By Ben Mattlin
For retirees, dependable income that doesn’t drain their portfolios sounds like a dream come true—especially during market volatility. But unless clients have a pension (and fewer and fewer do), how are they to find, manage, and afford this kind of secure retirement income?
Constance Craig-Mason, CEO of Concierge Financial Advisory in York, Pa., said careful preparation can help clients “move from confusion and fear into a strategic plan they can actually understand and trust.”
The first step, she continued, is to calculate the client’s basic financial needs—their necessary, non-negotiable, and fixed expenditures such as housing, food, utilities, taxes, insurance, and healthcare. Then they should figure out how much is coming in from Social Security and any other safe, recurring income sources they may have. If there’s a difference between the two figures, the client needs some additional guaranteed income.
She said advisors should “guide clients through a cash-flow-based income-gap analysis.” The gap, she added, is not a guess but an “intentional number” rooted in the client’s real-life needs.
The next step is to identify the ideal way of generating what’s needed to get by.
Annuities
One tool for clients wanting to secure necessary extra income is an annuity.
“Annuities offer a dependable income stream [that] can help mitigate the fear of deleting funds [from savings] during retirement,” said Kelly LaVigne at Allianz Life Insurance Company of North America in Minneapolis.
There are many different types of annuities, but all of them are essentially contractual agreements between a client and an insurance carrier. Many annuities offer guaranteed income that, in some cases, cannot be outlived. “The guarantees in an annuity are backed by the financial strength and claims-paying ability of the issuing insurance company,” LaVigne explained.
Clients who don’t want to trade off the growth potential of their market exposure for the income security annuities promise can choose a variable annuity, a vehicle that holds assets in mutual-fund-like subaccounts. They could also choose a fixed-index annuity, which is pegged to a market index. Also called an FIA, it pays out a fixed rate and augments the underlying account when the index moves upward. Most FIAs offer downside protection too, so that the account value can never decrease even if the index loses ground.
These days, annuity payout rates may be high enough that clients need not worry about being tempted to take extra money out of other investments, said Wade Pfau, author of The Retirement Planning Guidebook. Suppose a client puts half of their assets into an annuity that pays 5%, and the other half goes into market securities. Traditionally, it was considered safe for clients to withdraw roughly 4% of their portfolio each year throughout retirement. But with half their assets generating a 5% income stream from an annuity, they only need to withdraw about 3% of their other investments annually instead of 4%. “Having a portion of assets in an annuity can reduce the withdrawal rate needed from remaining assets to meet the client’s overall spending goal,” he said.
David Montgomery at Concurrent Investment Advisors in Tampa, Fla., added that annuities within 401(k) plans—a burgeoning trend made easier by the SECURE Act of 2019—are usually cheaper and easier to understand than annuities purchased on the open market.
“These in-plan solutions are also easier to buy and build up a balance in because employees can contribute to them every paycheck,” he said. “Employees can be confident that they are getting a vetted, quality solution because they are selected by someone who has fiduciary liability over it.”
Risks and Considerations
Not everyone likes annuities. “Annuities carry the risk of being very expensive,” said Edison Byzyka, chief investment officer at Credent Wealth Management in Fort Wayne, Ind. He also pointed out liquidity concerns: Many annuities charge a penalty if funds are withdrawn during a surrender period—generally the first three to seven years. (Typically, the longer the surrender period, the better the annuity’s other terms.)
Other skeptics note that, while many annuities feature guarantees, insurance companies have encountered financial troubles in the past. That’s why it pays to read the fine print of annuity contracts.
Bonds and Bond Ladders
Another alternative is Treasury bonds. A ladder made up of Treasurys with varying maturities can supply clients with cash infusions at predictable intervals.
Though T-notes are backed by the full faith and credit of the U.S. government, they do have drawbacks. Interest rate and reinvestment risk remain real concerns. If interest rates rise after a bond is purchased, the yield may underperform. Or, if rates fall, matured bond proceeds might be reinvested at a lower rate.
A criticism of both Treasury bonds and annuities is that they typically fail to keep up with inflation. (With some annuities, clients can purchase an inflation rider for an extra fee, but no annuities automatically adjust.) That’s why some advisors recommend Treasury Inflation-Protected Securities (TIPS)—federal bonds that track the Consumer Price Index. These come in maturities of five, 10, or 30 years, and though they pay out a low fixed rate, the principal value adjusts with inflation.
Some advisors suggest TIPS mutual funds or ETFs instead, which offer liquidity at the cost of increased volatility and fees.
“Bond ladders with TIPS are an inexpensive way to purchase income-producing investments,” said Lisa Featherngill at Comerica Wealth Management in Winston-Salem, N.C. “There is risk in buying long-term bonds because the price drops as interest rates increase. However, if an investor is comfortable with current rates, this is an option.”
Rental Income
For some retirees, rental income can be another solution. If they own property, they might generate steady income through long-term leases or short-term rentals like Airbnb.
“The average annual income from rental properties in the U.S. is $82,530,” said Scott Ward at Compound Planning in Birmingham, Ala. “So real estate ownership is a significant source of income and wealth for many Americans.”
But rental properties aren’t for everyone.
“Rental property is work!” said Featherngill. “Yes, in the right situation it can be income producing. … But when something goes wrong in the property, you need to get there and fix it, unless you want to pay someone to manage the property.”
She also suggested tapping IRAs for supplemental income in low-income years. That might include taking distributions or converting IRA assets to Roth accounts. Either will trigger income taxes, so the strategy makes the most sense in early retirement years when taxes are lower.
“Accelerating income in those [early, low-tax] years provides low-cost income and smooths the tax burden in future years,” she said.
Read original article in FA Magazine.
