Lesson #2
Why Conventional Income Plans Fail
7 Annuity Strategies of The Wealthy
Why Do So Many Conventional Methods Fall Short of Meeting Your Needs?
What To Do Right Now to Generate Retirement Income.
What You'll Learn in Lesson #2
We will thoroughly examine three common methods people use to generate income during retirement in this lesson. We will also dive into each option and outline its disadvantages. This may help you avoid experiencing the difficulties some may experience with each method while in retirement.
The 3 common methods are:
1. Principal investment in a fixed-interest-rate product, like a bond or CD, with hopes to live off the interest without ever touching the initial principal.
2. Annuity purchase that offers a lifetime income stream.
3. Systematic withdrawals from a portfolio that is not guaranteed and therefore contains a possible loss risk.
Ready? Let's go!
Option #1 - Interest-Only Retirement Income
As you enter retirement, one of your greatest concerns may be that you could run out of money!
Some people attempt to protect themselves from this fear by looking for the highest rate of return they can find in something “safe." This could be a CD or other fixed-interest-rate investment where they plan live off only the interest they earn, thinking this may solve their need for income without ever having to touch their principal balance.
Here's an example. 62-year-old Robert has $300,000 in savings. Robert has invested in a bond or CD that is paying a 3% rate of return, meaning his CD would generate interest income of $9,000 per year, or $750 per month. ($3 00,000 x .09 = $9,000) With this option, Robert hopes to avoid dipping into his $300,000 principal.
This strategy can work, and has for many people; but with the current low-interest-rate environment, retirees experience more challenges, more frustration, and more fear as they attempt to meet their ongoing financial needs with this approach.
Here's why:
Problem #1 – Competitive Interest Rates Are Hard to Find!
If you are living on an income stream derived from your earned rate of return, you tend to be a slave to the current interest rate environment.
We have witnessed a dramatic decline in interest rates on bonds and CD’s in recent years! Many retirees who were accustomed to fixed interest of 4% or better are now having to renew at less than 2%.
If our example retiree Robert was used to receiving a 4% return on his $300,000 principal investment, but is only able to find a 2% renewal-rate return, he will experience a 50% LOSS of his monthly income! ($300,000 @ 4% produces $1,000 per month of income, but $300,000 @ 2% only produces $500 per month of income).
This is one reason retirees depending on the interest income from their fixed-rate investments are having a difficult time financially.
How do you combat this problem?
You either have to go find a higher rate of return, which may not be possible at an acceptable level of risk given the current environment, or you must begin withdrawing both interest and principle at the same time. Imagine how this adds to the fear of running out of money you were first trying to avoid with this method.
Problem #2 – Compound Interest is a Thing of the Past When You Live Off Interest-Only.
"Compound interest is the eighth wonder of the world."
~Albert Einstein
Interest that earns interest on itself is the simple but powerful mathematical process known as compound interest. Over time, compound interest has a snowball effect on the growth of money.
Here's an example. Upon his arrival in the New World, suppose Christopher Columbus deposited $100 into two separate bank accounts. (Of course, this also supposes there was a bank conveniently waiting for him when he got here!)
Now suppose the first account paid 10% simple interest (interest only on the principal each year) and the other account paid 5% compounding interest (interest on the principal as well as the interest already earned). How much money would be in each account today, if left untouched?
The 10% simple interest account would contain $5,250 after 518 years whereas the 5% compound interest account would have a value over $8.61 trillion! Granted, you probably aren't going to have 500 years to save for retirement, but this interesting example certainly illustrates the power of compound interest!
What does this have to do with living off fixed-rate interest?
If you are living off the interest earned in something like a bond or CD, then you are, in effect, withdrawing your growth as soon as it’s earned.
If you are withdrawing your growth as soon as you earn it, your principal balance is not generating any compound interest. By using this approach, you could be missing out on the powerful mathematical law as you forego having it work in your favor!
So, how do you fix this? And is there a better way? In the next several lessons, we will offer some simple and helpful solutions to these challenges, so stay tuned! But for now, let’s explore the next way people commonly generate income during retirement and its related challenges.
Option #2 - Guaranteed Income Payout with an Immediate Fixed Annuity Purchase
Remember from Lesson 1...an immediate fixed annuity is a contract between you and an insurance company. The insurance company guarantees a monthly income for a certain number of years in return for giving them a certain-sum principal investment. The contract is set for a pre-set number of years (10, 15, or 20, etc.) or for your lifetime, depending on the payout option you choose upon purchase.
Way back in Roman times when annuities were first invented to pay retiring senators a continuing salary, and all the way to the present, people have relied on annuities for systematic, safe, and predictable income to help meet their needs during retirement.
When applied correctly, immediate fixed annuities can be a tremendous benefit. They have helped meet the income needs of retirees over centuries; however, they feature disadvantages that are more evident in a negative economy like we are experiencing currently.
Problem #1 – Irreversible Decision
When you purchase an immediate income annuity from an insurance company, you are effectively signing over ownership of your principal in an irreversible or irrevocable manner.
Remember Robert, our fictitious retiree we met earlier? Robert had $300,000 in savings, and after learning about the limitations that come with living off the interest generated from his CD’s, he wondered if an immediate income annuity might be a better option.
Let's explore. If Robert purchased a fixed annuity with his $300,000, he would receive guaranteed monthly income payments of $1,800 per month for the rest of his life, a much higher guaranteed income stream than he would receive from his CD’s.
Once he signs the annuity contract, however, Robert is unable to maintain ownership of his $300,000 principal so 5 years from now, if he needs to access money from his principle (say for an emergency), he will not be permitted to do so, even for a large surrender charge. Literally, the money does not belong to him any longer. He would, per the contract, continue to receive his scheduled $1,800 monthly income, but he can never again gain access to his principal...not for any reason nor for any amount of penalty. The money is no longer his.
Problem #2 – No Principal Preservation or Recovery
It is important to understand that in our scenario, Robert has forfeited his ownership of his principal and the principal is not preserved so there is no recovery of it at the end of the contract for him, his spouse, or his children...and the same would be true for you in this case.
If Robert selected a 20-year income stream instead of the lifetime term, the insurance company would pay out his entire original principal of $300,000, along with some minimal interest over a 20-year period but the contract would expire at the end. The income payments would stop and there would be nothing left.
Problem #3 – No Protection from Inflation
The vast majority (with some exceptions) of immediate annuities purchased in the United States do not offer income stream adjustments for inflation.
This means that Robert would receive the same monthly amount at age 80 that he began receiving at his inception age of 62. Of course, prices of everyday goods would have increased and potentially doubled within that 18-year time frame!
You can see that while annuities can offer some desirable safety benefits and guarantees, they also come with “tradeoffs” forced upon you. Most retirees want all three benefits of income, growth, and principal preservation at the same time, without sacrificing others to gain only one of the benefits.
What's the third common way people attempt to create income in retirement? Read on for more.
Option #3 – Non-Guaranteed Portfolio Systematic Withdrawals
By this time, our friend Robert is feeling less confident about an immediate annuity (or bond and CD interest) meeting his needs adequately in retirement. He wonders if perhaps he should consider a “professionally managed diversified portfolio” as an alternative option. He may be thinking that perhaps he could preserve his principal by earning enough interest each year, even as he plans to make consistent annual withdrawals for income purposes.
Let's see if Robert is right.
We will first look at some basic financial planning rules. Then we will investigate the main problems and frustrations we may face when exercising this type of option.
There are 3 primary phases in someone’s financial life:
Phase #1 – Growth & Accumulation
Phase #2 – Transition
Phase #3 – Income and Preservation
These phases are represented by the three graphics below.
Primary Financial Phases of Life
Growth/Accumulation
Ages 20-50
Moderate to Aggressive Risk
Transition
Ages 50-60
Less Risk - Increase Safety
Income / Preservation
Ages 60+
Little to No Risk - High Safety
When it comes to selecting the types of investments that make up your portfolio, most financial planners agree that this is the philosophy to follow.
You may be tempted to continue using risk-based investments well into your Transition Phase (and perhaps into your Income/Preservation Phase) if that is what you did during your actively working years. After all, we are creatures of habit!
Unfortunately, after working with numerous retirees across the country, we've witnessed the dominant causes of financial problems in retirement usually result from a continued use of a too-high percentage of risk-based investments during retirement while withdrawing income at the same time.
Remember the 2008 financial crisis? The problem was especially evident then as retirees realized major principal losses with the significant market downturn. Many were forced back into unwanted employment. The investors whose retirements were negatively impacted ended up in a very difficult situation; many because they didn't have their porfolio's correctly re-designed for their new (or next) phase of life.
Their Life Phase Cycle looked more like this:
Incorrect Phases
Growth/Accumulation
Ages 20-50
Moderate to Aggressive Risk
Transition
Ages 50-60
Moderate to Aggressive Risk
Income / Preservation
Ages 60+
Moderate to Aggressive Risk
This problem can sometimes be compounded by unknowingly working with an advisor or broker who focuses on growth and accumulation without developing a specialty in income and preservation.
Consider this: if you are 60 years old and have been working with the same advisor for the past 10 or 20 years (during your working career), chances are good that you are depending on an Accumulation Phase advisor, since the majority of your time working with them has taken place during that Growth and Accumulation Phase of your life.
If you are concerned about losing money, running out of money, or safely generating sufficient income with your current portfolio, that is compelling evidence that you likely have not been presented with effective income-producing portfolio concepts capable of solving these concerns.
Just like some doctors specialize, there are advisors in the financial services industry who specialize in different areas of expertise, as well.
You can always value your relationship with your respected and trusted advisor and appreciate the good work they have done on your behalf, but one of the most important decisions you can make as you prepare for retirement is to transition your portfolio into the service and care of an advisor who specializes in the Income and Preservation Phase. They are well-trained and better equipped to help you navigate the unique challenges of this phase of your life.
Now that you know about general financial planning for retirement, let’s look at what can go wrong when you depend on a non-guaranteed portfolio for provision of growth and income during retirement.
Problem #1 – Consistent Income Draws During A Declining Economy
Stockbrokers like to talk about “average” rates of return.
You'll often hear: “Some years you’re up 20 percent, and some years you’re down 20 percent, Robert. But on average, your portfolio should get about an 8% rate of return over the years.”
During the Accumulation Phase of life, you can almost afford to “play the averages” because you've got time and you aren't taking out any income. But can you imagine what happens mathematically when you begin pulling consistent income out of your portfolio? Think of the impact as you take money out every single year, whether the portfolio is up or down.
Withdrawing income every year during retirement makes the “bad” years much worse, and can make the “good” years not nearly as good. Why? Think about what happens to your $500,000 portfolio balance if you’re withdrawing $30,000 as income while losing 30% of your account value in a down economy. Your portfolio balance would drop from $500,000 to $320,000 in only ONE YEAR!
A situation like this is typically when a stockbroker will try to convince you to “hang on.” They will tell you the market will come back and “average” out with the next big rebound year.
But will it? Let’s see. Even in the best rebound years, we rarely see the market rise more than 25-35%. So in our scenario, let’s say your new portfolio balance of $320,000 has a 30% rebound return the very next year. Are you really back up to your $500,000 beginning balance? Did the “averages” work out like the brokers claimed?
You guessed it. The answer is no. Remember, you’re retired and don’t have a paycheck to buy health insurance and food or pay your mortgage and electric bill. You are dependent on your portfolio to provide for these expenses, so you still have to withdraw portfolio income out in this year, and the next, and the year after that. Not many retirees have the luxury of shutting off their monthly income for a couple of years to allow things to rebound!
So assuming our $320,000 participates in a 30% rebound the following year, does everything “average out?” Receiving a 30% gain on $320,000 would temporarily bring our balance up to $416,000, but when we subtract our $30,000 income to pay our bills and living expenses for the year, we are back down to $386,000, a 22% reduction of that life savings in the first 2 years of retirement! That's no much peace of mind for a 62-year-old with a 25-year life expectancy.
There are two extremely important points to understand about this type of strategy:
1. Losses can be twice as powerful as gains. If you lose 50% of your $100,000 in the first year, and then have a 50% gain the second year, you are NOT back to where you started. $100,000 minus 50% equals $50,000, but $50,000 plus a 50% gain only brings you back up to $75,000! It takes a 100% gain in order to offset a 50% loss, assuming you are not taking any withdrawals for income.
2. Income withdrawn from your portfolio each year can skew your averages. There are few things that can destroy a portfolio faster than drawing income in the same year your underlying investments are losing value.
What to Do?
We believe that most people over 55 are looking to do three primary things:
1. Create stable, predictable retirement income.
2. Keep their money growing safely and consistently every year.
3. Preserve their principal balance throughout retirement so they do not run out of money too soon or have nothing to leave as an inheritance.
Those same people over 55 are:
1. Afraid of losing money
2. Afraid of running out of money
3. Concerned about not having enough income to meet their needs
4. Worried about not having enough adequate growth of their nest egg
5. Frustrated with growth and income being eaten up by taxes and fees
There is a great deal of concern out there over retirement these days! And the reality is that many conventional financial products, investment vehicles, financial plans, and even financial advisors are not capable of providing all three of those requests at the same time; at least not with any mathematical certainty. Our experience is that many retirees are tired of conventional planning techniques that come with frustrating “trade-offs.”
How many “options” have been presented to you where you are given the choice between:
Income OR preserving principal
Growth OR safety
Predictability OR liquidity?
When facing financial challenges, it is natural for people to blame the stock market, or the economy as a whole, but in our experience working with thousands of retirees over the past decade, we believe the REAL causes of these problems are more specific. They are:
1. A lack of REAL solutions to these problems
These issues are solved only by proper PLANNING. They are not solved by PRODUCTS.
2. Not having a truly skilled advisor
It is important to find an advisor who is trained at giving the correct advice during the Income and Preservation Phase of life and knows the difference between Investment and Planning.
3. Confusion over best options
It's difficult to make an informed decision when you are barraged with unfamiliar information and bad advice. You develop analysis paralysis as you fear making the wrong decision, and you may end up feeling overwhelmed as you plan for this new phase of life.
4. Not following the basic rules of financial planning
It is important to work with an advisor whose specialty is different from the phase of life in which you are currently living and who understands the Proper Age/Risk Ratio.
Thomas Edison once said, “There’s a better way for everything. Find it!”
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