As advisors, we spend much of our effort helping clients reach financial independence. They may have begun this process early in their adult lives — creating a financial infrastructure like the one described by Thomas Stanley in his famous book, “The Millionaire Next Door.” We continue to help our clients reach the summit point where they can retire and have the money to live a life that is not only sustainable but enjoyable. Many have become financially independent: If they continue to work it’s because they want to, not because they have to. The client feels very much in control.
Still, when a client retires, they know the financial resources they have accumulated are now finite. There are no more regular paychecks. They will turn to you to build a retirement fortress. It’s certainly something you can help them do, but the building requirements are completely different than how you helped them build financial independence.
Advisors building a retirement fortress need to develop a plan for dedicating a client’s financial resources to what I call the four L’s of retirement life:
Liquidity: A portion of the retirement portfolio can have no risk at all so it can fund emergencies or hardship consequences of unexpected events.
Long-term care: Clients need to have assets to self-fund long-term care or have insurance products in place. Ongoing medical care costs also need to considered and planned for. Making choices about retirement housing are also part of long-term care costs considerations.
Lifestyle longevity: Help clients create a plan that will maintain their retirement lifestyle even if they live longer than they expect. Tactics like operating within safe withdrawal rates and using engineered flooring tactics are part of this step.
Legacy: Many clients want to leave a legacy to loved ones or charities. Also intergenerational circumstances may need you to look at the next generation’s financial capacities to see if an endowment approach is needed to provide cash flow to maintain inherited family vacation homes, rental properties, farm and timber lands, and business interests for the next generation.
Looking for solutions
The first stop for advisors to ensure they are covering all the avenues is to turn to places like The American College and The Investments and Wealth Institute. They offer technical information on specific areas, such as long-term-care planning, Social Security benefit claiming, RMDs, time segmentation, and so on. It’s organized just like when you enter Home Depot or Lowes — their solutions are in large “aisles” labeled by functional categories. When you enter these institutions, you start looking for the aisle you need. Like in Home Depot or Lowe’s, you might do a great deal of searching!
Solutions are not enough
With so many solutions, it’s easy to waste a lot of time pondering. Just looking at isolated tools one aisle after another — whether at Home Depot or repositories of financial planning options — can be just like noise cluttering our thoughts. The real issue is likely that we haven’t clearly defined what the perfect outcome would be to fix the problem.
It would be best if we first entered the “solutions store” already knowing for sure what we need and have a vision of the “best tool chest” for the problem we wish to solve. To know about the tools themselves is not enough — we need to have a vision of the best outcome to keep the client’s retirement fortress in place.
The first step of fortress building
Unfortunately, unlike home construction or repairs, there is hardly any margin of error in retirement planning — an advisor must get it right at the outset. That’s why it is essential that an advisor prepare a funded-ness ratio profile. The ratio will determine whether a client is overfunded, constrained, or underfunded for meeting their 4 L’s of retirement life. After the funded-ness ratio profile is done, an advisor is ready to enter a consultation that leads to recommendations.
The tool chest an advisor needs will depend on the client’s funded-ness profile:
• Client is over-funded. An advisor toolbox can be basically traditional portfolio management.
• Client is constrained. An advisor needs added pertinent engineered tactics along with portfolio management, and possibly as described below, some limited use of products.
• Client is underfunded. An advisor will need to rely on products, such as annuities, to gain “mortality credits” for the client. By pooling assets, annuities offer longevity risk management.
Expecting — not hoping —the fortress lasts a lifetime
Conventional investment industry wisdom invites retiring clients to only hope — but not expect — to have a sustainable, stable, and secure retirement income. Dr. Wade Pfau’s whitepaper “Two Schools of Thought about Retirement Income” highlights this dichotomy.
Dr. Pfau did not use the words “hope” and “expectation,” though he did label two schools of thought. For my purposes and context, I have labeled the schools “hope” and “expectation.”
The hope school uses models built on statistics, such as Monte Carlo simulation testing (as a variation of William Bengen’s 4% safe withdrawal rule). This school advises a retiree to first tactically allocate retirement savings between risky and non-risky assets. The retiree then hopes their chosen mixture successfully builds wealth over time. Statistics guide the retiree to be “confident” that their assets will last a lifetime as a formulated, steady stream of income (increased by inflation).
Why must a retiree, someone who has spent years and years building wealth, be left only with hope? They began with hope, the hope of ever having enough wealth to even think of retiring. They have gone through the early stages of money maturity, including innocence and pain. They have overcome the poor money management lessons of youth. They moved on to hope for a great vision of life during their working years. They became conscientious wealth-builders, seeking out wealth-building knowledge. They use a variety of tested tools and skills to build something analogous to a “hope chest” to fund their vision of life during their retirement years. Then, unfortunately, advisors from “hope” schools encourage them to again hope their money will last after they grudgingly relinquish control of money-making years for retirement income.
Probability statistics support this final “hope” proposition — statistics that are easily ignored during a large market downturn. But statistician-based jargon — “greater than 85% success rates!”— in financial planning models do not provide comfort or calm in down markets; it just makes a retiree miserable and does not reduce their panic.
My issue with the value proposition of “hope” school advisors is not that they are wrong, or even that they are not smart. My issue is that this type of proposition is out of whack.
An expectation proposition — one where a retiree can expect a stable, secure, and sustainable retirement income — is not an annuity sales pitch. I do consider annuities dependable. But they work best for retirees whose capital is constrained or underfunded for a lifetime of income.
My focus is on providing the expectation framework to affluent retirees who are typically constrained but not underfunded.
“Expectation” school portfolios use an asset dedication approach and engineering methods like flooring. No probability-laden processes here! An expectation proposition might look like this:
• For ages 65 to 75, ladder Treasury Inflation Protected Securities (TIPS) to fund 10 years of withdrawals not funded by a pension or Social Security. The 10-year rolling floor of TIPS can make a lot of sense for retirees who have a profile for being overfunded for retirement needs and can last to age 95.
• Use all or most of the remaining wealth not allocated to the 10-year TIPS ladder for “upside” assets. Structure this “upside” pool to have a 10-year rolling time horizon. It generally will include equity exposure. This pool can be dedicated to incrementally building another tenth-year rung in the rolling time horizon. I use part of this upside pool to create a ladder for years 11-20. To figure out the asset allocation for this ladder, I estimate expected inflation by subtracting the 10-year TIPS rate from the traditional 10-year Treasuries rate. I use this expected rate of inflation to determine the returns needed for years 11 to 20. Then I calculate the present value of assets needed now to fund each year’s ladder rung. I use an expected rate of return of stocks and bonds to do the present value calculation. Since the time horizon for this funding is always 10 years out, I generally use moderate equity risk exposure with bonds.
• The “upside” pool not dedicated to the ladder is left to grow a lot like the portfolio constructed in the pre-retirement years that has risky asset vs. a non-risky asset tradeoff construction.
For others who have retirement profiles that are constrained or even underfunded, you’ll need insurance and annuities to build an expectation portfolio. Here’s what I discuss with clients:
1. Long-term care insurance or products intended for long-term care. I typically tell clients likely long-term care costs can be about $300,000 for each spouse. I ask this question: “Can and will the couple self-fund out their existing assets or do they need or want to acquire long-term care coverage?” Then there is the decision of whether to acquire standalone LTC policies, hybrid insurance or annuity products with an LTC rider. I do discuss reverse mortgages, but I find few ”want to be in debt again.” However, clients who are determined to age-in-place are more likely to consider them.
2. A deferred annuity to maximize income later in life. They start paying benefits at age 85 and give you the opportunity to earn a mortality credit that favors those who outlive the other participants in the annuity pool. Before the client is age 85, I look at more aggressive spending and riskier allocations to enable clients more freedom to spend before age 85.
3. Partially annuitizing retirement income in later years. It essentially creates a “pension” of guaranteed income.
4. Annuitizing gradually over time, but preserving the real option value of delaying annuitization as long as possible. Manage the portfolio so that it retains sufficient value to buy an annuity to cover lifestyle spending after the first-time horizons have passed. If asset’s value drops below the value of the remaining lifestyle spending liabilities, seriously consider annuitizing or reducing spending.
When you follow the expectation approach, clients are free to enjoy their retirement without hoping it all works out over the long run.
Kerry G. Uffman, CPA/PFS, CFP, CFA, RICP, RMA, CPWA, provides tax and business consulting, financial planning, retirement planning and wealth management at TWRU CPAs & Financial Advisors, Baton Rouge and Walker, La.