Designing a Monthly Paycheck for Retirement MANAGING RETIREMENT DECISIONS SERIES

WHERE S MY PAYCHECK? That is a common question for new retirees and near-retirees when they start mapping out the retirement journey ahead. In their working days, many had regular paychecks coming in to cover ongoing expenses. But what will take its place in retirement? This Decision Brief points out the factors to consider. Social Security checks provide a portion of monthly income for most older people. Some also receive monthly checks from a traditional pension plan. These sources typically form the foundation of a retiree s income plan. But to maintain their standard of living, many people also need additional monthly income during retirement. How to build that additional income stream is the challenge. For many, the discussion revolves around two questions: Should I just take withdrawals from my savings and investment accounts whenever I need money beyond my Social Security or pension check? Or, should I purchase financial products like annuities that will pay me a guaranteed income stream? Look sharp: The choice between taking withdrawals and purchasing an income annuity involves many trade-offs, so it pays to look at the issue from many angles before reaching a decision. Disclaimer This Decision Brief is not intended to provide advice for specific individual situations and should not be construed as doing so. It is an information tool for general guidance. Individuals needing advice should seek the services of a qualified professional. Keep in mind that the tax code can change, the taxation of products and strategies vary, and individual tax needs and issues are unique. Consideration of tax issues is beyond the scope of this work. The Trade-Offs The trade-offs are easier to weigh once the terminology is clear. Here are the key definitions: Income annuity. This is a retirement savings plan an annuity that insurance companies offer to customers. It is called an income annuity (or an immediate annuity) because after the retiree deposits a lump sum into the policy, the annuity starts paying out a guaranteed monthly income for life (or for a set number of years, if preferred). In many ways, the income annuity functions much like a traditional pension plan. Most income annuities lock in the funds, so owners cannot dip into the account value for withdrawals later on. Other products with lifetime guarantees. These products (described in more detail later) go by names like variable annuities with lifetime withdrawal benefits, stand-alone living benefits and longevity insurance. All these products provide flexible access to liquid funds during the early retirement years, and lifetime income guarantees for the later years. 2

Withdrawals. This refers to money that a person takes out of personal savings and investment accounts. People can remove this money on an as-needed basis or, if they prefer, they can request that the institution withdraw funds on a scheduled basis (called systematic withdrawals). Withdrawals can continue only while there is still money in the account. The withdrawals are not guaranteed to continue for the life of the account owner. Here are some advantages and disadvantages of these retirement funding options: Features Income Annuity Other Products with Guarantees Guaranteed income for life Yes Yes, but at lower level than income annuity Mortality leveraging* Yes Some No Liquidity/access to funds Not in most products Yes, within limits Yes Remaining account value goes to heirs if early death Owner can control funds in the account while income is being paid out No Yes, after fees for guarantees Withdrawals No Yes No Yes, within limits Yes *Mortality leveraging means that early deaths among people receiving payouts from the pooled annuity funds subsidize the payouts for those who live longer. This pooling effect benefits policyholders by enabling higher payouts than if taking systematic withdrawals. The good news is that there are choices. The bad news is that it will take some time to sort out how to make choices that are best suited to the retiree s needs needs that may change due to changing circumstances. A good place to start is to assess how much flexibility the retiree is likely to need. Early in retirement, for example, people may have considerable flexibility to spend discretionary funds on hobbies or vacations. In the later years, however, this flexibility may decline or uncertainty may rise concerning health care costs or long-term care costs. Early Steps An early step in the retirement planning process is to project future sources of income and estimated expenses. Sources of future income may include Social 3

Reminder Most regular expenses, except for fixed-rate mortgages, will increase with inflation. Security, work-related pensions, or income from continuing to work. Some income items will adjust for inflation, like Social Security, and others, like most corporate pensions, are fixed for life. (Some corporate pension plans have made ad hoc adjustments for inflation, but such adjustments are becoming less common.) Factor in the Mortgage Retirees who have sufficient access to funds might consider this strategy: Use the funds to buy an income annuity and then use the annuity s monthly payouts to pay down the mortgage. That sounds like a rational approach. However, unless the mortgage rate is well below market rates, this approach is unlikely to make good financial sense. In general, it rarely makes sense to buy a financial product to pay for another financial product. For future expenses, experts suggest splitting them into two categories: 1) required living expenses, including taxes; and 2) discretionary expenses. Some even suggest three categories: 1) required living expenses based on minimum acceptable level of lifestyle; 2) additional expenses based on no changes in lifestyle; and 3) discretionary expenses. Either way, deciding on an approach can help with developing a reasonable plan. Individuals who have mortgage debt at the time of retirement need to decide whether to pay down all or part of the debt. A key decision factor is the amount of assets and liquidity that will remain after paying down debt. Ask this question: Will the pay-down of debt be too constraining? Those who have work-based retirement plans may have decisions to make before considering purchase of any retirement products. Example: Say that Rita has a traditional (defined-benefit) pension plan at work. At retirement, she will likely be given a choice between: 1) receiving a regular monthly pension payment; or 2) receiving a lump sum equal to the present value of those payments (which she could then use for living expenses). This choice is similar to deciding whether to purchase an annuity or take withdrawals. To help in the decision making, Rita should try comparing the employer s offer to the monthly income she can get from an income annuity that she might buy with the lump sum the employer has offered. Keep in mind that employer offers usually come with a fixed time frame for making the decision. Also, if Rita is married, she will need to consider the impact her choice might have on her spouse. Products with Lifetime Guarantees Once an individual fleshes out an approach and income plan, he or she will 4

need to scope out the available products that can help implement the plan. To the extent that future required living expenses exceed future income, people may decide to fill the gap with a product containing lifetime guarantees. Some examples follow. Income annuities. The most straightforward choice would be an income annuity. As discussed above, this is an insurance policy. The purchaser pays a certain dollar amount up front and the annuity pays a fixed amount per month for life. Income annuity products come with various features that make them adaptable for individual situations. For example, income annuities: Basic Test Here is a basic test of whether it makes financial sense to retire now. Ask this question: Does the person have enough money to purchase an annuity of sufficient size to fill the gap between basic expenses and retirement income? If the available assets are not sufficient, the income analysis should revert to the more basic question of whether retirement is affordable. Cover either single lives or joint lives. Come with various refund options for example, a guarantee that payments will last at least 10 years even in event of death of the payee. (The more attractive the refund feature, the lower the monthly payment.) Pay a flat monthly amount for life, in most cases, or make payments that step up by a set percentage each year. May adjust the monthly payments each year for actual inflation. Not all income annuities do this. (Note: The pricing which shows up as a reduction in monthly payments otherwise available may be overly steep. Some retirees may prefer to purchase an annuity that pays a flat amount or a set percentage step-up, and use other investments to provide inflation protection.) Variable annuity with a GLWB. The variable annuity (VA) with a guaranteed lifetime withdrawal benefit (GLWB) has become a very popular annuity product in income-planning circles. The VA lets annuity owners invest the policy s account value in an assortment of subaccounts including equity, bond and even a fixed interest account. People can add a GLWB to their VA for an annual fee. The GLWB guarantees that the policy owner can make lifetime withdrawals from the VA at a fixed percentage (typically 5 percent) even if the VA subaccount values drop to zero. Those who are interested in VAs with GLWBs should compare them to income annuities. The VA with GLWB is conceptually like an income annuity with an equity-linked refund feature. The refund, in this case, is the value (if greater than zero) of the underlying subaccounts. 5

However, unlike lifetime income annuities, which provide no death benefit, VAs with GLWBs protect heirs from financial losses due to early death of the purchaser. Also, because there is less financial loss from early death, monthly payments tend to be lower than those for no-refund income annuities. On the other hand, some income annuities provide inflation-adjusted payouts while current VAs with GLWBs do not. Despite their popularity, VAs with GLWBs do have some negatives to consider. For example: Complexity. VAs include various ratchets, bells and whistles, making it difficult to assess the values over time. Expense. Annual costs of a VA with a GLWB may exceed 3 percent of asset value. (Note: Annual cost refers to the amount the insurance company charges for expenses and guarantees in the product. An annual cost of 3 percent means the insurer will reduce the rate of return on the product by 3 percent.) Heavy surrender charges. These can limit the policy owner s ability to switch to other retirement options. No inflation adjustment on the withdrawal benefit. This can hurt the income plan later on. Stand-alone living benefits. The stand-alone living benefit product is similar to a VA with a GLWB except the core product is a mix of mutual funds rather than VA subaccounts. The guarantee ensures that the account owner can take withdrawals at a fixed percentage for life even if the portfolio is depleted. The owner pays for the guarantee with an annual fee that is a percentage of the portfolio value. Longevity insurance. A few insurance companies are beginning to offer this product. It is like an income annuity except that the initial payout is delayed for a number of years. Take the example of Pete, a 65-year-old who buys longevity insurance that begins paying a monthly income at age 85. Pete can then live off withdrawals from his regular investments until he reaches age 85. He can do this because he has the assurance of knowing that there will be a source of extra lifetime income available after age 85, should he live that long and if he remembers to claim the benefit. 6

Other products. Annuities, including not only VAs but also fixed annuities and fixed indexed annuities, also offer a lifetime income feature that some retirees may want to consider. This is known as annuitization, which is a technical term for a process that converts the account value in the annuity into guaranteed income payouts. Sometimes, retirees can even use some forms of cash value life insurance to generate income for retirement. However, these are not the products that most directly meet the need for guaranteed lifetime income. What about the Costs? In an ideal world, each product category would have a number of attractively priced products available to retirement-minded consumers. However, some product categories are still new and developing. That means consumers may have difficulties locating providers and distributors in one category or another, or difficulty locating a variety of prices and options. In general, in today s market, the following trends prevail: Key Questions for Retirees The key questions for those who are considering income products with guarantees are: 1. What type of annuities or other products with guarantees to buy? 2. What amounts of guaranteed products to purchase? 3. What is the best time to purchase an income product? The decisions should be done in a way that maximizes expected usefulness to the retiree. VAs are widely available. Income annuities are widely available. Stand-alone living benefits are offered only by a few companies. Longevity insurance is offered only by a few companies. Bottom Line When comparing regular investments versus products with longevity guarantees, retirees and their advisors will find some very attractively priced regular investment products available. These include index funds and exchange-traded funds, both of which cost a fraction of 1 percent a year. Some retirees and near-retirees may prefer to invest in products with guarantees. The market for income annuities is competitive, and low-cost products are available. However, availability of low-cost products is more limited in markets that offer other types of products with guarantees. For instance, VAs with lifetime guarantees typically factor significant commission expenses into their pricing, and the other products (such as SALBs) are newer with less market competition. This disparity in guarantee offerings may impact the decisions that older people make regarding selection of retirement products having guarantees. 7

Retirees will need to think carefully about the trade-offs involved in using these products or not. In choosing products, they will need to pay attention to the tax effects. Tax treatment varies among the different financial products, so after-tax results may look quite different from before-tax results. They should also pay attention to the financial strength of the insurance company selling the product. It is essential to work with advisors who are experts in this market and who understand the tax effects. Advisors or individuals who use financial projection software in their planning should check to be sure the software takes tax considerations properly into account. It is important to understand how the advisor is paid. Some advisors are paid more based on the types of products sold, and others are paid fees for time spent. Some are paid a combination. Find Out More Pechter, Kerry. Annuities for Dummies. Hoboken, N.J.: Wiley Publishing. Dolan, Farrell. Applying the 4-Box Strategy to Retirement Income Planning: Generating a Lifetime of Income. LIMRA s MarketFacts Quarterly. Tomlinson, Joseph A. Income Choices. Financial Planning. 8

The Society of Actuaries would like to acknowledge the work of its Committee on Post-Retirement Needs and Risks in producing this series. The committee s mission is to initiate and coordinate the development of educational materials, continuing education programs and research related to risks and needs during the post retirement period. Individuals interested in learning more about the committee s activities are encouraged to contact the Society of Actuaries at 847-706-3500 for more information. Additional information and research reports may be found at http://www.soa.org. 9