How ready for retirement are baby boomers and Generation Xers? The two groups have different retirement time horizons, but both have expressed concerns whether they will be able to save enough to enjoy a comfortable retirement.
In 2017, only 32 percent of boomers reported saving more than $250,000 for retirement. That's one-fourth of the generally accepted amount a retiree needs to last a lifetime.
Meanwhile, many Gen Xers (ages 37-51) report feeling burdened by student loan and credit card debt and unsure about being able to save enough for retirement. So, it's very likely that many of your clients are facing a retirement savings deficit and need your help in catching up.
Often, this shortfall is due to unforeseen, sudden life events that aren't easy to plan for—the loss of a job, divorce or death of a spouse, care-giving responsibilities, or even major stock market downturns.
Thankfully, there are several strategies that can help your clients overcome a retirement savings gap. This article will explore some possible options that can assist them in: saving more and spending less during accumulation and in retirement, identifying alternative savings vehicles and protecting against or mitigating different risk factors.
Saving More, Spending Less
One obvious-sounding solution is not as simple as it may seem: saving more and spending less before retirement. A good starting point is helping your clients understand how reducing their discretionary spending on items such as vacations, new cars or a larger home can significantly reduce the amount of income they will need in retirement. Even a modest reduction in spending now can pay big dividends down the road, allowing your clients to more closely match their current standard of living in retirement.
Another potential way to reduce current costs is mortgage refinancing, assuming your clients plan to remain in their home long term and can qualify for a lower interest rate (due to an improved credit score or a low interest rate environment). Ultimately, they would have to consider the fees associated with the refinancing and compare that to the potential monthly savings to decide if will reduce their costs.
Salary increases or additional sources of income can also be used to raise the rate of pre-retirement saving. Some examples of these “extra” income sources include: bonuses, raises, inheritance, tax refunds and money freed up by becoming empty nesters. Encourage clients in these scenarios to defer their bonus or raise into their employer sponsored plan instead of receiving the income. In this way, the extra money cannot be missed if it was never received it to begin with. While this is a sacrifice of certain pleasures now—the extra funds could be critical for success later.
Mitigating Risk And ‘Seeking Alpha’
As retirement draws closer, it becomes increasingly important to mitigate risk by reducing the downside potential within a portfolio. Taking on too much market risk can lead to serious damage to a retirement account.
Using a hypothetical example, if your client’s assets lost 20 percent of their value due to stock market losses, they would need a total return of 25 percent the following year to break even. Assuming a modest 2 percent compound annual gross rate of return, it could take them more than 11 years to make up that loss. Even if we assume a higher rate of, say, a 6 percent compound annual gross rate of return, it could still take 3.8 years to recover that loss.
Reducing downside potential can be accomplished by “seeking alpha” —an estimate of the return expected from a portfolio of investments in relation to the return of the overall market when both are adjusted for non-systematic risk (risk that can be reduced through diversification such as owning stocks in a variety of companies or industries, or having a mix of investments or securities).
This strategy can be useful to those who wish to simulate the returns of a given index but want to add a level of protection from the alpha (by investing in risk-free securities), or for those who wish to take on additional risk by taking positions exposing them to non-systematic risk, by choosing individual stocks. The return on a portfolio with an alpha of, say, 1.25 percent could be expected to be 1.25 percent higher than the return of the market over the course of a year, as one example.
‘Catching Up’ Before Retirement
One of the easiest ways for people over the age of 50 to “catch up” is increasing their contributions to tax-qualified retirement arrangements. Those who are 50 and older can contribute an extra $1,000 per year to traditional or Roth IRAs and an extra $6,000 per year to 401(k), 403(b) and 457 plans. Also, keep in mind that contributions can be made for spouses as well.
Another tool to set aside additional money for health care and retirement is a health savings account (HSA). An HSA is an option for those with a high deductible health-care plan.
Among the benefits of an HSA: allowing the unused balance to roll over from one year to the next; ability to accumulate tax-deferred investment earnings on account balance; at age 65, HSA money can be used for any expenses, not just health care, without an additional federal tax; distributions will be taxed as ordinary income. The money remains untaxed after age 65 when used for qualifying medical expenses, including Medicare Part B premiums.
Protecting Against Certain Risks
One solution to help protect a portion of clients’ retirement savings against certain risks is non-qualified annuities. Non-qualified annuities can provide tax deferral; reduce interest rate risk (some annuities); protect against market volatility (some annuities); may generate guaranteed income for life reducing longevity risk, and may include death benefits for beneficiaries. It’s important to note that guarantees on these contracts are backed by the financial strength and claims-paying ability of the issuing company.
It’s also critical to clarify that non-qualified annuities are not a suitable solution for every situation. Some clients may find liquidity an issue. Although rare, others may already have enough guaranteed retirement income. Some individuals may be at an age where it no longer makes sense to purchase a non-qualified annuity since it is a long-term vehicle. Be sure to consider these factors before recommending a non-qualified annuity for your client’s portfolio—but also remember that implementing an annuity strategy appears to work better when done sooner, rather than later, so clients shouldn’t delay in exploring this option.
Cash value life insurance is another vehicle that is used to help protect against risk. It can provide the primary need for death benefit protection for beneficiaries. In certain cases it also offers potential supplemental retirement income, helps provide a level of protection against market volatility, helps diversify retirement income hedges against inflation when using cost of living riders (which may be optional and at an additional cost) and may provide tax-advantaged loans or withdrawals. (Policy loans and withdrawals will reduce the available cash value and death benefit and may cause the policy to lapse, or affect guarantees against lapse. Withdrawals in excess of premiums paid will be subject to ordinary income tax. Additional premium payments may be required to keep the policy in force. In the event of a lapse, outstanding policy loans in excess of unrecovered cost basis will be subject to ordinary income tax. Tax laws are subject to change and your clients should consult a tax professional.)
Check with your clients to see if they have term life policies that have a conversion feature to a permanent policy. It is not uncommon that they don’t need the initial death benefit they took out, but still need a portion of it on a permanent basis beyond the length of the original term. This is especially important if they have declined in health as they could keep their original health rating instead of going through underwriting again.
Another possible consideration for your clients focuses on required minimum distributions (RMDs). Thinking ahead to RMDs before your clients reach age 70½ (when RMDs are mandated to begin) may help you bring additional value to your clients. Tax deferral today may need to be sacrificed for longer, possibly more controlled, deferral during retirement. That is because leaving assets in traditional IRAs or qualified plans to defer taxes may move the client into higher tax brackets when RMDs begin.
A client might have an income well below the top of the 12 percent or 22 percent tax bracket. But when the client turns 70½, his taxable income from the IRA may cause a jump to the next tax bracket—because the RMDs are distributions from a traditional IRA and are taxed as ordinary income. You should also consider the possibility the RMD distributions may cause more taxation on Social Security benefits.
One strategy to help address that problem would be strategically moving a portion of their assets into a nonqualified annuity, paying taxes, then continuing to accumulate with no current taxes on gains. Clients might also delay their Social Security benefit until age 70, being conscious of mitigating considerations such as poor health or poor family health history. And if their tax advisor is in agreement, they might withdraw from the traditional IRA until they’ve “filled up” their current tax bracket. By doing this they still have deferral (non-qualified annuity and IRA), but they are controlling the tax bracket applicable to traditional IRA distributions while they can.
The benefits of the nonqualified annuity and paying more tax in the lower bracket early can be substantial, due to potentially paying less tax on the IRA distributions now. Different assumptions will cause different results and clients should consult their tax advisor for their own unique situation.
Your client may also want to consider Social Security benefits and income strategies. Taking Social Security at age 62 means the Social Security retirement benefits would be permanently reduced. This should be considered one of the last sources of income before full retirement age. As an alternative, clients may consider using non-qualified assets or a combination of after tax and IRA distributions for their early retirement income needs, claiming their Social Security benefits later. This could provide for more guaranteed income for the life of both spouses throughout their retirement.
Multiple Strategies Needed
Given the complexities of retirement planning, it may take a combination of strategies to help clients close the retirement gap. In most scenarios, saving more aggressively is a key to their retirement income success, but it’s clear that a combination of strategies covering investments, risk protection and strategic tax deferral will provide the best opportunity to help clients achieve their goals.
It’s important to remember that retirement strategies become more sensitive to variables when the time horizon is short. Therefore, it will be critical to periodically review your client's situation and revisit these “catch-up” strategies throughout the retirement process.
Kelly LaVigne is vice president of advanced markets at Allianz Life.