Middle-class Americans are enjoying the same trends as the wealthy when it comes to living a longer life. Unfortunately, that also means they run a much higher risk of depleting their assets long before they die.
For these clients, advisors have to be particularly creative when it comes to stretching modest portfolios well beyond their dollars. But this is more than possible with the right blend of investment vehicles, according to Schyler Adams, CFP and director of advanced strategies and planning platforms for Allianz Life Insurance.
Adams presented a different way of thinking about investment vehicles and unwinding assets during a webinar in mid-December called, “Decumulation Diversification: Draw-Down Retirement Strategies To Help Make The Most Of Hard-Earned Assets Accumulated.” The webinar was produced by Financial Advisor magazine and sponsored by Allianz Life.
“Ideally,” Adams said, “a decumulation strategy would keep income in step with inflation and reduce taxes as much as possible in order to retain or even improve the value of what was accumulated.” Diversifying the portfolio by vehicle, not asset class, can achieve these objectives, he added.
Adams illustrated how one or more shifts can accomplish that with a case study:
Take a married couple, both 58, both of whom make $100,000 a year before taxes, and both of whom want to retire at 65. One has a life expectancy of 92 while the other’s is 94.
Once retired, they estimate annual expenses of $115,000 in today’s terms. They will wait until 70 to tap Social Security, and they’re assuming that inflation will be 3% over the long haul.
For assets, they have $150,000 in taxable investments, two 401(k)s with a total worth of $850,000 and a paid-off house worth $500,000. With no liabilities, their total net worth is $1.5 million. Their combined taxable and nontaxable investments are earning 5.46%, and their assumed tax rates are the current marginal federal tax bracket and a 6% state income tax rate.
When the details were run through a Monte Carlo simulator, they revealed the frightening reality many Americans face, Adams said.
“When we look at the current scenario given these inputs, we can see that our clients currently have just a 59% probability of success of funding all of their expenses throughout their retirement,” he said.
Anything below a 70% to 75% probability of success could require clients to adjust their plan in more than one way if they want more acceptable odds, he said. Therefore, solving for this shortfall can be a two-, three- or four-step process.
But it is possible to “fix” a client’s portfolio so they can enter retirement confident that they will not have to resort to working longer or reducing their already modest spending.
“Obviously, when we talk about working longer and spending less, those aren’t very positive conversations to have,” he said. “What we need to focus on is becoming as efficient as possible with their assets.”
The Cost Of Doing Nothing
Over time (barring any dramatic change in their circumstances), the clients in Adams’s example face total expenses of $7.5 million during the years when they’re between ages 65 and 94. Their Social Security, which begins when they are 70, will end up contributing around $3.9 million, which is only about 52% of the total income they need. The remaining $3.6 million would have to be covered by their investment portfolio.
If the clients live as long as they hope to but their portfolio performs below average, unfortunately it would cover expenses only until they’re 85 years old, Adams said, and by the time the second spouse dies at 94, he or she will come up short by more than $800,000.
“As we know when we have an investment portfolio, it’s susceptible to things like market risk and interest rate risk,” he said. “We see spikes in volatility that could really scare our clients if we see a massive drop in a given year. So we want to increase those guaranteed inflows and not have to rely so heavily on their investment portfolio to cover their expenses.”
Finding The Fix
Adams ran through several options to improve the clients’ situation.
One is a scheduled conversion of $300,000 to a Roth. Another is a $300,000 investment in a registered index-linked annuity (RILA) with an increasing income stream. And a third option was to do both at the same time but separately, with $600,000.
This strategy helped the couple with their expenses by reducing taxes or increasing income (or both). However, the maximum benefit occurred when Adams combined the Roth and the RILA into a single instrument.
In this approach, the client purchases the RILA with an increasing income stream for $300,000, and then does the Roth conversion from within the RILA. From the time they are age 58 to 62, the client converts $60,000 a year to the Roth inside the annuity to even out the tax bill and avoid the two-year Medicare look-back period.
The process involved in this approach, Adams said, is to:
• Create a qualified RILA;
• Transfer $300,000 from the clients’ 401(k) to the RILA;
• Create a Roth IRA portion of the RILA (where the distributions are changed from ordinary income to tax-free income);
• Set up the installment schedule to fund that over the next five years; and
• Take the distributions from the Roth portion of the RILA.
“Now we’re becoming tax efficient with that annuity by making all of the distributions from that annuity during our clients’ retirement completely tax-free,” Adams said. “Our probability of success has now jumped from 59% up to 87% by being smart with our distributions, and by tying our tax-diversified income into our inflation hedge.”
The total expenses are now $7 million and the guaranteed income is $5.2 million, leaving just $1.8 million to be funded by the portfolio—far less than the $3.6 million the clients started at.
And even with the worst-case, below-average market assumption, the clients would be able to leave almost $500,000 at the end of their lives to a beneficiary. They could leave almost $1.6 million behind for heirs if the market performed at its average.
“That’s off of a $300,000 transfer to the registered index-linked annuity where it provides an inflation hedge with tax diversification within our drawdown strategy,” he said. “It’s definitely something from an advisor’s standpoint where you can show the value that you’re providing to the client’s financial plan.”