Distribution planning will move to the forefront as boomers retire.

Part 1 of 2

It's a well-known if not mundane fact by now. Some 77 million Baby Boomers are advancing toward retirement. To be sure, it's a slow moving storm system. At the forward edge are those born in 1946, who are still eight years away from the traditional age of retirement. But advisors, academicians and product manufacturers are starting to see the tsunami moving toward shore.

And all parties involved are beginning to sense the problems and opportunities that await them at landfall: Advisors will be pressed to create lifetime income for clients while maintaining a profitable revenue stream for themselves; financial services firms that have long focused on helping people accumulate assets for retirement will be forced to create retirement income distribution products that ensure asset retention and thus revenue; and, lastly, consumers-who many believe are woefully unprepared for the huge responsibility of managing retirement savings-will be faced with making hard decisions about bequests and the little-known subject of mortality, or longevity risk.

"A number of marketers believe this post-savings market will ultimately offer more business potential than the accumulation market," wrote Editor Jim Sholder in a recent issue of DSG Dimensions, published quarterly for clients and friends of The Diversified Services Group Inc. (DSG) in Wayne, Pa. "The overriding belief is that the holding period for managed assets is longer, more easily defined, more stable, and people definitely need help. There is also the view that the need for help will increase with increasing age. All of these factors translate into a substantial business opportunity to develop long-term and profitable customer relationships."

To be sure, some of the wave is already breaking on land. An estimated 6,000 Americans now retire each day, and that number is expected to rise to about 10,000 by the time the peak of the boomer wave turns 65. But what's troubling at the moment is that there is only a limited body of knowledge, and very few authorities, on the increasingly important topic of whether and how Americans will create an income stream during retirement that will last a lifetime. A search for subject matter experts on the CFP Board of Standards Web site finds none. Retirement planning, yes. Retirement income distribution planning, no. A Google search also turns up very little in the way of reliable information on the subject.

To be fair, there is some literature (promotional, academic and consumer-oriented) on the subject, and some experts do exist. Margaret "Peggy" Malaspina has authored two books on the subject. DSG has published research on the subject for several years. Lightbulb Press has published a book, in association with the National Association of Variable Annuities, on creating retirement income. And J. & W. Seligman & Co. Inc. has created a Web-based illustrator and the Seligman Harvestor fund to help advisors help investors manage the process of creating lifetime income. Unfortunately, for many advisors and financial service firms, it's still a subject in development. "If you look at the whole universe of investors, the general emphasis tends to be on accumulation," says Gary Terpening, vice president of Seligman Advisors in New York.

The reasons why the subject is still in an incubation phase vary. For most advisors, there is very little demand on the part of clients. "I don't have many clients asking me about it," says Michael S. Finer, CPA, PFS, CFP, CLU, ARM, MST, chairman of Salem, Mass.-based Major League Investments Inc. Indeed, DSG's Sholder notes that most consumers are still focused on saving enough money for retirement. "Before retirement, consumers give little attention or even recognition to the need to provide for income during retirement," he says in the DSG Dimensions article.

Frank Gencarelli, an executive vice president with GE Financial Services' Retirement Services Group in Richmond, Va., believes there is a retirement savings crisis going on that sometimes overshadows the near-retirement and at-retirement challenges. "The key problem that is looming is that there is a lack of a robust, disciplined savings program by most working Americans, '' he says. ''It's a bigger problem than retirement income distribution. ''

Bigger, perhaps, but some advisors have had to become experts out of necessity. Bill P. Bengen, CFP, a sole practitioner in El Cajon, Calif., specializing in investment management, is among those who qualify as a bona fide expert. About a decade ago, Bengen says he was faced with the prospect of helping some of his clients, who were offered early retirement packages, to create retirement income for life.

Since then, he has published several articles in the Journal of Financial Planning detailing post-retirement investment portfolios, withdrawal rates and conservation strategies. Bengen's research suggests that retirees create a portfolio of at least 50% to 75% equities and the remainder in fixed-income securities, and withdraw 4% per annum on an inflation-adjusted basis. That withdrawal rate should enable clients to create a retirement paycheck for life. "With retirement assets, a lot of folks think they can pull out 6%, sometimes 7% per year," says David W. Polstra, CPA, CFP, CIMA, PFS, chairman of Norcross, Ga.-based Polstra & Dardaman LLC. "And that can be a recipe for disaster." Polstra says that higher withdrawal rates improve the odds of clients achieving their income objectives, which some advisors put at 75% of pre-retirement income, but it also increases the odds of clients running out of money.

And that's a problem, says Michael Williams, managing director of Genesis Partners in Chicago. "Most people underestimate how long they will need the money. The odds are higher than they think."

At the moment, Bengen and other advisors are focusing much of their attention on creating retirement income by using investment portfolios and asset allocation and withdrawal strategies focused on retirement stages, rather than income-producing insurance products. Studies, and books such as The Prosperous Retirement by Michael S. Stein, CFP, are suggesting withdrawal strategies for different phases of retirement-active (through age 75), transition (age 75 through 85) and passive (beyond age 85). Others are evaluating the most tax-efficient distribution strategies using totally tax-deferred funds, partially tax-deferred funds and after-tax funds.

That's the theory anyway. In reality it works this way: Polstra describes the case of a 75-year-old retired manufacturing executive who came to him with an investment portfolio of $616,258 and post-retirement annual income needs, excluding Social Security, of $47,000 per year (excluding inflation). That translated into a withdrawal rate of 7.6%, at least in year one.

"Clients tend to think that if their portfolio earns 8% they can pull out 7%," says Polstra. "Unfortunately, it doesn't work that way. The reality of the market is that you do not get consistent returns, and because of that you need to reduce the withdrawal rate to no more than 4% of the start-of-year investment portfolio value."

To help this client and other clients better understand the retirement income distribution issues, he's created a spreadsheet called "Why Returns are Rarely Average." With the spreadsheet, Polstra walked the former manufacturing executive, whose only other asset was his home, through various investment return scenarios in which the client withdraws $47,000 per year for 20 years until age 94. In Scenario 1, he assumes the client's portfolio (a mix of 60% stocks and 40 % bonds) would rise exactly 8% per year and that the client will be left with a tad more than $740,000 at the end of 20 years.

Knowing that markets never rise exactly 8% per year, Polstra showed the client Scenario 2, which uses a Monte Carlo simulation to depict the market experiencing bull and bear markets. The portfolio rises dramatically in the early years and less so in the later years, but ultimately averages 8% per year. In that scenario, Polstra says his client's portfolio would be valued at $1.26 million at the end of 20 years.

And in Scenario 3, Polstra showed the client a portfolio that rises, again using Monte Carlo simulation, only modestly in the early years and dramatically in the later years, but still averaging 8%. In that case, the client would run out of money at the end of 16 years. Polstra says he considered purchasing an annuity to create lifetime income, but that the client wished to leave an inheritance to his children, a feature that an annuity presently does not accommodate.

After sorting through various issues-including the client's bequest desires, the likelihood that his living expenses would decline in his later years (his wife's health being a chief issue today), the possibility of his returning to work part time if need be, the possibility of using a reverse mortgage to cover any income shortfalls, and the possibility of him moving in with his children-the client still opted for a high, fixed withdrawal rate. "The client is aware of the risk of running out of money," says Polstra, noting that the client feels comfortable that he has made an informed decision about his withdrawal rate.

An informed decision is the key to retirement income distribution questions, says Polstra. To help clients make informed decisions, Polstra has also created a timeline spreadsheet that helps clients understand when to withdraw money from different types of retirement accounts. "Clients view their accounts as different pots of money," says Polstra, who notes that the tool can help people see the "pots" as one.

For Bengen, the theory and reality of retirement income planning are a mismatched couple as well. Like Polstra, he recommends a 4% withdrawal rate. But the reality of a 4% to 4.5% withdrawal rate in year one, on the average lump sum payout of a 401(k) portfolio of $160,000, is a mere $6,400; hardly enough to achieve an average American's post-retirement income of $40,000. Even with Social Security, the income shortfall can be great.

So what's an advisor to do? "The best you can do is explain the risk," says Bengen, who tells the story of a couple, then age 63, who came to him seven years ago with a taxable and tax-deferred investment portfolio of $500,000. The couple, he says, insisted that they needed to withdraw $35,000 per year, or 7%, to maintain their pre-retirement standard of living of $60,000 per year. Despite Bengen's urging to the contrary, the husband, a former engineer, and his wife, a homemaker, insisted that the stock market would continue to do well and that it was unlikely that they would run out of money over the next 30 years.

"That worked well for a couple years," says Bengen, who created what he describes as an optimal post-retirement portfolio of 65% stocks and 35% fixed-income securities for the client. "And then the bear market hit and they got clobbered, and by the end of 2002 they felt pretty sorry."

Sorry, indeed. Bengen says the portfolio, now valued at about $320,000, would vanish in seven years if they maintained the same pre-bear-market withdrawal rate. And given that the couple could live another 20 years, that left 14 years of just getting by on other sources of retirement income, including Social Security and money from a defined benefit plan. "They weren't willing to come to grips with reality," says Bengen. "Experience is a great teacher, but it can be painful. The numbers don't lie."

The couple is now learning just how painful. They have reduced the amount they are withdrawing from their portfolio to $12,800, which translates into a withdrawal rate of 4%. And they have reduced their standard of living. They have stopped traveling and splurging on gifts for grandchildren. They have refinanced their home mortgage to lower expenses. "They had a lot of fat in the system," says Bengen, who now is optimistic that the couple will no longer outlive their income.

According to Bengen, the couple represents the exception rather than the rule in his practice. "Most of my retirement clients came through in one piece," he says. "They stayed within the (4%) limits."

Bengen says that the need for retirees to adjust their standard of living in retirement is very common, although solutions to making income last a lifetime, including the use of annuities to create income-requiring a case-by-case analysis by advisors.

Robert J. Powell III, co-author of Decoding Wall Street, executive producer of PBS' More Than Money, and former editor-in-chief of Mutual Fund Market News, operates a financial services communication and consulting firm based in Swampscott, Mass.