Boomers may turn to annuities for retirement income.

Part 2 of 2

Many financial advisors along with financial services firms are reconsidering the use of immediate variable annuities or immediate fixed annuities as part of the retirement paycheck solution.

The problem, as we discussed in part 1, is this: Millions of baby boomers are nearing their golden years, but they have limited knowledge and few authorities to consult about creating an income stream that will last throughout retirement.

Annuities, viewed as second-class products for middle-brow investors, are suddenly seen as part of the answer. "It's the core of an ongoing academic debate: whether you want insurance for living without income," says Dallas L. Salisbury, president and CEO of Employee Benefit Research Institute in Washington, D.C.

Indeed, economist John Ameriks at the TIAA-CREF Institute, the research and education arm of New York-based TIAA-CREF, has produced research that shows it's more likely retirees will enjoy higher incomes over longer retirements if they annuitize 25% to 50% of their assets.

According to Ameriks and others, retirees face inflation, market, savings shortfall, medical, and longevity or mortality (the possibility of outliving income) risks. "People don't have a good handle on mortality risk," says Ameriks. "Insurers can pool the risk and use assets from those who don't make it to fund payouts to those who do. No fund or advisor can do that."

Michael C. Henkel, president of Ibbotson Associates, a Chicago-based asset allocation service provider, concurs. He notes most market risk can be managed with asset allocation, longevity risk can be managed with annuities, and inadequate savings can be managed with an increase in savings. He also says advisors and their clients have the additional responsibility of sorting through not just post-retirement risks but also post-retirement goals, including lifestyle and bequests.

Baby boomers have a reputation for wanting it all, Henkel says. Advisors must be prepared to help clients find the right balance between assets and annuity products to meet income and bequest goals and to address market and longevity risks, he adds.

"Boomers don't want to underconsume, and they want to know where their next paycheck is coming from," says Henkel. He notes many large institutions are now standardizing the inputs required to create post-retirement optimization outcomes using annuities and asset classes for their clients. Those inputs, he says, are risks and returns, risk tolerance, desires for consumption and bequests, the investor's assessment of the probability of living beyond life expectancy, and expenses and fees.

According to Diversified Services Group Inc. (DSG) in Wayne, Pa., it's also important for advisors and clients to address health care funding and housing when creating a retirement income strategy. Kurt Cerulli, the founder and principal of Cerulli Associates, remarked in a speech at the Investment Company Institute's meeting in May that converting personal financial wealth to income is a function of three assets: financial wealth (IRAs and brokerage assets), which produces supplemental income; retirement wealth (pensions and Social Security), which produce secured income; and nonfinancial wealth (housing wealth and other assets), which can provide equity income. (See inputs below.)

Fidelity Investments Institutional Services Co. says advisors can take these key steps to help clients with retirement income:

Develop an income distribution plan to determine how and when clients should take distributions.

Develop a comprehensive and flexible budget forecast.

Name beneficiaries in line with legacy goals.

Make sure beneficiary choices are sufficiently documented.

Maximize the tax opportunity and benefits of an IRA within an estate plan.

Determine which Required Minimum Distribution (RMD) method is appropriate.

Consider a Roth IRA conversion.

Consider taking advantage of Net Unrealized Appreciation (NUA).

Evaluate whether their 401(k) plans meet their investment, beneficiary and distribution needs.

Plan for health-care costs.

"Is it desirable for people to plan on using their homes to create retirement income? Yes. Is it realistic? No." says EBRI's Salisbury. The pros and cons of other income sources should be considered, he says. For instance, Medicare and bankruptcy rules might adversely affect IRAs in a way that an annuity would not, he adds.

Industry observers say advisor compensation must be addressed before the planning community adopts annuities as a post-retirement income distribution strategy. Many advisors who now earn fees from assets under management could lose up to 50% of their recurring revenue were they to invest up to one-half of a client's assets-as some research suggests would be appropriate-in an annuity. "Everything hasn't caught up yet," says Henkel. "It's not like people haven't been imaginative regarding compensation. Someone will figure it out."

Salisbury and others suggest that clients should seek advisors who are free from the conflict of interest of managing money while also providing retirement-income distribution advice and who evaluate clients on an individual basis. "Many use average life expectancy, and as a result they are guaranteed to be wrong half the time," Salisbury says.

Compensation is one hurdle, but there are others. Product manufacturers and service providers need to offer more education and choices that address the chief disadvantages of annuities. For example, the universe of intermediate variable annuity providers was 20 companies in 2001 and is not much greater today, according to DSG. What's worse, Jim Sholder editor of DSG Dimensions, a DSG quarterly publication, wrote, "Few executives believe the opportunity is immediate, and therefore little in terms of resources is applied to delivering retirement income solutions."

Cerulli agrees. He noted in his ICI speech that distribution costs, technology and compensation are barriers that must be overcome to advance new product introductions, including the bundling or combining of elements from a variety of markets, such as banking and insurance. Unfortunately, firms are hesitant to allocate resources to new market ventures. "Return-on-equity constraints hamper investments in low-revenue, high-cost markets," he says.

Educating advisors and consumers will prove to be part of the solution, say Cerulli and others. Value-added services and financial planning support in the form of case studies, client seminars and comprehensive planning tools will also help put the subject of retirement income distribution on the radar screen. "There is fear that if you buy a pure annuity, you will lose the money if you die before your life expectancy," says Frank Gencarelli, an executive vice president with GE Financial Services' Retirement Services Group in Richmond, Va.

He adds the same principle that applies to car insurance applies to insuring retirement income. "Living beyond one's income is not a bet I would like to lose." In 2002, GE Financial introduced an annuity called Income Manager, in which the funds are managed like a traditional pension fund, that essentially allows people to purchase their own pension. Investors are guaranteed a certain annual income, which may be increased if investment returns exceed assumptions.

The nation's largest financial firms are beginning to realize that thousands of advisors and millions of people will need help. John Benson, senior executive vice president of John Hancock Financial Services, weighed in on the subject at the annual conference of the Association for Advanced Life Underwriting. He stated the typical firms will derive 30% to 50% of its revenue from the sale of income products.

Fidelity Investments President Abigail Johnson and chief operating officer Robert Reynolds have said in public speeches this year that the giant mutual fund firm wants to become the nation's top retirement income-distribution planning expert. What's more, Fidelity has assembled a special task force comprising different business units to tackle the issue of training employees and creating tools that will meet the retirement income needs of its customers and prospects. Already, Fidelity has put together two virtual retirement income seminars.

For the financial services industry, the stakes are indeed large. With the prospect of asset growth through client acquisition growing smaller, asset retention becomes a critical concern. Financial services firms and advisors who fail to provide technical expertise and products to retiring baby boomers struggling with making their incomes last a lifetime will find themselves on the losing end of the asset retention stick.

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.