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As retirement income planning is still a relatively new discipline, advisors may not have a clear process for developing a plan. Here are 10 steps for developing a robust retirement income plan that addresses the client’s income needs, the various risks that clients face in retirement, and legal and tax issues that impact the plan.
1. Evaluate the client’s current situation
Building a retirement income plan for the future requires a complete understanding of the client right now. That holds true if the client is still working and is in the planning stage or if you start working with the client at or after retirement. This process involves reviewing quantitative data, such as current financial statements. The cash flow statement shows both current in¬come and spending habits. You also learn a lot by analyzing a statement of net worth, as it will identify long-term debts as well as assets that may be available to meet retirement needs.
The evaluation process also includes a qualitative fact-finding process. Fact finders and conversations can reveal information about the client’s current financial challenges and concerns. Appropriate questions about their experiences with financial profes¬sionals might help you understand what they are looking for from you, and personal information about their family, activities and organizations they support give you a picture of what is important to them.
2. Identify and prioritize retirement goals
This may sound easy but it really isn’t. Some clients may know what their lives will look like in retirement, but many will not. They may need help envisioning what their future will look like. There are many new tools to help people think through what they may want to spend their time doing in retirement, and what legacy they might want to leave after they are gone. The harder job may be helping clients consider what issues arise in the later years of retirement, for example, addressing the possibilities of needing long-term care, providing for a spouse after death or simply living longer than expected.
3. Estimate retirement income needs
Combined with information about current expens¬es you can begin to flesh out projected retirement expenses. You can divide expenses based on whether they are essential or discretionary. This distinction is important as income solutions for basic expenses may be different than for discretionary ones. The other issue is that expenses do not stay constant over retirement. The idea that you identify expenses for the first year and then increase them throughout retirement for inflation can provide an inaccurate picture and possible overestimate of expenses. For many retirees, expenses in the later years of retirement actually decrease as activity levels and abilities decline.
4: Identify sources of income and assets available to generate retirement income
The obvious sources of retirement income are Social Security benefits and employer-sponsored defined benefit plans. These benefits will depend on when work stops, when benefits begin and the form of payment selected. However, there can be many other sources as well. Executives may have supplemental nonqualified employer-sponsored benefits. Some may have in¬come from rental property or renting out part of their home, income from selling a business or other streams of income. Part-time employment can be another source of income in retirement, although historically more people indicate that they will continue to work than actually do.
With assets, it is appropriate to ask questions to make sure that you identify less obvious sources, such as cash value life insurance, home equity and collectibles. Some people with vacation homes may plan to move into that home in retirement and sell their primary residence. The list of those assets, however, should be limited to those likely to be used to generate retirement income.
5: Make a preliminary calculation of the client’s preparedness for retirement
Make a preliminary calculation of whether current income sources and income generated from available assets will be sufficient to meet the client’s estimated need throughout retirement. Many software tools and worksheets are available for making these determinations—and they can generate a wide range of results depending on what the software is modeling and the assumptions used about rate of return, longevity, inflation, etc. With regard to the first issue, the advisor must understand what the program is illustrating. For example, Monte Carlo probability analysis has become quite common, but neither the advisor nor the client may fully understand what the results mean and how they were derived. Assumptions need to be reasonable and appropriate for each specific client.
6: Develop strategies for addressing a retirement income shortfall
After making the calculations, it may become obvious that the client is not financially prepared to meet his or her retirement objectives. At this point, the focus of the plan turns to identifying strategies to eliminate the shortfall. This could mean saving more, getting better performance out of the portfolio, working full-time longer or working part-time in retirement. It could also mean deciding to live on less. Telling a client that they are not prepared to meet their goals can be difficult. On the other hand, solving the problems before or during early retirement is much less painful than discovering the problem later.
7: Consider legal and tax issues that can derail the plan
Recognize that there are tax strategies that can improve a client’s financial situation, such as using appropriate tax-advantaged vehicles for saving for retirement and choosing the appropriate order of withdrawals once the client is in the decumulation phase. Tax issues can also undermine a plan. For example, failing to satisfy the required minimum distribution rules from qualified plans and IRAs can result in a 50 percent excise tax. Some of the legal issues that need to be addressed include planning for the possibility that a client will not be able to make financial or health-care decisions, and putting the appropriate estate-planning tools to use to meet legacy objectives.
8: Consider retirement contingencies in developing alternative solutions
As you start formulating strategies for addressing a shortfall or for converting assets into income, it is important to stress test the plan. The plan must address the various risks and contingencies that will be faced in retirement. For example, how does the plan address the possibility that the client will live longer than expected, that the market will have a sustained down period in the first few years of retirement, or a spouse dies at an early age? Before offering retirement income solutions, thinking through how the solutions will address these and many other retirement risks is critical.
9: Determine an appropriate strategy for converting assets into income
Some think this step is what retirement income planning is all about, but a successful plan requires a comprehensive analysis to come up with appropriate strategies for a particular client. For example, converting a 401(k) account into a life annuity may be an excellent solution for the client with little other guaranteed lifetime income but not for someone with a significant pension benefit. Plus, increasing lifetime income isn’t entirely about converting assets to income. It can also be figuring ways to maximize Social Security benefits, using a reverse mortgage to tap home equity or making better tax decisions to increase after-tax income. Another option for solving cash flow needs is reducing expenses instead of increasing income.
Once you’ve clearly established the need to generate income from financial assets, you must choose the appropriate way of framing the issue. Some advisors look to create an income floor for essential expenses, in which case the product solutions for meeting the income floor may be different than for discretionary expenses and legacy goals. Others start with the question of how much they can afford to withdraw from the portfolio each year and still make the money last, in which case some type of systematic withdrawal strategy seems more appropriate.