CE Course: Lifelong retirement income: the zone strategy

How do you decide what strategy to follow and which products to use?

What works for one client may be disastrous for another. So, to start, you need to evaluate two critical factors: a client’s emotional capacity, and his/her financial capacity. Only then can you select the correct strategy.

If a client’s emotional capacity is high enough, she can hold a portfolio of fluctuating equities, so the degree to which a client can tolerate volatility can be one of the limiting factors in financing his retirement. But more importantly, you need to evaluate the client’s financial capacity.

Before you can talk about your client’s dreams—or the wisdom of asset allocation, or the virtues of investing large cap or small cap—you must first determine if your client has the means to finance retirement. If she doesn’t, then no amount of emotional capacity and risk tolerance will improve the outcome.

Determining the financial capacity can be easy, so long as you convey to your client what retirement planning is: providing realistic solutions and strategies that ensure his or her capital lasts a lifetime. It is not plugging some average numbers into a retirement model—the averages don’t cut it. For proper retirement planning, you must base your retirement solutions and strategies on potential adverse outcomes and worst-case scenarios. Using the Monte Carlo simulators is a step in the right direction, but most fall short of reflecting historic market realities.

Drawing Income

The Sustainable Withdrawal Rate (SWR) is the largest periodic income that can be drawn from an investment portfolio without depleting the assets and is based on market history. For an investor to be deemed to have sufficient cash, not only must she have the ability to finance her retirement, she must also be able to finance the time value of fluctuations in her portfolio (these being defined as the losses created by long and short-term market fluctuations and inflation in distribution portfolios).

Ideally, the SWR indicates a 0% percent probability of portfolio depletion. For practical purposes, combined with proper annual reviews, we can accept a more liberal probability of depletion. For our purposes, we’ll assume the SWR means a maximum of 10% probability of depletion at the age of death.
When it comes to retirement income, there are three significant risk factors for the retiree:

• Longevity: living too long;
• Market: the portfolio running out of money prematurely; and
• Inflation: the inability to maintain purchasing power due to inflation

A retirement plan must cover all three factors to be considered well designed.

Special attention must be paid to longevity risk. Don’t use the average life expectancy to calculate a client’s retirement plan, because that’s merely the age by which half of the people will die, but after which the other half survives. In other words, if you use average life expectancies to determine the age of death in your retirement plans, at least half of your clients will run out of money during their lifetimes. Not a good track record for an advisor.

Some financial planning software tries to go a bit further by calculating an average life expectancy based on a list of questions, such as “How much do you drink?” or “How many speeding tickets did you get in the last two years?” It compares the person’s answers to averages and then spits out a number. But unless you are an insurance underwriter, these questions are useless. These averages don’t mean anything. Clients are individuals and responses are subjective.

The proper way to handle the longevity risk is to review the mortality tables. They indicate the percentage of survivability for each age, and the age of death in a well-designed retirement plan should be high enough that the probability of survival won’t exceed 15%.

So, for a 65-year-old client, use age 95 as the age of death, where the survival rate for a male is 7% and for a female 14%. When calculating for a couple, use age 95 for the younger spouse.
We use 95 as the age of death to cover all three risks: longevity, market and inflation (see “Sustainable Withdrawal,” below). Using the sustainable withdrawal rate, you can calculate assets needed to finance one dollar of annual income from an investment portfolio. This is calculated as 100 divided by the sustainable withdrawal rate (see “Asset Multiplier,” below).

SUSTAINABLE WITHDRAWAL:

Asset mixes and drawdown rates assuming client will reach age 95*:

Retirement Age	Asset Mix Equity / Fixed Income	Sustainable Withdrawal Rate
55	50 / 50	3.1%
65	40 / 60	3.7%
75	30 / 70	5.2%

*Sustainable withdrawal rate from an investment portfolio based on the market history, rounded to a single decimal, allowing for a probability of depletion less than 10%. The equity proxy is SP/TSX from 1919 to 2010, average dividend 2%, and average portfolio costs 2%. On the fixed income side, the long-term net return (after expenses) is assumed 0.5% over and above the six-month deposit rate.
Source: Otar & Associates

ASSET MULTIPLIER:

Capital Required at the start of Retirement for each dollar of indexed annual withdrawal

Retirement Age	Capital Required
55	$32.01
65	$26.80
75	$19.32

Source: Otar & Associates

The Green Zone

If the client’s retirement savings at the start of retirement is equal to or larger than the capital required, then his investment portfolio will likely provide a lifelong income. He’s in the green zone with abundant savings and doesn’t need to worry about annuities or variable annuities. His investment portfolio can finance retirement as well as the time value of fluctuations.

To make things easier, we can plot the asset multiplier. The horizontal scale indicates the retirement age. So, divide the client’s total savings by his annual income required at the beginning of retirement and mark that on the vertical scale. Observe if the point falls into the green (abundant) zone.

For example, Bob, 65, is just retiring. He wants his money to last until he is 95. His savings are $1 million and because he has other indexed pensions already, he needs only $20,000 annually (indexed to inflation) from his portfolio. Does Bob have abundant retirement savings? There are two ways to make the calculation:

• Use tables:

  The capital required for retiring at age 65 is $26.80 for each dollar of income. The minimum capital he must have in his investment portfolio is $536,000, calculated as $20,000 * $26.80. He already has $1 million and therefore he has abundant retirement savings.

• Use the chart:

  The capital available for each dollar of annual income is $50, calculated as $1,000,000 divided by $20,000. Plot that against age 65. The intercept—where the two arrows meet—is deep in the green zone. Therefore, Bob has abundant retirement savings. He can keep all his money in an investment portfolio and have a lifelong, indexed income (see “Abundant Savings,” below).

ABUNDANT SAVINGS:

Our hypothetical client has plenty of savings on which to retire.

By plotting the portfolio value over his retirement, as if he were to start his retirement in any year since 1919, we get a view of the range of all outcomes.

The top 10% is designated as “lucky” and the bottom 10% is designated as “unlucky.” The median is where half of the outcomes did better and half did worse (see “Lucky or Not?” below).

LUCKY OR NOT?

Initial savings levels are the largest determining factor for comfortable retirement

The Red Zone

Not all clients have abundant savings and many will have to manage with less. If your client has insufficient savings then the most effective way of eliminating longevity, market and inflation risks is to buy a single premium immediate life annuity with payments that are indexed to CPI, either fully or partially, depending on the client’s needs. For the same age of retirement, a life annuity pays more than the sustainable withdrawal rate from an investment portfolio. This is because in an annuity, both the capital and the longevity are pooled.

Therefore, in the red zone, your client has one practical choice—an indexed life annuity.

It will pay less per month than what the client needs, but she will have lifelong income. She does not need to worry about running out of money, and won’t be checking her portfolio every minute and driving her advisor crazy in the process (see “Annuity Outlays,” below).

ANNUITY OUTLAYS:

Capital required, for each dollar of periodic income to purchase an annuity at the start of retirement:

Premium Required for each dollar of income
Retirement Age	Female	Male
55	$30.61	$27.03
65	$23.01	$19.64
75	$16.18	$14.19

Source: Annuity quotes by Equitable Life, December 13, 2011, 3% annual indexation, 10-year minimum guarantee period, payments are monthly. Normally, we would use fully CPI-indexed annuity. However, at press time, these were excessively priced due to the high price of real return bonds and low yields of long-term bonds because of the current global financial turmoil.

If the client’s savings at the start of his retirement is less than the capital required as indicated in the “Annuity Outlays” table, then he has insufficient savings and he is in the red zone. For example Mark is 65 and is just retiring. He wants his money to last until he’s 95. His savings are $1 million and he needs $60,000 annually from his portfolio.

Is Mark in the green zone? The capital required for a 30-year time horizon is $26.80 for each dollar of income. He needs $60,000 income, and therefore the minimum capital he must have in his investment portfolio is $1,608,000, calculated as $60,000 * $26.80. He has only $1 million, falling well short of the green zone. But is Mark in the red zone? The cost of a life annuity is $19.64 for each dollar of income. To purchase that, he’d need $1,178,400 in capital, calculated as $60,000 * $19.64. Since he only has $1 million saved, he’s in the red zone. He does not have enough savings to maintain his lifestyle throughout his retirement.

Plotting this on a chart bears that out (see “In the Red”, next page). The capital available for each dollar of annual income is $16.67, calculated as $1,000,000 divided by $60,000. If that is plotted against age 65, the intercept is deep in the red zone. Both calculation methods show that Mark has insufficient savings.

Mark has only one feasible choice: buy a single premium immediate life annuity. This would pay him an annual income of $50,916 indexed at 3% for the rest of his life, calculated as $1,000,000 ÷ $19.64. He’ll need to adjust his lifestyle expenses but nevertheless will have a guaranteed lifelong income, and that’s a much better outcome than holding a potentially volatile investment portfolio and living with a high probability of running out of money.

Mark might think that if he’s going to cut expenses to $50,916 per year that it might make sense to keep the money in an investment portfolio, draw off an income, and take his chances.

But if he invests his money instead of buying a life annuity then he has a 67% probability of running out of money by age 95 (see “Cash Out,” below). Anything above a 10% risk for running out of money is unacceptable in a properly designed retirement plan. In fact, if he withdraws more than $37,000 from her investment portfolio annually, his retirement finances would be at risk.

IN THE RED:

Client doesn’t have enough savings at the start of retirement.

CASH OUT:

Drawing an unsustainable income from a $1 million portfolio means the client has a good chance of running out of money during his life.

So the lesson is, if retirement savings are insufficient, only a single premium indexed life annuity can provide guaranteed lifelong income, nothing else. Discourage your clients from taking undue risks and tell them to resist the urge for the short-term gains that will likely bring long-term pain.

The Grey Zone

But what about the grey area between the green and the red zone? In this region, your client only has sufficient retirement savings. You need to weigh the options carefully to determine what combination of products will generate the lifelong retirement income.

Some risk must be exported to an insurance company, because the risks of financing the retirement solely through an investment portfolio are too high. In these situations, an advisor must find the perfect mix of an investment portfolio and an indexed life annuity to provide lifelong income.

Keep in mind that most clients don’t like buying annuities, but there are two things you can do to ease the pain. First, always buy the annuity that offers a minimum payment guarantee option. That way, in the event of premature death, some or all of the premium reverts back to the beneficiary or the estate. Second, instead of buying an annuity in one installment, spread it over two or three years and build an annuity ladder. This might reduce the interest rate risk.

For example, Jane is 65 and ready to retire. She wants her money to last until she’s 95. Her retirement savings total $500,000 and she needs $20,000 from her portfolio. The available capital for each dollar of annual income is $25.00, calculated as $500,000 divided by $20,000.

The capital requirements to put Jane in the green zone are $26.80, and for the red zone, it is $23.01 for each dollar of income. Jane has $25.00 of savings per dollar of income required, which is in between the two figures.

If you plot her $25.00 of capital available against her age 65, the intercept is in the grey zone, as seen in Just Enough. She’ll have sufficient savings, provided that the risk is exported to an insurance company.

JUST ENOUGH:

Exporting some income risk to an insurance company helps these retirees make it

The Perfect Mix

Here is the formula to calculate how much of the assets should be allocated to buy a life annuity in the grey zone:

Percent annuity required = (AM – AC) ÷ (AM – CLA) * 100%

where:

• AM is the factor from the “Asset Multiplier” table (see page x)
• CLA is the cost of life annuity from the “Annuity Outlays” table (see page x)
• AC is available capital per dollar of income

So, how much of Jane’s money should go to buy a life annuity? At age 65, the AM is $26.80. Her CLA is $23.01. Her AC is $25.00. Plug these numbers into the perfect mix formula:

(26.80 − 23.01) = 47.5%

This calculation indicates Jane should buy an indexed annuity for $237,500, calculated as 47.5% of $500,000. The rest of the money, $262,500, stays in her investment portfolio. She would then have a lifelong income. The probability of depletion by the end of age 94 is now 9%, based on market history. Keep in mind the formula is based on small differences of large numbers, so the calculated annuity amount can vary wildly depending on quotes from different insurers.

ANNUITY ADVANTAGE:

Income from both the life annuity and the investment portfolio provides the client with lifelong income.

Annuity Ladder

In the grey zone, the purchase of annuities can be staggered over a number of years to reduce the interest rate risk. Also, as the client gets older, the annuity payout increases for the same premium.

As a rough rule of thumb, the premium paid for each rung of the ladder should be about one half of the preceding amount. Going back to the perfect mix example, we calculated that Jane needed a life annuity for $237,500 to ensure lifelong income. Instead of buying it all at age 65, she can purchase it in two installments: $160,000 at age 65, $77,500 at age 67.

Stop-Loss Annuity

In the grey zone, instead of purchasing a life annuity outright, you might also do a conditional “stop-loss:” purchase a life annuity only if the withdrawal rate exceeds a predetermined level. This strategy usually causes a small degradation in purchasing power; however, it can be suitable for those who resist purchasing life annuities. If the client is lucky, a life annuity is never purchased.

In the case of Jane’s example, if she were to purchase a life annuity only if her annual withdrawal rate were to exceed 5%, historically, this would have happened 62% of the time.

But what if Jane does not take your advice, refuses to buy an annuity, and keeps all her money in the investments? In that case, the probability of running out of money by age 95 is 16%, not very high but still beyond the established comfort level of 10% (see “Suffer the Consequences,” below).

SUFFER THE CONSEQUENCES:

Refusing to buy the life annuity in the grey zone means that the retiree might run out of money prematurely.

In the red zone, do not ladder annuity purchases; the risk is too high for any delay. In the green zone, the client does not need any annuities but if she wants to buy them just to feel safe, you can then suggest laddering. However, if a client wants to buy an annuity in a single installment, don’t argue about laddering; just do as instructed.

Variable Annuities

Variable annuities with withdrawal guarantees were introduced to Canada in 2006. While they can cover the longevity and market risks, they do not cover the inflation risk. Furthermore, market history shows the marketing claims that “the retiree’s income might increase if markets do well” do not happen as often as generally portrayed.

Variable annuities might be suitable only in some very specific situations for non-indexed income.

Other Zone Considerations

• Risk Factor:

  In the green zone, the risk is volatility of returns. In the red zone, the risk is the sequence of returns.

• Luck:

  In the grey zone, luck is the most important determinant of a portfolio’s success. In the red zone, luck cannot help significantly. In the green zone, you don’t need luck.

• Emotion to Elicit:

  Successful advisors do not sell products; they sell emotions. In the green zone, elicit hope of growing assets; do not sell fear. In the red zone, it is the opposite: elicit fear of running out of money and never sell hope.

• Time Horizon:

  In the green zone, time is your friend. In the red zone, time is your enemy.

• Estate Planning:

  In the green zone, there is no conflict of interest between the client and his or her children; both want assets to grow. Therefore, it is a good idea to get children involved in the estate-planning discussion. On the other hand, in the red zone, the client needs lifelong income through annuities, and children usually want assets. Because of this conflict of interest, it is better to keep children out of the estate discussion until retirement planning is completely designed and implemented in the red zone.

Other Considerations

In many situations, you can help a client move from the red zone to the green zone. Suggest one or more of these actions: delay retirement, spend less, work-part time during retirement, rent part of the home, downsize home, sell home and rent, reduce portfolio costs, and stop giving money away.

Practice Management

Can you make use of the zones in your day-to-day practice management? Definitely.

Many advisors chase high net worth clients in anticipation of larger commissions or trailer fees. It is not unusual for me to have a portfolio review with a high net worth client and find out that he is in the red zone, usually as a result of excessive income requirement. The zone strategy described here gives you an excellent indication of the staying power of the high net worth client over a long-term. You don’t want to attract high net-worth clients, only to convert them into a low net worth client in 10 years! You want them to prosper as time goes on. The key in distribution planning is not how much asset you have, but at what rate you withdraw from them.

If you want to minimize your workload, maximize your efficiency, avoid frantic phone calls from nervous clients after routine market fluctuations, and increase your income then try to attract and retain clients who are in the green zone. Generally, these people made it into the clear for a reason.

More often than not, they combine higher incomes and careful spending habits that allow them to save more for the future. Such clients value and respect your advice, treat you as a partner, and think that you deserve what you earn.

Red-zone clients, by contrast, are there because, for one reason or another, they couldn’t put aside sufficient retirement money. These clients are more likely to expect miracles from you, despise paying any fees, and phone you for your market opinion every time there is a hiccup.

These clients tend to believe the success or failure of their retirement depends on your actions, rather than on the fact that they didn’t save enough in the first place. And sometimes, you can’t really help a client in the red zone, so it becomes a matter of how much time and energy you’re willing to earmark for him or her.

Keep it simple.

Suggest the life annuity strategy, and if they don’t take the advice and want to gamble with their insufficient savings, send them to the competition.

Of course, there are many other considerations for complete retirement planning. Each case is different. However, implementing a methodical approach based on market history will help you develop bulletproof strategies that clients can enjoy for a lifetime. It will also help you reduce your professional liability risk.

Now that you’ve finished reading, complete the exam to receive your CE credits. If your score is 85% or higher, take a screenshot of your score and e-mail it, along with your name, to jim@retirementoptimizer.com to get a one-time free retirement calculator used for this article and free pdf copy of his 525-page book Unveiling the Retirement Myth.

Next steps

• Go to CECorner.ca to take this course’s test. 
• A CE Certificate will be issued electronically through the website after you pass the exam with a score of 65% or greater.
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