Strategies for maintaining income in retirement

Retirement experts discussed the various income strategies available to retirees at a recent Morningstar conference in Chicago. Josh Charlson reports.

Retirement income is a hot topic, and the low-interest-rate environment is a devilish challenge for advisers and investors. The topic of retirement income was front and centre at a panel on ‘Retirement income strategies’ at Morningstar’s recent conference in Chicago.

Panellists for the session were Frank Armstrong, founder of US financial planning firm Investor Solutions and author of four books; Christine Fahlund, a senior financial planner and vice president of T. Rowe Price Group; and Tom Idzorek, chief investment officer and director of research for Morningstar’s Ibbotson Associates.

The panel was moderated by Morningstar director of personal finance, Christine Benz.

Here’s what the panellists have to say about some of the most pertinent topics.

The traditional fixed-income retiree portfolio is a dying breed

Armstrong said it is virtually impossible to generate enough current income for retirees from the traditional bond-only, or income-oriented, portfolio.

“We’re advocates of a total-return approach,” he said. He said Investor Solutions focused on “synthetic dividends.”

Armstrong prefers a 60/40 equities/bond split, with the fixed income focused on the short-term, high-quality portion of the universe.

At T. Rowe Price, Fahlund said, people avoid talking about income and instead refer to withdrawal rates, with the focus on producing a sustainable level of withdrawals during retirement. That generally entails a mix of stocks and bonds.

Don’t overshoot on withdrawal rates

Both Armstrong and Fahlund were interested in the fact that investors tend to aim for higher rates of return than the 4 per cent withdrawal rate that research has generally confirmed is the most sustainable rate.

Fahlund told of a conference she spoke at where an investor was carrying on about his need to earn 12 per cent a year to sustain his retirement needs, until finally a man stood up and shouted “It’s like the lady said: 4 per cent!”

Fahlund also elaborated on some of the nuances of T. Rowe’s guidance regarding the 4 per cent rule. For one thing, they expected to increase the amount each year by the inflation rate, which the firm currently forecasts as 3 per cent.

The investor, she hoped, would develop a lifestyle that fits that income level. But there’s flexibility to the approach. In years of deep market declines, like 2008, an investor should revisit his or her portfolio balance and consider taking out less.

After bull market periods, the investor could consider withdrawing a bit more. The bottom line: “Every retiree should be checking every year to see if they’re still on track.”

The good, the bad, and the unknown of annuities

The biggest area of debate revolved around the potential use of annuities in a retiree’s portfolio. Armstrong takes an absolutist stance against using them.

Among his objections were unsustainably high promised rates of return, high costs, and the risk that the insurance company may not survive to pay out when the time comes.

Moreover, he thinks the sales mentality of insurance companies drives much of the product development.

“If there’s anyone I trust less than the U.S. government, it’s the insurance companies,” Armstrong said, to laughter from the audience.

Ibbotson’s Idzorek takes a more balanced view. He thinks his company can serve an important purpose for investors whose account balances are likely to last only as long as their life expectancy. For those who end up living longer, an annuity can provide great security.

He noted, too, that there are many different “flavors” of annuities that offer a range of income and guarantee options.

Both Idzorek and Fahlund noted that plan sponsors are very interested in providing some kind of guaranteed income option for their employees.

T. Rowe Price, as a large retirement plan provider but not an insurance company, has been exploring options but has encountered several challenges — in particular, the need to educate plan participants about very complex products, and the fiduciary responsibility incumbent on employers for selecting a high-quality insurance provider. Idzorek echoed the risk-averseness of plan sponsors but said: “At some point a paradigm shift will occur where offering some form of annuities becomes the norm.”

Low interest rates: No easy answers

All panellists agreed that there was no easy answer to the low-interest-rate environment. Stretching for yield or duration, Armstrong noted, inescapably increases risk, and perhaps puts investors into products they don’t really understand.

He remains committed to the 60/40 stock/bond mix, with an emphasis on very short-term, high-quality fixed-income instruments. Fahlund also believes equities exposure is a must and suggested that balanced or target-date funds could be a useful option.

Idzorek said that Ibbotson projected low inflation risk during the next one to two years, but it would be a rising risk thereafter. Ibbotson recommends up to 50 per cent of a retiree’s portfolio be devoted to inflation-protected bonds, with additional allocations to real estate investment trusts and commodities to help ward of inflation risks.

Perhaps the biggest problem, Armstrong observed, was that clients arrived at retirement with too little saved to adequately fund their retirement.

Fahlund said that T. Rowe Price’s studies had advocated the benefits of working longer, thereby providing income for a longer period, drawing out employer health and other benefits, and increasing the ultimate social security payments.

Josh Charlson is an analyst at Morningstar.