similar to systematic withdrawals

Concluding Thoughts

Determine Approach For Meeting Client s Goals Safety first (flooring) approach Systematic Withdrawals from a single portfolio Bucket or multiple portfolio approach Consider advisor s preferences Consider client's preferences (safety of income, potential for upside, legacy) Consider client's funding status

What We Learn from Each Approach From the safety first approach we learn that we need to prioritize client s goals and determine which are most important From the systematic withdrawal approach we learn that we need to carefully consider how much can be withdrawn from resources and still have them last a lifetime From the bucket approach we learn that a plan has to tell a story so that the client understands how the plan works when things happen

Staying the Course Does the client understand the plan? Did the client choose the plan? Was all information considered? Do assets match up with liabilities? Is there enough reevaluation and review?

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