Income in Retirement - Integrated Results


Time for the rubber to meet the road and for all (three?) of us left on this bus to reach our nerd-tastic destination. In this final article, we’ll walk through two case studies to see how an integrated retirement income strategy plays out in comparison to an investment-only approach.

Let's set the scene:

We’re going to look at two hypothetical pre-retirees at different ages - a 35 year old and a 50 year old. We’re going to lean again here on research from Wade Pfau, Ph.D., CFA. He’s a Professor of Retirement Income at The American College for Financial Services. You can find a copy of his white paper here.

Assumptions - 35-YR Old

  • Married, with two kids.

  • Life expectancy of age 89.

  • Has presently saved $65,000 in his 401(k) plan at work, and would like to retire at age 65.

  • Making $100,000 each year, adjusted for inflation

  • Able to set aside 15% a year from his salary towards his retirement planning.

At age 65, he will either use his investments alone (at a safe withdrawal rate) or a combination of an income annuity & investments to satisfy his retirement income needs. For the integrated approach, we’re assuming Steve utilizes a whole life insurance policy at a premium of $4,500/yr to both generate the cash value accumulation and allow us to use a single-life income annuity at age 65.

The insurance death benefit in this example is approximately $400,000. We’re subtracting the insurance cost from his 15% savings amount, so his investment contribution in this integrated approach will be somewhat less than 15%. This will shift over time as his salary grows - the insurance cost is fixed, so more of the 15% will flow to the investment program over time.

Outcomes - 35-YR Old

We’re going to measure outcomes at three points - the Median, the 10th percentile (under-performance) and the 90th percentile (out-performance). So if you'll recall, one of the important metrics we talked about in the previous post was likelihood of success. We want to know what each approach looks like when things don't necessarily go according to plan (the average).

Interesting things to note:

For our enterprising young 35-year old, there are some very interesting things to take note of in this data:

401k Asset Values:

Since we are contributing less to the 401k in the integrated scenario, naturally the value of this account is less at the retirement age of 65. However, it’s not drastically less. Remember, we were able to take a more aggressive posture in this account because of the inclusion of the bond-like return of the insurance cash values.

It’s also important to note what we’re not showing here: we’re not showing those cash values. At age 65, that whole life policy would project to have $340,000 of cash accumulation. We’re leaving it out of our analysis here because the death benefit is the primary function of that component, but it does remain an asset that’s available for use by our retiree. Therefore, the total pot in the integrated approach is actually larger in an average outcome.

Total Income @ Age 65:

This is where the integrated approach really shines. Notice how our unfavorable result for the integrated approach (the 10th Percentile) is virtually identical to the average (Median) result under the investment-only approach. Also note the drastic difference between the average result for the investment-only approach as compared to its unfavorable result.

This is sequence risk. Again, if you just happened to live during a bad sequence of market returns, your income just got cut in half…sorry...

Note that the total income under the integrated approach is superior for any outcome.

Legacy Value @ Age 100

We include this for two reasons: we want to see if there’s any money left at age 100 (in case you’re really virile) and we want to see if there’s money left for the next generation (which is important to some retirees).

Note that in the unfavorable outcome for our investment-only folks the money has run out by age 100. In fact, the money actually ran out sometime before age 100. So, our retirees in this case had to adjust their spending along the way or they ran out of money.

Also notice that our median result for the integrated approach is 228% higher! Whoa! This means we have plenty of money to keep on living or plenty to leave to our kids (or favorite charity).

The investment approach does provide a higher value in the 90th percentile, but we’re at point here where the concept of marginal utility (see article 2) is in play and we just don’t care that much.

The 50-YR Old

So, its also important to see whether this approach plays out the same for an older pre-retiree. Let's perform due diligence and bump this strategy out to a later starting date to see if we experience the same outcomes. This 50-year old is in a different life stage; he/she is well into their career, has already started a nest-egg of savings and is looking to get into the best overall position for finishing out their retirement income plan.

Assumptions - The 50-YR Old

  • Married, with two kids.

  • Life expectancy of age 85 (sorry, if you’re already 50 you’ll probably die sooner than people who are just now 35).

  • Has presently saved $625,000 in his 401(k) plan at work, and would like to retire at age 65.

  • Is currently making $215,000 per year

  • Able to set aside 15% a year from his salary towards his retirement planning.

At age 65, he will either use his investments alone (at a safe withdrawal rate) or a combination of an income annuity & investments to satisfy his retirement income needs. For the integrated approach, we’re assuming he uses a whole life insurance policy at a premium of $13,500/yr to both generate the cash value accumulation and allow us to use a single-life income annuity at age 65.

The life insurance death benefit in this example is approximately $600,000. Again, his investment contribution in this integrated approach will be less than the total of the 15% he's saving. Similarly to our 35-year old, as his salary grows, more dollars (in percentage terms) will flow to the investment component of the integrated plan as time goes on because the insurance premiums are fixed.

Outcomes - The 50-YR Old

Interesting things to note:

What’s quite interesting here is that, while the numbers themselves are different, the outcomes as compared to the 35-year old are extremely similar. The data plays out the same; an integrated approach is superior for this 50-year old pre-retiree.

401k Values:

Again, our 401k values in the integrated approach are more muted due to the smaller contribution. However, it’s again not drastic and we are forgetting the cash accumulation values that we now have in the life insurance contract, which would be approximately $310,000.

Total Income @ Age 65

A similar result as our younger retiree here as well. The unfavorable income under the integrated approach is actually higher than the average income under the investment approach. The average income is substantially higher under the integrated approach - a difference of +45%.

Legacy Value @ Age 100

Our retiree using the investment approach also ran out of money at some point under the unfavorable outcome. Oops. Notice how our legacy value under the integrated approach is 451% higher assuming average results. Wow.

Wrapping Up

This has been a bit of a nerdy series, so thanks for hanging in there. When it comes to retirement income planning, there are a lot of opinions and agendas floating around and it can be tough to separate the wheat from the chaff. Hopefully, we’ve shown that by using the best parts of both “worlds”, you’ll be able to craft an integrated approach which is not only superior from a mathematical standpoint but also from a “feel” standpoint.

As we demonstrated, some cohorts of retirees using the investment only approach will either run out of money or (more likely) have to make significant changes to their income throughout retirement. The integrated approach is more stable and, therefore, more comfortable. There is additional upside potential utilizing the investment-only approach, but again we run into concepts like marginal utility and the prospect theory (see article two).

Something I alluded to in article one but didn't actually address during the data-crunching is the difficulty of money management and decision making in our later retirement years. As our cognitive powers can decline in the sunset stages of life, an added layer of difficulty emerges with respect to making portfolio and investment decisions.

This can further exacerbate the problems inherent with an investment only strategy. In practical terms, an integrated approach can be shifted to be “more actuarial” in these years if reasonable outcomes are achieved along the way. The simplicity and guaranteed income of the actuarial world is sometimes in the best interest of the retiree from a cognitive and decision making standpoint.

Hopefully you've also noticed throughout this series that solving the problem of retirement income is not simple. Crafting these strategies on your own, without the help of an expert, can be very tricky.

As always, the advice I’m provide here is intended to be general in nature. We would never want to make this conversation the focus for an individual if they had other, more urgent financial issues to address. Talking about retirement planning is only for people who are financially healthy today!

Retirement income planning is very much an evolving science as well as an ongoing debate. If you have questions or contrary opinions to what I’ve set forth here, I’d love to hear from you!

Everyone will be at least a little different. I’d love to personalize the advice here to your situation if you want to connect.

 

Disclosure on investment, return, expense & other assumptions used in calcuations:

Insurance cash values are based on a non-guaranteed dividend scale. SPIA rates used are an average of top three current market quotes for 2015, and single-life male rates were 6.74% while joint-life rates were 5.6%. Based on current market conditions for SPIA rates, we assumed a 1% bump over present day rates in our calculations, representing a reversion to the historical mean for SPIA rates in anticipation of a continued rising-rate environment. For investments we used 50,000 Monte Carlo simulations based on both today's interest rate environment as well as a going-forward higher interest rate environment to help determine the "safe" withdrawal rate. For investment returns, we assumed use of a target fund to match our target retirement age in each scenario. For taxes, we assume contributions to the investment account are tax-deductible and tax-deferred, while contributions to the insurance component of the plan is after-tax. We made an allowance in the 15% savings rate to provide for taxes-paid on the whole life component of the integrated plan. For the immediate annuity at retirement, we assume the purchase is made with qualified funds from the retirement plan, and therefore those annuity dollars are fully taxable upon distribution. Other cash flow strategies may yield better results, but it was done this way in the aim of simplicity.


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