Planners will need to seek innovative ways to help keep the baby boomers from exhausting their nest eggs.

    Other than being the start of a leap year, January 1, 2008 may seem like an ordinary New Year's Day. But it will actually be one of the most momentous days in U.S. history. As the brilliantly lighted crystal ball falls in Times Square, the first of 76 million baby boomers will reach the age of 62, ushering in a long-awaited wave of retirements like nothing the nation has ever seen.

Since the end of World War II, boomers have been the big bulge in America's population growth curve, and that trend shows no sign of diminishing anytime soon. For the rest of this decade, the fastest growing group of U.S. households will be boomers aged 55 to 64, notes Tower Group, the Needham, Mass.-based consulting firm (see chart on U.S. demographics); some younger population groups are expected to be stagnant or even shrink.
A    nd with boomers retiring and some $10 trillion to as much as $30 trillion of their investable assets up for grabs in the coming decade or so, financial advisors are facing an unprecedented opportunity to expand their practices. But along with the opportunity will come a set of daunting challenges as advisors and the asset management, banking and insurance industries that serve them attempt to meet the needs of a generation that is making the transition from full-time employment to a new lifestyle that will probably include some work, more leisure time-and a new raft of worries about generating an income stream for years to come. Remember that at least one member of a 65-year-old couple today has an excellent chance of living into his or her 90s. That puts a lot of pressure on someone who wants to build a sustainable income plan-not one for the next decade, but for the next two, three, or even four.

This overriding concern-having a sufficient retirement income to replace a regular paycheck-promises to reshape the entire financial services industry, which for decades has focused mainly on building the best plans, strategies, and products to help consumers amass savings. Or, as the Retirement Income Industry Association's founder François Gadenne puts it: "Let's go build a mountain of cash. Results may vary." But that attitude may not cut it anymore with aging boomers, who Martin V. Higgins of Family Wealth Management in Marlton, N.J., observes are moving from "accumulationland to distributionland."

New Breed Of Products

Recognizing that the shift will only grow more pronounced as the postwar generation continues to gray, financial services firms are turning to their labs for a new breed of products that emphasize income and capital preservation. For example, several major life insurers have recently rolled out variable annuities that de-emphasize costly life insurance features in favor of guaranteed long-term withdrawal benefits-a feature once limited to income annuities.

A few large asset management firms, meanwhile, have introduced mutual funds that emulate the systematic withdrawal features of the new variable annuities without actually offering guarantees-and their costs. A number of international banks have also gotten into the act, selling U.S. and global high-net-worth investors structured notes that seek to guarantee the return of their principal or assure a set withdrawal schedule while providing returns linked to various market indexes. Gadenne, who also runs a consulting firm, Retirement Engineering Inc. (, in addition to his trade association, has even developed a synthetic deferred income annuity that he hopes to license to a financial products manufacturer.

Even retirement products experts concede that none of these newfangled inventions is a panacea, and it is worth noting that few have been tested in times of extreme market malaise such as those that followed the collapse of the technology bubble in 2001 or the twin oil shocks of the 1970s. Indeed, Wall Street is littered with the remains of financial firms that promised or implied guarantees that they could not fulfill. Just remember what happened to one of the biggest of them: Mutual Benefit Life, a century-old insurer that went under selling "safe" guaranteed investment contracts to pension funds in the 1980s. To fund its guarantees, the insurer made riskier and riskier bets on real estate. Then the property market imploded and Mutual Benefit went bust.

Sixteen years later, the guaranteed product menu is more diverse and the income and principal guarantees more limited. To reap the maximum benefits of today's boomer income products, for example, investors may have to surrender some liquidity or face higher fees than they would have to pay for, say, conventional equity or fixed-income mutual or exchange-traded funds. Research on modeling consumers' income needs has also mushroomed in recent years, providing planners and their clients with a growing library of white papers and books on everything from modeling income portfolios to estimating the costs of health care for retirees (see retirement resources table).

Issues, Issues

In this two-part series on the growing retirement income market, we will examine both planning issues and products-the newest ones as well as some tried-and-true strategies for generating income including fixed-income instruments and high-quality, dividend-paying stocks. We have also polled Financial Advisor's readers on their retirement tool kits and will report back to you in November's issue. In this first installment, however, we will focus more on the major issues confronting planners as their boomer clients grow older.

The first question is to define "retirement." Although the word implies that on one day someone is working and the next she is sinking putts on the 18th hole in Palm Beach, the truth is that retirement contains several distinct phases, each with its own risks and planning requirements. Let's call them the early, middle, and later years. The biggest risks in phase one are market-related. Those continue into phases two and three, but as clients age the focus shifts to health-care spending risks (Tower Group estimates that a retired couple aged 65 will need to set aside $200,000 for future medical costs not covered by Medicare) as well as information risks (even at a seemingly modest 3% average annual inflation rate, a dollar will lose nearly half its purchasing power over two decades).

The first phase of retirement actually starts about five years before-say, when a person is 55 to 60-and covers the first five years after retirement day. Prudential Financial even coined a name for the phase: "The retirement red zone." Whatever it's called, this period is critical for a number of reasons.

For example, if a client hasn't saved enough, now is the time to salt more away or even take a second job. Indeed, this may be the prime issue for many middle-income boomers. According to the Employee Benefit Research Institute, a Washington-based think tank, the average 401(k) plan balance for workers in their 60s was only $141,000 at the end of 2005. Those in their 50s had saved even less: $128,000. With Social Security currently providing an average retirement benefit of just $12,600 per year and the average 65 year old now expected to live well past 80 (see chart), some consumers will have to stay on the job for many years to come just to keep food on the table. "My theory is that we are all going to have to work for the rest of our lives," quips Samson Wang, founder of Runnymede Asset Management in Morristown, N.J.

Mr. Market's Impact

For consumers with more substantial savings, however, the big risk in retirement's first phase is what happens to their portfolio in the financial markets. At a recent retirement planning conference, Gadenne noted that because of the magic of compounding, more than half of an investor's nest egg is typically amassed during the 5 to 10 years before retirement. But he added that what compounding can build up, the market can take away: A period of zero returns during the first decade of retirement shows an 80% correlation with "portfolio ruin"-the commonly used euphemism for running out of dough.

"Structuring Income for Retirement," a recent study by W. Van Harlow, managing director of the Boston-based Fidelity Research Institute, and Moshe A. Milevsky, a professor at York University's business school in Toronto, illustrates this peril. The study, published by Fidelity's research arm and available for free online, examines two hypothetical investors' $100,000 portfolios. Each earns a compounded annual average return of 9.4% over 20 years and is intended to support an annual withdrawal of 7% per year-admittedly an aggressive target. The first portfolio suffers losses in four of its first 10 years and, after annual withdrawals are taken into account, runs out of money by year 13. The second portfolio earns the same returns as the first, but in reverse order. Even after annual withdrawals and some losses in its later years, it still finishes the two decades with a value of $351,295.

One way to help ameliorate this risk is to get a handle on a client's estimated spending over the first five to ten years of retirement and set part of her portfolio aside to make sure her income needs can be met whatever happens in the market. Be sure, of course, to include any work-related earnings during the period as well as pension or Social Security benefits and withdrawals from accounts containing non-qualified assets. "Most of our clients prefer us to say, 'tell me how much I can spend and not have to worry,'" says Michael Kitces, director of financial planning at Pinnacle Advisory Group in Columbia, Md. But even before crunching the numbers, Kitces believes that advisors should "take a small step back" and focus on a client's goals and how they can be quantified. This will help tell you whether the old standby formula-withdrawing 4% of a nest egg annually for 20 years or more-is within the realm of a client's needs. Says Kitces: "We ask clients, 'Exactly what does retirement look like? Will you be traveling? Is there a second home?'"

And beware of "using anything that's just a replacement-of-income approach," he says. "We have people who take 50% to 70% of their preretirement income, and others who spend 10%, 20%, 30% more because they love to travel." Even among Pinnacle's well-heeled customer base, "We have more and more clients for whom retirement means all your income does not go away. And part-time income can have a very substantial effect on people's ability to sustain themselves through retirement."

How to set these assets aside is a subject of considerable debate right now. For middle-income clients who have managed to accumulate around $1 million in savings, Higgins, for example, prefers to buy a five- or 10-year immediate annuity for a portion of their assets and keep the balance invested in a "moderately aggressive" portfolio for continued capital growth. This lets "the performance of the markets do what it is supposed to do" he says, noting that after the initial annuity comes to a close, he may advise a similar strategy for the next five to 10 years.

Other advisors follow widely varying strategies. Kitces says that Pinnacle, for one, takes a "total return approach" to asset management using tactical asset allocation rather than packaged products to carry out its strategy. His clients, he says, tend to keep 45% to 60% of their assets in equities, an allocation that "gives you the most bang for your buck without getting too much risk."

Mark Constantini, president for variable annuities at John Hancock Financial Services Inc. in Boston, offers an alternative strategy that may be more applicable to pre- or new retirees who don't plan to start drawing down their qualified assets until they are in their 70s. One of several insurers offering variable annuity policies containing guaranteed lifetime minimum withdrawal benefits, Hancock allows buyers of its Venture series of variable annuities, for example, to start taking a 5% annual payment immediately. Or, buyers can postpone withdrawals into later retirement years and have the principal in their accounts boosted by a predetermined amount. Hancock makes sure the accounts are always invested in some equities; those clients agreeing to hold off on withdrawals for ten years will see the initial value of their investment doubled-equivalent to a compounded annual return of about 7%.

Extraordinary Risks

As clients ponder retirement, the issue of extraordinary spending needs cannot be ignored. Just as clients would be foolish (or even be flouting the law) to forgo damage or liability insurance on their auto or home, they cannot ignore the effect of uninsured medical expenses on their long-term income plans.

Nashville, Tenn.-based futurist Grady Cash, in a presentation at this year's Financial Planning Association Retreat, observed that it is vital for advisors to "help clients identify and manage risk in health care." This includes not only helping them manage their direct financial exposure, but also such issues as lifestyle and exercise that will affect their overall well-being, and thus their health-care spending as they age. As medical technologies have improved, he says, people now "live through medical shocks" that once would have killed them. The financial costs of coping with repeated medical events "will challenge some of the best financial planners," predicts Cash. Or, as Fidelity's Harlow puts it: "Asset allocation won't help you hedge everything."

One way of helping clients cope with this risk, of course, is to purchase some form of long-term care insurance. Advisor Higgins points out that in the Philadelphia metropolitan area, where he practices, the average cost of nursing home care runs to $250 to $300 per day. To cover that risk, he counsels clients to buy at least five years of long-term care coverage, and urges those in their 60s to purchase policies that cover the rest of their lives. Such a policy, including regular adjustments for inflation, can cost $8,000 to $10,000 per year, Higgins says.

It is important to work the cost of long-term health-care coverage into calculating a client's overall income plan, many advisors say. Kitces, for one, uses elaborate Monte Carlo simulations to model all of a client's anticipated cash flows. Higgins, meanwhile, gooses up his medical-cost and inflation estimates when he runs simulations of his clients' spending needs.

Planning for the boomer retirement tsunami is no longer a matter of figuring out what the assets are and how to replace some or all of a consumer's preretirement income. It involves dealing with a complex matrix of risks, goals, and financial products over several decades. Financial planners may find they need to learn new techniques as their clients move from accumulationland to distributionland. As the retirement wave intensifies, those who don't risk being swept away.

Bill Glasgall is a freelance writer specializing in financial topics. He can be reached at [email protected].