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© 2010-2014 Income Discovery.
Manish Malhotra, President & CEO, Income Discovery @manish96 and @incomediscovery
Retirement Distribution Strategies “What works and what doesn’t under
investment return and tax uncertainty”
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
3
Annual Income
Bond Ladder
Social Security
$
Systematic Withdrawal
Portfolio
Annuities
Finding optimum among multiple
strategies
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
17
Social Security
Systematic Withdrawal Portfolio
Pension
Bond
Ladder
Immediate Annuity
Retirement Income By Source Over Time
Shortfall Years
Short
fall
$
Risk – Unfortunate Retiree Case
18
Years of full income for Unfortunate
Retiree
Percent of
Income
during
Shortfall
Years
Again, Story of an Individual
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
22
Early Middle Late
Discretionary spending reduces as
they age; essential spending rises -
10% drop in total spending. $100K
$90K
Essential
Spending
Higher Medical
Expenses
Discretionary
Spending
Strategy 1 – Social Security @66
23
Real Income By Source Over Time
$100K
$90K
Social Security of $54K
Systematic
Withdrawal Portfolio (SWP)
Pension Pension
Strategy 2 – Social Security @70
24
$100K $90K
Real Income By Source Over Time
Higher withdrawal from SWP for 4 years
Social Security increases to $71.2K
lowering withdrawal from SWP over
last 26 years
Pension
Social Security @70 Better
• 214 retirees with full income
• 3 years of full income
• 18% in shortfall • 1.9 times Legacy
Why? 15-20% lower withdrawal from SWP over 26 years
25
$100K $90K
Social Security of $71.2K @70
Hig
he
r w
ith
dra
wa
l
fro
m S
WP
fo
r 4
yrs
. Lower withdrawal from
SWP over last 26 years
Pension
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
Annual Income
Sam Peter John
Annual Income
Peter
26
After 20 years
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
28
$100K $90K
Social Security of $71.2K
Real Income By Source Over Time
Pension
Annuity payout of $6K
Strategy 4 – Level Payout Annuity
29
$100K $90K
Social Security of $71.2K
Real Income By Source Over Time
Pension
Annuity payout of $9.3K
Purchasing power of nominal
payout falls with inflation
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 Full Income Retirees
30% Avg. Legacy
31
Why Annuity doesn’t help with SS@66?
32
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%
$100K
$90K
Social Security of $54K
Pension
Systematic
Withdrawal Portfolio (SWP)
Portfolio avg. flow
rate is $37K /
$800K = 4.6%
Why Annuity doesn’t help with SS@66?
33
4.6% Flow
Risk
3.9%
How Annuity helps with SS@70?
34
Portfolio avg. flow
rate is $29.3K /
$800K = 3.7%
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%
$100K
$90K
Social Security of $71.2K
Pension
Why Annuity helps with SS@70?
35
3.7% Flow
Risk
3.9%
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 Partial Income
• 8% Avg. Legacy
40
41
1. If Annuity
bought in Taxable
Account, it runs
out in 1.5 years
Strategy B Cash Flow
42
2. Roth hasn’t
had time to grow,
it can give
income only for
2.5 years
Strategy B Cash Flow
43
3. Full taxable withdrawals
from IRA in the later
phases exhaust it faster
Strategy B Cash Flow
44
1. Taxable Account
has assets to
sustain longer as
annuity is bought
in IRA
Strategy A Cash Flow
45
2. Then, IRAs kick in
Strategy A Cash Flow
46
3. Roth has time
to grow tax free
and fund 7+
years of
withdrawal
Strategy A Cash Flow
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
Variable Annuity with Guarantees
49
Contr
act
Valu
e
Benefit Base Locks
@Highest Past Value
GMIB contracts also allow
min guaranteed growth
Of Benefit Base
Time
Contract Value
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 Full Income Retirees
- 7 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 in risk as more retirees can’t get full income
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
56
Percentile Last year’s GLWB Benefit in today’s dollars
25th Percentile $4,082
50th Percentile $5,246
75th Percentile $7,399 81% higher than 25th Percentile
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
58
Cash flow not sensitive to
interest rate movements if
bonds held-to-maturity
Principal Maturity
Semi-annual coupons
Fill-in for Social Security Using Ladder
59
TIP
S
La
dd
er
Real Income By Source Over Time
$100K
$90K
Social Security
Pension
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
60
Bond quotes as of 25 March 2013