I have some friends who developed a wonderful estate plan
for their kids that involves the purchase of a large survivorship life
insurance policy. However, because of today’s lower interest rates, the
projected premiums on their policy have increased significantly. That means
some of the money they were putting into a 529 plan might have to be diverted
to pay those rising premiums.
This raises a common question about future legacy vs.
finding money for shorter-term needs: Which one should take priority? (They are
both important; there will have to be some trade-offs, but thoughtful planning
can lead to less disruption than you might assume.)
You could describe this as a problem for the 1%, but most of
us — not just our estate planning friends — need income for legacy planning,
gifting, bucket list items or essential living expenses, and we need to address
these potential retirement income gaps either now or in the future.
Longevity — An Unplanned-for Income Gap
If you are in or near retirement you should start planning
to live longer. A 2018 study showed that men ages 60 to 79 had a biological age
four years less than the men in an earlier generation, in part because of improvements
in lifestyle and medications. This suggests that not only is this group living
longer, but they’re also staying healthier longer. (This experience is in
contrast to a reduction in overall life expectancy from communities hit hard by
COVID, opioids and extreme poverty.)
If you’re in the 60 and older group highlighted in that 2018
study, these developments may mean that many of you will need more money than
your current plans permit. I have pointed out before that traditional
retirement planning often advises retirees to simply spend less when their
savings are diminishing because of market corrections or greater longevity.
Maybe you can fend off outright disaster that way, but does it offer the best
peace of mind or happiness? It certainly results in a smaller financial legacy
to your heirs.
As a cautionary example, the retiree I profiled in my
previous column, “How to Generate an Extra $20,000 a Year in Retirement,”
created an income plan that would pay her $160,000 a year at age 70. To
maintain her lifestyle and income value, even with modest inflation, she will
need to generate $250,000 at age 95. Cutting back to make up any shortfall
eventually means she may have to give up her lifestyle and legacy plans during
the last years of her long life. That’s not her goal.
Fifty percent of us live beyond the life expectancy for the
group we belong to. And failure to plan beyond life expectancy creates the
Longevity Income Gap. Perhaps you have planned for living longer than your life
expectancy. But ask yourself, will your income sustain itself or decline during
that period?
Two Other Types of Income Gaps to Prepare for
Besides the Longevity Income Gap, which derives from a
combination of good news, (living longer and healthier lives) and poor planning
(not planning for lifetime income), there are two other income gaps to
consider:
Your Total Income Gap: This is the difference between
your income goal (designed to cover both your essential living expenses, and
your bucket list expenses) and the amount of guaranteed lifetime income you’ve
earned during your employment, including Social Security, pension benefits and
any deferred compensation. For our example retiree — who receives $62,500 per
year from her Social Security and pension and who wants $160,000 per year to
maintain her lifestyle, adjusting upward for inflation — her Total Income Gap
is nearly $100,000 per year. She needs to generate nearly 5% per year from her
$2 million in retirement savings, plus growth, to meet her income goal.
Your Planning Income Gap: The final gap represents
the portion of her income goal not met by her planned-for income. In our
friend’s situation a traditional plan using asset allocation delivers only
$72,000 per year from her savings in today’s market, meaning she has a Planning
income Gap of over $25,000 per year. To fill that gap, she immediately has to
start her plan by drawing down on her capital.
As I have stated before, as time passes the two typical
choices for our retiree when “bad things happen” to her plan (like low interest
rates or a stock market meltdown) are spending less or drawing down even more
of her savings. Drawing down your savings runs the risk of forcing a major
mid-course correction, which is the last thing she or her kids want to do when
she’s healthy and enjoying her life.
How to Bridge Income Gaps with a Smarter Plan
Consider an alternative to the traditional retirement plan:
an Income Allocation plan recommends that you allocate your income among
interest, dividends, annuity payments and IRA withdrawals. And in some cases,
drawing down or extracting equity from a primary residence.
The solution is pretty straightforward:
Add annuity payments with a portion starting today and
another portion starting in the future, with both continuing for your life.
They will replace a healthy portion of the income on your bond investments in
your personal savings accounts. The
allocation of a portion of savings to lifetime income annuities produces more
income and tax benefits.
Invest in high-dividend, value-oriented ETFs that deliver
increasing income, potential for growth in share value, low fees and lower
taxes. Add some fixed-income ETFs with management that deploys artificial
intelligence for securities selection.
Manage your IRA withdrawals from an account invested in a
balanced portfolio of low-fee growth and fixed-income ETFs. Under this approach
the amount of the withdrawal is set (managed) to produce a steadily increasing
level of income rather than simply meeting RMDs. This management works together
with an allocation of a portion of these savings to QLAC — a tax-advantaged
deferred income annuity – described above.
If the above steps don’t eliminate the Planning Income Gap,
consider a modest drawdown of equity in a primary residence until age 85.
Although the usual form is a reverse mortgage, there are other home equity
extraction products coming to market. By pairing the drawdown with longevity
protection, she protects her income and limits the drawdowns only to age 85.
In our example, our friend was able to eliminate the
Planning Income Gap, and actually created a surplus averaging around
$6,000 per year – without any capital
withdrawals or drawing down from her home equity.
We’re convinced that this approach will produce the smartest
retirement income plan — and make your planning decisions easier when you must
balance long-term and short-term cash flow needs like our estate planning
couple above.
What About Capital Withdrawals to Fill the Gap?
In this article, we discuss the risk of capital withdrawals
when retirees face a deficit between their income goal and withdrawals from
their IRA, dividends and interest. If they don’t follow an income allocation
approach with annuity payments or home equity extraction, they are faced with a
dilemma: (1) reduce their goal, (2) rely on capital gains or (3) withdrawal
capital. The first option requires a change in lifestyle, the second involves
taking market risk, and leaves the retiree with the risk of running out of
savings.
To measure the potential risk from capital withdrawals we
developed a planning model to measure how withdrawals impact the value of the
retiree’s portfolio or liquidity. Using capital withdrawals to meet an income
goal may be appropriate when the income deficit is reasonably small or when the
retiree may not expect an average lifespan. In our retiree’s case above the
income deficit was small enough to meet her income goal through age 95.
However, the capital withdrawal strategy left her with a
lower margin for adverse events. And it left her with virtually no legacy at
her passing at age 95. See chart below that compares the total portfolio value
between the asset allocation (capital withdrawals) and Income allocation
(annuity payments) planning.
Bottom line, using Income Allocation planning with annuity
payments can provide lifetime income and more long-term legacy, provided your
willingness to give up liquidity in your early years. In our retiree’s case she
increased her legacy at age 95 by nearly $1.5 million.
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original article.