take financial planning prowess as you juggle the effects of inflation, distributions, taxes, asset allocation, and expenditures. Are you up to the task?
The baby-boomer generation will change the rules for retirement just like
they changed the rules for every other stage of their lives. They will also face
new challenges and risks never envisioned by prior generations of retirees.
Planning effectively for boomer clients will require an optimistic attitude
tempered by frequent reality checks. Many in this generation have been
comfortable managing their own investments over the years as they converted
excess annual income into capital, but they are much less secure in their
ability to convert that capital back into sustainable annual income. Here are
the issues you will have to tackle in planning their golden years.
How much will they need?
George Forman, the boxer-turned-spokesman for portable grills, may have best
summed up the retirement conundrum facing baby boomers: “The question isn’t at
what age I want to retire; it’s at what income.” The amount clients need each
year to maintain their desired standard of living is the most critical variable
to identify in the retirement planning process. No rule of thumb will suffice.
Boomers will likely spend as much, if not more, in the early years of
retirement as they have done during their working years. They will be fulfilling
the many dreams and desires they have postponed during their career and
child-rearing years. In later years, the cost for their health care will become
a significant factor in determining their income needs.
A recent study estimates that a couple retiring in 2006 will need savings of
anywhere from $330,000 to $480,000, depending upon their age at retirement to
fund health care costs for the duration of retirement. Note that these estimates
did not include funding for long-term care, which can range from $44,000
annually in Midwestern states to a high of over $200,000 per year in Alaska. It
is a myth that a retiree will only need some fraction of preretirement annual
income during the full course of retirement.
Competing goals
Planning for their own retirement isn’t the only thing on a clients’ minds.
Explore whether clients have aging parents or special-needs children that may
affect the funds available for their use. Funding children’s college education
is the classic siphon that depletes assets earmarked for their retirement.
How long will they need it?
Longevity is perhaps the greatest challenge for boomer retirement planning.
Most boomers seriously underestimate their life expectancy. Perhaps this is due
to a misunderstanding of what mortality age really means. In fact, half the
population will outlive their life expectancy.
When the mortality table tells us that a 65-year-old man has a mortality age
of 85, it means that half of all men who are 65 today will die before age 85,
and the other half will still be alive. The mortality tables also include the
entire population, not just those who receive the level of nutrition and health
care that most advisory clients enjoy.
Another frequent misunderstanding about mortality age is the statistical
increase in mortality age that occurs when calculating joint mortality. A male
age 65 has a 50% chance of living to age 85. A female age 65 also has a 50%
chance of living to 85, but as a couple, they have a 50% chance of one of them
living to age 92. In fact, as a couple, they have a 25% chance that one of them
will still be alive at age 97. A worker retiring early at age 55 may need to
generate more than 50 years of retirement income. This is the basis for the new
definition of long-range planning.
The double bite of inflation
The increased longevity boomers can expect contributes to the serious risks
of inflation, which is the long-term tendency for money to lose purchasing
power. This has two negative effects on retirement income planning. It increases
the future costs of goods and services that retirees must buy, and it
potentially erodes the value of their savings and investments set aside to meet
those expenses. Even at a modest inflation assumption of 3% annually, the
effects of inflation over a half century of retirement could be devastating.
In prior generations, inflation was not such a worry, since retirees were not
expected to live much more than five or 10 years past the age of 65. In fact,
when the Social Security retirement age of 65 was enacted in 1932, the average
mortality age for a man was 64.
The planning process
Explore any and all sources of guaranteed income available when retirement
begins. Social Security, pensions, annuity benefits, and any other income
sources must be quantified as to how much, from what source, and for how long.
Pay careful attention to whether benefits index with inflation or continue to a
surviving spouse, since survivor planning is an important part of retirement
income planning. You should develop three cash-flow models—both spouses living,
husband dies, wife dies—to identify any gaps in cash flow that need to be
addressed by additional savings or insurance.
Next, inventory all assets that will be used to generate retirement income.
This is where the traditional financial planning tools are needed to project
future values and income streams from various types of assets. You must be alert
to the differences in taxation during distribution among various types of
assets.
Retirement accounts will generate less spendable income than an investment
account, because of the taxes due on distributions from retirement plans. There
are advisors who reduce all assets to an after-tax value in order to project
cash flow. Our experience is that a software program that actually calculates
taxes in order to generate a cash-flow model is more accurate, especially when
rental real estate, stock options, and the alternative minimum tax are planning
issues.
Be cautious in encouraging your boomer clients to consider their primary
residence as an investment asset. Many will tell you that they plan to downsize
later, but experience tells us that they are reluctant to leave a familiar home
in their advanced age. Encourage your clients to be zip-code flexible in making
their retirement plans. Many areas of the country have low to no income tax, and
there can be significant differences in the cost of housing and health care.
The risks involved
Most advisors do not consider themselves to be property and casualty
insurance specialists. If you don’t either, you should advise your clients to
meet with their insurance broker to ensure that they are carrying adequate
homeowners, auto, and personal umbrella liability insurance for their
circumstances.
Health insurance, disability insurance, life insurance, and long-term care
insurance should also be evaluated as part of any retirement plan. These
policies can be expensive, and they may not be necessary for those clients who
have significant assets. However, they can provide an important safety net in
the absence of such assets, so be sure to review these or at least suggest that
the client have their agents conduct a review.
For many professionals, litigation is a very real risk to their retirement
assets, and professional liability insurance is a must. Divorce is another
landmine that can blow up even the best retirement plans, but to date, there is
no insurance policy available to reduce this risk other than a well-drafted
prenuptial agreement.
Asset allocation: Between a rock and a hard place
The double whammy of longevity and inflation creates an asset allocation
dilemma for boomers. The old adage of subtracting a client’s age from 100 to
obtain the optimal percentage of equities just doesn’t hold for a five-decade
retirement portfolio. Invest too conservatively, and their money may not grow
enough to last their lifetime considering the erosion of long-term inflation.
Invest too aggressively, and they run the increasing risk of outright capital
loss without adding significant years to their plan under average market
conditions.
Advisors must determine an appropriate exposure to equities, then design an
allocation within those equities to ensure meaningful diversification among
asset classes and investment styles. Cash and fixed income will play a larger
role in retirement portfolios, since provisions must be made for the orderly
withdrawal of assets.
Don’t make your clients call you to sell something when they need money. Set
up regular portfolio transfers to their bank account to enable them to manage
their income just as they did when paychecks were funding their expenses. This
tends to dampen overspending by imposing some discipline on the withdrawal
process. Otherwise the portfolio could easily become an ATM machine.
Setting a realistic withdrawal rate
We’ve all seen the overly optimistic client who states that he figures he can
withdraw 10% annually from his accounts since they have earned, on average 12% a
year. Run, don’t walk, away from this guy. There are also some financial authors
out there who are advocating withdrawal rates of 6% or more for well-diversified
portfolios. Most of the evidence, though, seems to point to 4% as being about
right for a sustainable withdrawal rate for decades of retirement.
It is important to take the time to show boomers the effect of different
withdrawal rates on different portfolio mixes over various time periods. These
charts and the software to generate them are widely available, so use them.
The withdrawal rate is the one variable over which your clients have the most
control—not their mortality, not their health, not their investment returns, not
inflation, just their withdrawal rate. They must understand that this is the
lever they will need to pull when things don’t go as planned. Being realistic
about what they can spend and keeping a sufficient contingency reserve fund will
ease the pressure that withdrawals put on retirement portfolios.
The challenges facing boomer retirees are significant, but not insurmountable
with some realistic and prudent planning. You will need to use your financial
planning skills to determine what they own, what they owe, what they will make,
and where it will go in order to develop a workable retirement income plan.
Don’t sugarcoat reality. If they have sustainability issues, talk about
part-time work or delaying the onset of retirement. Be honest with these clients
and do a professional job of assessing their needs and their ability to meet
them, and you will have a clients for life.
