“Many people focus on the accumulation objective,” Bruce Ferris, head of sales and distribution, product management and marketing for Prudential Annuities, told PLANADVISER. “But it’s just as important to think about cash flow needs in retirement. What gets left out is an understanding of cash flow in retirement and the factors that can threaten cash flow, such as tax, inflation, health care costs and sequence of returns.”
Ferris pointed out the decades-long conventional wisdom that a 4% drawdown would sustain an individual through 30 years or so of retirement. It was true for many years, he said, but study after study has proven this is no longer the case.
The most recent update to the National Retirement Risk Index, published in October 2012, found 53% of households are at risk of being unable to maintain their pre-retirement standard of living during retirement (see “Many Unable to Keep Standard of Living In Retirement”). (The index is produced by the Center for Retirement Research at Boston College and sponsored by Prudential.) In its research, the center took a closer look at the impact of low interest rates on the Index.Interest rate levels alone would have only a modest impact on this Index. A key reason is that Social Security and defined benefit income, which are not impacted by interest rate changes, make up the majority of total wealth for most Americans, according to the center’s research. The index assumes households annuitize their financial and housing wealth at retirement. This measure protects the income generated from those assets against interest rate risk as well as equity market and longevity risks. For those who do not protect their retirement income, however, these risks can have a significant impact on their retirement prospects.
Prudential raises other points in “Planning for Retirement: The Impact of Interest Rates on Retirement Income”:
•Advisers can help clients determine an appropriate target retirement age, track retirement savings in terms of an income goal, and help them understand how guaranteed lifetime income products can be leveraged in retirement planning.
•Investors need to understand the impact of interest rates on different types of retirement products. The amount of monthly payout from an immediate annuity, for example, is dependent on the interest rates at the time of the annuity purchase. The higher the interest rate, the higher the payout.
•The level of payouts from a variable annuity with guaranteed lifetime income benefits does not depend on interest rates at the time income payments begin.
•Without a customized financial plan and proactive steps to insure their income, improvements in the economic climate alone—such as increasing interest rates—will not be enough to guarantee a dignified retirement.
To raise awareness among plan sponsors of how guaranteed income solutions can work within a defined contribution plan, Ferris said he would start with a discussion about how retirement incoming planning has changed over the past 20 years. “In 1983 the foundation of the pyramid was pensions, then Social Security, then an individual’s nest egg. Now the pyramid is inverted,” Ferris said. “It’s very narrow and uncertain, with pensions at bottom, then Social Security, then an individual’s nest egg.”
Key Points for Plan Sponsors
As plan sponsors think about how to prepare their participants for retirement and what they should be offering, it is important to think about how those pension plans were invested, which was mostly in fixed income in order to provide long-term certainty of income. As plan sponsors and fiduciaries think about their role they need to think about how to get people to save earlier and stay the course and provide options with income guarantees that cannot be outlived, Ferris said.
In an earlier study, “Changing Attitudes About Retirement Income,” Prudential found a majority of survey respondents (84%) said they would be likelier to stay in the stock market even while experiencing short-term losses if they had a retirement investment product with guaranteed income.Market volatility has definitely affected people’s behavior, Ferris noted. During the financial crisis of 2008-09, the average investor lost about one-third of the value of his portfolio. In 2012, because they were afraid of losing money in equities, people began investing heavily in fixed income, which was at historically low rates. But, Ferris pointed out, they made these investing decisions when the market was up 13%. Net outflows of equity mutual funds were at an all-time high. Ferris feels investors would have been better served by investing in guaranteed income products to help preserve principal and guarantee income for retirement.
Providing solutions with income within the retirement plan provides certainty of income, according to Ferris. “Guarantees help people stay the course; save appropriately and have a portfolio that will withstand volatility and give a smoother ride. Retiring Americans would be well served by having more options that provide a guarantee.”
Annuities are one form of providing this guarantee of income, Ferris said. “We need to provide more advice through the institutional plan community relative to helping people prepare for the risks.” Auto enrollment and auto escalation are features that can and should be used, and plan sponsors should become more aware of in-plan guaranteed lifetime income products.
According to Ferris, the financial services industry also needs to provide more options and flexibility. “The way we protect managed risk in those plans requires us to make certain recommendations,” he said. “In the institutional world, there’s not a reluctance, but a lack of understanding about how to coordinate those two things so that a plan meets the needs of employees but allows insurance companies to manage the risks associated with those liabilities,” Ferris said.
Three questions are fundamental, Ferris said, and all stem from the value of a financial professional. Advisers help people answer, first, how much to save; how much a person needs annually; and what are the threats to cash flow—taxes, health care costs, inflation—and how can these threats be mitigated?
“Planning for Retirement: The Impact of Interest Rates on Retirement Income” can be downloaded here.