Retirement Distribution Strategies
“What works and what doesn’t under
investment return and tax uncertainty”
Manish Malhotra, President & CEO, Income Discovery
@manish96 and @incomediscovery
© 2010-2014 Income Discovery.
Takeaways
• Synergistic interaction among retirement
income strategy components
• A framework to find these synergies
• Discover up to 20% higher post-tax
retirement income at higher safety
2
Retirement Income Strategies
Finding optimum
among multiple
strategies
Social
Security
Bond
Ladder
Annuities
Systematic
Withdrawal
Portfolio
$
Annual Income
3
Current Approach
• Portfolio expected return and volatility – not
sufficient
• Probability of success -> sustainable
withdrawals
• Reward: Retirement Income
• Prob. of success – appropriate framing?
4
Presenting Risk
• Improve risk presentation by using learning
from Behavioral Finance research
• First, a primer on Behavioral Finance
5
Fast Thinking
• Reaction to this picture
• Instantly see that she is
angry;
• System 1 of the mind
processed it
• Associative Memory
6
Slow Thinking
• 185 X 27 = ?
Takes effort
• Different part of your mind used, called
System 2 – conscious reasoning self
• Impressions and decisions are an interaction
of System 1 & 2
7
WYSIATI
• What You See Is All There Is
• Will John be a good leader? He is intelligent
and strong
• Answer: Yes. Associative Memory.
• Did you think about attributes of a good
leader?
8
John – Good Leader?
• .. He is intelligent, strong, corrupt and cruel
– Still Yes.
• He is corrupt, cruel, intelligent and strong –
No, not a good leader
• First Impression is the Last Impression.
9
75% Probability of Success
• What does client think?
• Associative Memory Triggered
Appropriate risk presentation?
10
75% Probability of Success
• Good – context of gambling and sports, very
good
• Does client understand 25% chance of
failure?
• No – WYSIATI explains it
• Issue with both words, probability and
success
11
Alternative Presentation
• Out of 1000 retirees,
• 750 were successful in generating the
desired income
• 250 were not successful
12
System 1 Processing of Frequency
Real people like them
and their peers
They imagine a room
full of retirees; 250
unsuccessful segregated
in a corner.
Why call them a failure?
13
Partial Income Retirees
Systematic Withdrawal
Portfolio exhausts,
creating shortfall
14
No Success or Failure
• Full Income or Partial Income
• 85% of desired income in shortfall years is
not a complete failure
15
Story of individuals, not a statistic
Risk: # of retirees out of
1000 that received partial
income.
16
Unfortunate Retiree
20th highest Cumulative Shortfall out of 1000 retirees
Shortfall $
Shortfall Years
Systematic Withdrawal Portfolio
Immediate Annuity
Pension
Bond
Ladder
Social Security
Retirement Income By Source Over Time
17
Risk – Unfortunate Retiree Case
Years of full income for Unfortunate
Retiree
Percent of
Income
during
Shortfall
Years
Again, Story of an Individual
18
Risk-Reward Framework
• Primary Reward: Retirement Income
• 1st Risk: Retirees with Full Income
• 2nd Risk: Years of Full Income for
Unfortunate Retiree
• 3rd Risk: % of Income in Shortfall Years for
Unfortunate Retiree
• Secondary Reward: Average Legacy
19
Distribution Strategies
• Social Security – defer or take early
• Single Premium Immediate Annuity
• Withdrawal order across different accounts
and purchase account for annuities
20
Brady Case Study
• 66 year old couple
• Total Assets: $800K
• Monthly Pension: $500
• Social Security @66
- $2.5K and $2K pm
Low Return (µ 2% than history) and Moderate Inflation (2.5% µ and 2% σ) Capital
Market Assumptions; Conservative inflation protected model portfolio. Same as in
JFP paper.
21
Real Income Over Time
Discretionary spending reduces as
they age; essential spending rises 10% drop in total spending.
$100K
$90K
Discretionary
Spending
Higher Medical
Expenses
Essential
Spending
Early
Middle
Late
22
Strategy 1 – Social Security @66
$100K
Systematic
Withdrawal Portfolio (SWP)
$90K
Pension
Pension
Social Security of $54K
Real Income By Source Over Time
23
Strategy 2 – Social Security @70
$100K
$90K
Pension
Social Security increases to $71.2K
lowering withdrawal from SWP over
last 26 years
Higher
withdrawal from
SWP for 4 years
Real Income By Source Over Time
24
Social Security @70 Better
$100K
$90K
Pension
Higher withdrawal
from SWP for 4 yrs.
• 214 retirees with
full income
• 3 years of full
income
• 18% in shortfall
• 1.9 times Legacy
Lower withdrawal from
SWP over last 26 years
Social Security of $71.2K @70
Why? 15-20% lower withdrawal from SWP over 26
years
25
Annuity – Mortality Credits
Sam, Peter & John pool
their assets together to
provide income for all
who survive
Only Peter survives to
claim benefit from the
pooled assets
After 20 years
Annual Income
Annual Income
Sam Peter John
Peter
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Immediate Annuity
• $160K Purchase – can it help?
• Inflation adjusted payout: $6,047
• Level payout: $9,329
• Which is better?
Inflation adjustment is based on CPI-U index
27
Strategy 3 – Inflation Adjusted Annuity
$100K
$90K
Pension
Annuity payout of $6K
Social Security of $71.2K
Real Income By Source Over Time
28
Strategy 4 – Level Payout Annuity
Purchasing power of nominal
payout falls with inflation
$100K
$90K
Pension
Annuity payout of $9.3K
Social Security of $71.2K
Real Income By Source Over Time
29
Annuity Comparisons
Level payout better than inflation adjusted
48
Full Income Retirees
4 Years of Full Income for Unfortunate
Retiree
24%
Average Legacy
Inflation adjusted annuity based on negative real yields not
attractive under moderate inflation
Based on quotes as of Mar 15, 2013.
30
Social Security and Annuity
• Does level payout Annuity help if Social Security
was taken at 66?
• No. Compared to SS@66, buying the annuity
causes
21
30%
Full Income Retirees
Avg. Legacy
31
Why Annuity doesn’t help with SS@66?
$100K
Systematic
Withdrawal Portfolio (SWP)
$90K
Pension
Social Security of $54K
Portfolio avg. flow
rate is $37K /
$800K = 4.6%
Immediate Annuity with 3.9% avg. flow rate
Immediate Annuity with 5.8% initial payout under 3% inflation expectation has
avg. flow rate of 3.9%
32
Why Annuity doesn’t help with SS@66?
Risk
4.6%
Flow
3.9%
33
How Annuity helps with SS@70?
$100K
$90K
Pension
Portfolio avg. flow
rate is $29.3K /
$800K = 3.7%
Social Security of $71.2K
Immediate Annuity has 3.9% avg. flow rate
Fixed Annuity with 5.8% initial payout under 3% inflation expectation has avg. flow rate
of 3.9%
34
Why Annuity helps with SS@70?
Risk
3.7%
Flow
3.9%
35
Key Learning
• Not the isolated impact of the component
of a strategy
• But, their cumulative impact
• Rules are not general
• Need to optimize for each client; DON’T
rely on intuition
36
Tax Sensitive Analysis
• Tax sensitive analysis valuable for a higher
net worth client
- Full tax brackets and standard deductions
- Rules for taxable portion of Social Security
37
HNW Brady’s
• Taxable Joint Account: $1 million
65% average cost basis
• Peter’s IRA: $1.25 million and Lisa’s IRA:
$800K
Both 15% post-tax basis
• Roth IRA: $200K
38
Tax Sensitive Strategies
• Strategy A
- Withdrawal Order: Taxable, IRA, Roth
- Purchase $800K of immediate annuity in
Peter’s IRA
• Strategy B
- Withdrawal Order: Taxable, Roth, IRA
- Purchase $800K of annuity in Taxable
39
Tax Strategies Comparison
Strategy A is better – Taxable-IRA-Roth;
Annuity in IRA
• 66
Full Income Retirees
• 1
Year of Full Income for Unfortunate
• 6% point
• 8%
Partial Income
Avg. Legacy
40
Strategy B Cash Flow
1. If Annuity
bought in Taxable
Account, it runs
out in 1.5 years
41
Strategy B Cash Flow
2. Roth hasn’t
had time to grow,
it can give
income only for
2.5 years
42
Strategy B Cash Flow
3. Full taxable withdrawals
from IRA in the later
phases exhaust it faster
43
Strategy A Cash Flow
1. Taxable Account
has assets to
sustain longer as
annuity is bought
in IRA
44
Strategy A Cash Flow
2. Then, IRAs kick in
45
Strategy A Cash Flow
3. Roth has time
to grow tax free
and fund 7+
years of
withdrawal
46
Summary
• Synergistic interaction among retirement income
strategy components
• A framework to find these synergies
• Discover up to 20% higher post-tax retirement
income at higher safety
47
Appendix
48
Contract Value
Variable Annuity with Guarantees
GMIB contracts also allow
min guaranteed growth
Of Benefit Base
Benefit Base Locks
@Highest Past Value
Contract Value
Time
49
Strategy 5 - Variable Annuity GLWB
• Immediate lifetime income at 4.5% of
benefit base
• GLWB rider at 0.95% fee and 0.3% MEA fees
• Moderate inflation protected allocation
• 160K purchase with Social Security@70
50
VA GLWB – helps?
• Risk increases
36
Full Income Retirees
3 Years of Income for Unfortunate
Retiree
5% points guaranteed income for
Unfortunate Retiree
8%
in Avg. Legacy
51
Strategy 6 - Variable Annuity GMIB
• Growth phase with 1.75 times guaranteed
income base after 10 years
• Rider fees 1.5%; MEA Fees 1.3%
• Payout rate: 4.75% of Income Base
• Moderate Inflation Protected Model
• 160K purchase with Social Security@70
52
GMIB – helps?
• Risk increases
- 84
-7
Full Income Retirees
Years of Income for Unfortunate Retiree
- ↔ guaranteed income for Unfortunate Retiree
- 43%
in Avg. Legacy
53
Current VAs – why
risk?
• For Retirees that barely got full income:
• Fees and poor returns combination doesn’t let
Income Base step-up.
• Without Income Base , VA behaves like an
immediate annuity, but with
payout
•
payout means
get full income
in risk as more retirees can’t
54
Older VAs with Guarantees
• 6% compounded return for 10 years
• 200% guaranteed income base @10yrs
• MEA Fees 0.85%, Rider fees 1.1%
• Payout rate at 6% when clients are 76 years
old
• This VA reduces risk
55
VA under Better Returns
Percentile
25th Percentile
Last year’s GLWB Benefit in
today’s dollars
$4,082
50th Percentile
$5,246
75th Percentile
$7,399
81% higher than 25th Percentile
56
Current VAs– Use?
• Not very appropriate for essential expenses
• But a good strategy for discretionary
expenses that can be locked
• Client frees rest of the portfolio to be
structured for inheritance
57
Certain Cash Flow Using Bond Ladder
Cash flow not sensitive to
interest rate movements if
bonds held-to-maturity
Principal
Maturity
Semi-annual
coupons
58
Fill-in for Social Security Using Ladder
$100K
$90K
TIPS
Ladder
Pension
Social Security
Real Income By Source Over Time
59
TIPS Ladder Performance
• Psychological comfort of safe cash flow
• But because of negative real rates
• 25
Full Income Retirees
• 1 Year of Full Income for Unfortunate
Retiree – stability of cash flows
• 20%
Avg. Legacy
Bond quotes as of 25 March 2013
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