A broker-dealer executive asks me to explain why, given a smilar investment amount, Total Return Portfolio with Systematic Withdrawal illustrates different results than The Income for Life Model

I often describe the IFLM income-planning software as a complement to traditional financial planning programs. Traditional planning software is very good at organizing the investor’s assets and identifying the income needs during retirement. But traditional programs are also limited in their ability to illustrate outcome-focused investing strategies.

Earlier this week I was asked to comment on two approaches to investing retirement assets. One strategy was produced using financial planning software and the other from The Income for Life Model.

Because understanding the differences between alternative approaches for generating retirement income is a key issue for both investment professionals and broker-dealers, I’ve prepared this analysis which I’m also going to use as the basis for an upcoming article on this issue.

As you know, there’s a great deal at stake with the retirement income business opportunity. If executed properly retirement income will produce significant new business. The other side of that coin is that getting it wrong will yield nothing good.

Traditional software illustrates a pro-rate, systematic withdrawal from on overall investment portfolio. Is that an effective plan of retirement income distribution? For some investors it certainly is. For others, it is clearly not. The traditional illustration is based upon an investing strategy (Total return Portfolio) that uses a Systematic Withdrawal Plan (SWP) to distribute the retirement income. By contrast, The Personalized Analysis for Income for Life Model illustrates an investing strategy which is based upon time-segmented asset allocation (“bucketing”).

In short, this is an Apples and Oranges comparison. In fact, this comparison goes to the essence of the stark differences between investing assets for accumulation versus investing assets for income distribution. Accordingly, it’s important for all investment professionals serving retirement income clients to understand for whom these strategies are appropriate.

Understanding the Client and the Need

Before I explain the differences between the two illustrated investing approaches, let’s first consider the type of client who may be appropriate for either or both strategies.

In the context of accumulation investing the industry segments clients by their level of AUM- e.g. mass market, affluent and high net worth. In the context of retirement income needs, client segmentation is approached in another manner. The non-profit Retirement Income Industry Association has developed a client segmentation framework that is meaningful for investment professionals who offer retirement income distribution planning services. In the retirement income context we segment clients by applying a mathematical expression:

 “C” divided by “FC.”

 “C” = “consumption,” the expected annual spending in retirement. “FC” = “financial capital,” the amount of investible assets. When we segment clients this way three categories of investors emerge:

Irrespective of their level of investible assets, clients with a ratio of less that 3.5% are “Overfunded.” These investors can safely use any investing approach for generating retirement income including a Total Return Portfolio with SWP.

However, investors in the “Constrained” and “Underfunded” categories must be extremely careful in selecting a retirement income investing strategy. “Constrained” and “Underfunded” investors should prudently rely upon a combination of guaranteed investments and at-risk (equity) investments in their retirement income investing strategies, ideally including annuities with lifetime income guarantees, or an alternative means to deliver  guaranteed lifetime income. This multi-product framework is often described as “Strategic Product Allocation.”

“Constrained” and “Underfunded” investors have little or no margin of error: they cannot tolerate an unfavorable sequence-of-returns scenario lest they face portfolio ruin- running out of money. These investors disproportionally benefit from the security of period-certain guaranteed income and/or lifetime income guarantees to help ensure that their essential living expenses can continue to be met through their retirement years. 

The Total Return with SWP strategy- the approach illustrated by the financial planning software- is, in my view, not appropriate for Constrained and Underfunded investors. There are several reasons:

1. The Total return with SWP strategy distributes income via pro-rate withdrawals from the overall investment portfolio, including the equities in the portfolio. In a declining market, liquidating equities is extremely dangerous because, depending upon the sequence of returns, investment losses cannot be overcome with the result that the portfolio can often become depleted, eliminating the investor’s capacity to produce retirement income.  Unfavorable sequence of returns scenarios have occurred all too frequently in recent years.
2. SWP strategies provide no buffer to cushion against investors’ ill-timed, emotionally-driven decision making. The 2008 economic crisis demonstrated that many investors who relied upon Total Return with SWP strategies proved unable to remain consistent with the investing strategy when markets turned turbulent. Too often investors sold out of the strategy at exactly the wrong time with the result that they permanently impaired their retirement security. This fact has driven a dramatic decline in popularity of the Total Return with SWP strategy among advisors as quantified by research from the FPA.
3. In order to mitigate the potential for SWP strategies “blowing-up,” the principle of the “safe withdrawal rate” was developed. Adhering to the safe withdrawal rate, generally 4%, may or may not immunize the SWP strategy against running out of money too soon. However, the “safe withdrawal rate’ has the practical effect of artificially lowering the level of retirement income that can be obtained, especially when compared to other investing approaches. For example, the “bucketing” strategy can typically deliver at least 50% more retirement income than SWP and it can do so with income guarantees that add a level of psychological comfort that SWP strategies don’t provide.

Mitigating Investors’ Risks 

In providing income distribution guidance, the investment professionals’ number one priority is to mitigate risks that may cause the investor to have insufficient income during retirement. The Total Return with SWP strategy uses asset allocation to mitigate investment risk. It’s a one-dimensional and incomplete picture of what’s actually needed in retirement income investing. Asset allocation is but one of several risk management techniques that are used in an outcome-focused investing strategy. In effect, retirement management, the process of managing the investor’s assets through the distribution phase, is centrally not about allocating across asset classes, but rather about allocating across several risk management techniques including risk hedging, mortality pooling and traditional asset allocation.  Retirement management, therefore, is a bit more complex, but it needs to be because the investor’s downside risk- running out of income- is so draconian. The framework for investment professionals to practically implement allocation across risk management techniques is strategic product allocation.

Understand the Advisors’ Prospects and Minimize Financial Liability Potential

It’s important to understand that “Constrained” and “Underfunded” investors represent a significant share of the retirement income prospects investment professionals work with on a daily basis. Even Investors with significant investible assets can be and often are considered to be either “Constrained” or “Underfunded.” In my judgment a broker-dealer will assume unacceptable levels of financial liability potential if Total Return with SWP is utilized with these investor segments. When I consult with broker-dealers I stress actions the firms may take that will have the effect of minimizing long-term financial liability. The fact is the majority of investors cannot tolerate investing risks that may compromise their ability to meet their essential living expenses. Retired investors whose investing strategies “blow-up” are likely to be a source of litigation in the years ahead.

What Type of Retirement Income Investing Strategy Should Broker-Dealers Recommend?

Based upon what we know today, most investors should be shown outcome-focused investing strategies that begin by establishing a “floor” of lifetime guaranteed income. Only after the “floor” is in place should the appropriate amount of additional retirement assets be exposed to “upside” consistent with the investor’s risk profile.

Funding “buckets” above the floor is an ideal way to deliver the upside, with each “bucket” designed to be held for a specific period of time. I call this approach a “Hybrid Bucketing Strategy” (HBS). The HBS approach balances the investor’s needs for protection with long-term exposure to equities. The income security provided by the guaranteed income empowers anxious investors to remain consistent with their long-term investing strategy even through turbulent markets. The HBS approach will shrink the financial liability risk a broker-dealer faces in this market.

Both “bucketing” (the approach you illustrated), and HBS are easily illustrated by The Income for Life Model. Training of your reps should address the importance of the HBS approach, and ensure that reps know how to illustrate and implement HBS strategies. The Pershing integration with The Income for Life Model makes this easy. Wealth2k take on the training responsibility.

Conclusion

The differences in results illustrated by financial planning software versus the income for Life Model are attributable to the central fact that one approach is based upon an accumulation-oriented investing strategy while the other is based upon an outcome-focused approach. The outcome-focused approach never produces income from an overall withdrawal of portfolio assets as is done with the Total Return with SWP. Rather, it strategically combines both fixed and equity investments in a manner that produces greater levels of retirement income, with all retirement income sequentially derived from guaranteed sources. This approach mitigates risk, provides investors emotionally-driven benefits, and produces a higher level of retirement income.

In today’s uncertain world where “Black Swan” events seem to occur with increasing regularity, all broker-dealers are advised to guide reps toward outcome-focused investing approaches in order to mitigate the risk of developing unhappy clients and unwanted financial liability.