Thinking about emergency planning for retirement portfolios leads to an unexpected conclusion.

    In 1974, I was a crew member of a Lufthansa 747 that crashed upon takeoff from Nairobi Airport in Kenya. The disaster claimed 59 lives but thanks to airline planning and training, I was able to think rationally and help save 90 passengers.

After we plunged into a hillside, the bottom of the first-class cabin collapsed. I unbuckled and began helping passengers evacuate. When I could see no one else, I made one last, hurried trip up the aisle to make sure I hadn't missed anyone. I was about to evacuate when I heard a cry from beneath an overturned seat. I pulled away some rubble and found a bleeding, elderly man gasping for breath. I yanked him down the aisle and as we struggled out the emergency exit. An explosion that followed appeared to doom anyone still trapped in the wreckage.
    However, once we reached an area about a hundred yards away from the wreckage where the evacuated passengers and crew had gathered, a woman appeared in the exit doorway I had just left, waving frantically and screaming. It turned out her husband was lying next to her, seriously injured, and unable to get up and out the exit. As I ran back toward the plane to help the couple, I yelled back at the others to help, but no one joined me. I can't say I blamed them; they were terribly frightened and most lacked the emergency training I had received.

I managed to get to the woman, and together we dragged her semiconscious husband down the chute and off the plane. We were no more than 30 yards away, still dragging the poor fellow, when a final series of explosions consumed the cabin in flames. We were lucky to be alive.
    Today, as principal of a financial advisory firm in Irvine, Calif., I see many people approach retirement planning as they would a commercial flight. They tell themselves that everything will be fine. But while the chances of an airline crash are remote, the odds of a retirement ending in a crash are considerably greater. Many retirees are ill-prepared for the transition from earned income to portfolio income, and those lacking adequate planning may not survive a financial emergency.

I try to get my clients to discuss "emergency planning for their retirement portfolios." What will happen to their retirement if there's a severe market downturn? What if it's prolonged? Will they have to change their lifestyle or return to the workforce?

Optimism Is Not A Strategy
    As advisors, how can we best assure our clients will have an adequate income stream for their lifetimes? Whatever investment products or asset allocation is chosen, we can't predict future market performance or client life spans. Do we simply chose an appropriate investment strategy and hope clients don't outlive it? Can't we do better?

An investment product I never thought I would be recommending is one that guarantees clients won't outlive their retirement income. It's a new generation of variable annuities.

Hold on. I know the negative reaction most advisors have to the use of variable annuities in retirement planning. In the past, the only time variable annuities made sense was for high-tax-bracket clients with maxed-out contribution plans. It was positively obscene to have a variable annuity inside a qualified account.

That environment has changed completely. When guaranteed income for life is the objective, the new variable annuities actually are more appropriate in a qualified retirement account. Consider that the explosion of variable annuity sales is being driven by guaranteed income benefits, most occurring in retirement accounts. The reason is that using these vehicles to generate income in a nonqualified account, as opposed to buying mutual funds or stocks, creates the potential for converting long-term capital gains treatment into ordinary income. Qualified accounts are now the most efficient and appropriate vehicle for variable annuities with guaranteed income benefits, since distributions are treated as ordinary income anyway.
 
Change Of Heart
    In the mid-90s Dr. Moshe Milevsky, a finance professor at York University in Toronto, and Steven Posner, a derivatives quant expert with Goldman Sachs, published a widely cited research study that concluded the typical variable annuity policyholder was being "grossly overcharged for the so-called protection and peace of mind."

But in his article, "Confessions of a VA Critic," in the January 2007 issue of Research Magazine, Milevsky does an about-face on variable annuities in light of the new guaranteed benefit riders: "Regardless of what you want to call these increasingly heterogeneous products, it seems the relative value pendulum has swung in the opposite direction ... the annuity has finally returned to its roots; it is providing longevity insurance."

In fact, Milevsky suggests that some insurance companies may not be charging enough for their annuities, adding that "the same mathematical models that told us a decade ago that basic death benefit guarantees were overpriced are now telling us that many living benefits are underpriced."
    That's quite a reversal of opinion by an expert on the subject.

Whatever combination of investment vehicles is chosen for retirement portfolios, uncertainty prevails as to whether they will generate an income stream sufficient to last the client's lifetime. Debate the merits of one asset allocation strategy against another, but what is most important to retirees is that their income stream is guaranteed for as long as they live. That's one reason why I find the new variable annuities with guaranteed income benefits so compelling as a retirement planning tool.

Beware The Potholes

Variable annuities are complex instruments. They're not cheap and not always the best choice for retirees. Fees typically run 1% to 1.5% higher than average no-load mutual funds. Compounded over time, this can add up. Are the new variable annuities worth the price?  
    Consider a retirement portfolio of mutual funds averaging an 11% annual return. Over the long haul, it will experience volatility and losing years. As sub-accounts inside a new annuity, the same investments would generate only 9% or 9.5% average annual return because of the variable annuities insurance cost. The retiree would, however, receive a guaranteed income stream for life. Whether the benefit overcomes the somewhat diminished portfolio performance is a question that must be answered case by case.  
    Some variable annuities represent better buys than others. The choice is not always obvious. Consider two variable annuities: One pays 7% guaranteed annual income, the other 5%. Most clients will choose the higher rate, but a key consideration, often missed by those unfamiliar with the new variable annuities, is whether the contract treats distributions on a pro rata or dollar for dollar basis.

Variable annuities with dollar for dollar withdrawal treatment usually offer lower guaranteed income rates because the guaranteed income base will never deteriorate, even if the actual account balance depletes due to withdrawals and an extended down market. This presumes the client does not take excess distributions.

Variable annuities with pro rata treatment typically offer higher income rates but are subject to having their guaranteed account balance decline in value if investment performance lags. If that happens, the owner may be forced to choose between reducing annual withdrawals or annuitizing the balance before it dwindles further. Both may be unappealing options. What does a higher rate do if clients must annuitize to get it?
    Excess distributions also can be dangerous. Depending on how the insurer treats them, they can defeat the purpose of the variable annuity by eroding the guaranteed income base and subsequently the guaranteed income itself. Worse, the client continues to pay a premium, which could be as much as an additional point or more, for a guarantee benefit that is no longer in force. In this case, the client would have been better off funding the portfolio outside of a variable annuity.
    Guarantees, of course, are based on the claims-paying ability of the issuing insurance company, so diligence in choosing a product sponsor is vital. Also, withdrawals prior to age 59 1/2 may be subject to a 10% IRS penalty, surrender charges may apply and are taxed as ordinary income. Obviously, a long-term focus must be the foundation for any variable annuity strategy.

Responsibility To Clients

It goes without saying that the client should be instructed to carefully review the product prospectus, but we have an obligation to our clients to go far beyond that caution and fully explain the nuances of the variable annuity product under consideration.
    Advisors have a choice of taking an up-front commission or an ongoing service fee from product sponsors for selling variable annuities. Taking the commission leaves little incentive to monitor clients' progress over the years to ensure they don't inadvertently abuse or invalidate any of the variable annuity's provisions, such as excess distributions.
    I believe the industry would be better off if sponsors spurned up-front commissions. It would force advisors to rely on trailing income, prompting better service and helping clients avoid making errors or compromising their investment objectives.
    Incidentally, I don't recommend anything I don't buy for my own portfolio. Approximately 80% of my retirement assets are invested in variable annuities with a guaranteed minimum benefit rider.

Misplaced Focus

Advisors generally focus on optimizing investment returns to generate adequate retirement income. For decades, we have recommended asset allocation strategies based on maximizing investment returns. But investing is not the goal-it's merely the vehicle. The goal is replacing earned income with guaranteed income-or life. Somehow, that vital point gets overlooked.  
    Studies show that the optimal investment mix to last a client's lifetime is 80/20 equities to fixed income, assuming a 5% annual withdrawal rate. But no matter how good the odds of the income lasting long enough, there is always the chance of running out of money. There is also the chance that poor investment performance will render the calculations meaningless. It can be difficult to get retirees to accept the optimal mix because the potential volatility may scare them. What often happens is that retirees choose a less than optimal portfolio mix with a higher chance of failure.   
    One advantage of variable annuities with guaranteed income benefits is that they allow retirees to choose the most appropriate asset mix, even if it suggests greater volatility, because their income stream is guaranteed for life even if portfolio performance lags. This can make life much easier for retirement planners. The principal goal of ensuring a lifetime income stream is assured so retirees have more flexibility and less stress in choosing investments.  
    Variable annuity fees, charges, investment options, death benefits and minimum income and/or withdrawal options are among the most important issues for discussion with retirees. Feature and benefit comparisons among available variable annuities, as well as other investment options, such as mutual funds, should also be considered.
    It doesn't take a catastrophic crash to cause significant injuries, in an airliner or in a retirement plan. Submitting client retirement portfolios to emergency planning is one way to help plan for unforeseen contingencies. Variable annuities with guaranteed income benefits can be a valuable part of this contingency planning, provided advisors understand their complexities, match the appropriate variable annuity and benefit rider to client requirements and ensure that the strategy is being employed in a long-term planning environment.

Tom Scott, based in Irvine, Calif., is a registered principal with and offering securities through Linsco/Private Ledger. He can be reached at [email protected] or www.tomlpl.com.