The ‘secured income strategy’ can help guarantee retirement income and balance your retirement saving
Let me share with you a not-so-hypothetical story. Paul was 64 and had been investing his entire life. He built up quite a nest egg and was ready to retire comfortably next year.
The year was 2008.
We all know what happened next. Paul lost a great deal of his retirement portfolio, making it worse by panic-selling as stocks tumbled, and only just retired in 2014.
Paul isn’t some imaginary investor but a real person that saw his retirement goals destroyed in the financial crisis. Of course, there were many Paul’s and Paula’s over the past decade.
With the market reaching new highs and advisors warning of an imminent correction, a lot of pre-retiree investors are shifting money to cash to protect their retirement dreams. In fact, many people are becoming too conservative with their retirement investments that it is jeopardizing their returns nearly as badly as a crash.
Most investors are woefully behind on saving for retirement. If you had planned on an annual 6% average return to meet your target, what happens when half of your money sits in cash and loses 2% a year on inflation?
There may be a solution to the challenge of protecting your retirement investments but maintaining enough risk to produce returns.
A ‘secured income strategy’ may allow you to guarantee retirement income while giving you the confidence to invest a larger percentage of your portfolio in the assets that will meet your return goals.
What is a Secured Income Strategy?
As a younger investor, I was always skeptical of annuity products because of the low returns generally offered. As I get closer to retirement and having seen three major stock market crashes during my lifetime, two as an investment analyst, I’m starting to see the benefit.
An annuity is an investment product sold by a life insurance company that offers some level of guaranteed payment into the future, usually for the life of the holder. Payments can start immediately or at some point in the future as in a deferred annuity.
A deferred variable annuity with a guaranteed lifetime withdrawal benefit (GLWB) offers guaranteed retirement income by ‘locking in’ some level of future payments while still also offering a level of growth potential.
In essence, the GLWB secures you a level of retirement income and gives you a lot of options with the rest of your portfolio. With the confidence in a base level of retirement income, you can invest a larger percentage of your portfolio in stocks and higher-yield bonds to increase your expected return.
Benefits of a Secured Income Strategy for Retirement Investors
There are three risks that most affect pre-retirement investors, those between the ages of 55 to 65 years old. This is when your income is most at risk to changes in your retirement investing strategy and market forces beyond your control.
Overreacting to short-term market events. Researcher DALBAR reports that the average investor earned just 2.6% annually over the decade through 2013. That’s despite the fact that stocks in the S&P 500 grew by an average 7.6% annually over the period.
We all know that the market will eventually recover, so why is it so difficult to hold on during the roller-coaster of a market crash? Even the most trained money managers can’t resist buying at market highs and panic-selling at lows.
Sequence-of-returns risk. The risk to a sudden drop of investment value is particularly bad for those just entering retirement. For those just starting retirement, a market crash can mean selling investments at the worst time to pay for living expenses.
Now instead of withdrawing 4% of a $1 million portfolio to pay $40,000 in expenses, you’re withdrawing an unsustainable 6.7% of your $600,000 portfolio.
You’ll see your retirement account shrink much faster until it eventually causes you to seriously cut back on spending.
This is called sequence of returns risk. It’s the idea that the timing of annual returns may be just as important as the level of returns.
The graphic below demonstrates the point. An investor with a $500k retirement portfolio and earning 5% a year on a blended portfolio should be able to withdraw $35,000 annually for 25 years.
Let’s look at three scenarios each where a significant market drop of 20% happens at different times, in year 1, 10 and 15 for the different investors.
The unfortunate investor that saw a market drop the first year of his retirement runs out of money after 16 years. The second investor that suffers a market correction in the 10th year of retirement sees the account last for 20 years while the final investor is able to stretch their retirement into 22 years.
Longevity risk. Longevity risk is the pleasant idea that you live to a ripe-old age but the unhappy coincident that your retirement assets do not last. On average, a woman at 65 years old can expect to live another 23 years while men can expect another 20 years according to current stats. Most advisors recommend planning for 30 or 35 years of retirement to avoid running out of money.
But what happens if you are one of those exceptional few that lives well into your 90s? Is the reward for a healthy life, having to spend your remaining years in poverty?
How Does a Secured Income Strategy Help Mitigate Retirement Risks?
Buying a deferred annuity with a GLWB helps to mitigate some of these risks and may even completely eliminate them. The product transfers the risk to the insurance company through the guarantees in the contract.
- A GLWB Gives You the Confidence to Wait Out the Market. The guaranteed benefit means you don’t worry as much about short-term swings in your retirement portfolio. You will be able to count on the GLWB for living expenses and can allow the market to recover before withdrawing too much from retirement assets.
- Guaranteed Retirement Income for Life. The GLWB offers a base annual amount for life, whether you live to be 80 or 800. Some annuities offer optional coverage to forward an additional amount on to surviving spouses.
- Additional Investment Growth Potential. Most GLWB products on annuities allow for regular increases in the rate of return in a rising market. This helps to grow your income while not putting it at risk.
Using a GLWB product can allow an investor to take slightly more risk with the rest of their retirement portfolio. The guarantee in the annuity payout helps to mitigate risks to over-reacting after stock market corrections and the problem of sequence of returns.
“The use of a secured income strategy may help conservative investors feel comfortable with a little more risk and, thus, the potential for higher longer-term returns into their portfolios,” says Tim Gannon, vice president of product management at Fidelity Investments Life Insurance Company.
The lifetime guarantee on the annuity transfers all the longevity risk to the insurance company.
What Type of Investor Should Use a Secured Income Strategy?
There are two types of investors that benefit most from a secured income strategy with a GLWB.
The first is the extremely risk-averse investor, fearing a market correction and shifting their retirement assets to cash. While the stock market will eventually fall, this extreme in market timing is rarely a good idea.
Cash accounts lose money annually to inflation and even high-quality bonds offer little real return, both making it impossible to meet long-term return needs to grow your retirement portfolio.
A secured income strategy can help even the most risk-averse investor ensure that market events won’t destroy their retirement goals.
The second type of investor that would benefit from a GLWB would be someone just entering retirement but concerned that a near-term market selloff would force them back into work. This is the sequence-of-returns risk at its worst and one of the prime benefits to a secured income strategy.
Important Considerations on Guaranteed Retirement Income with a GLWB
You may not need a secured income strategy or an annuity if your portfolio is high enough to handle severe market drops and still provide enough income. If you’ve also got other retirement benefits like a pension or other annuities, then you might not need the safety in a GLWB.
Finally, remember that an annuity is a guaranteed payment only to the extent that the insurance underwriter is solvent. While most insurance companies have vastly improved their balance sheets since the financial crisis, make sure you choose a company with a solid credit rating.
The secured income strategy, combining a deferred annuity with a GLWB, can offer guaranteed retirement income and the confidence you need for retirement investing. Consider the process from five to ten years before your planned retirement date to protect your assets and the quality of life you deserve.