7 Lessons On Strategies

The Rich Use To Buy Annuities

Lesson #2

Why So Many Income Plans Fail

Understand Why So Many Conventional Methods for Generating Retirement Income Fall Short of Meeting Your Needs. And What To Do About It Right Now

Introduction

In this lesson we are going to be thoroughly examining three very common methods that people use for generating income during retirement and why each option contains certain disadvantages that may cause someone to experience difficulties in retirement.

The 3 common methods are:

1. Investing your principal in a fixed interest rate vehicle, such as a bond or CD, and then attempting to live off the interest without touching principal.

2. Purchasing an annuity that offers a lifetime income stream.

3. Making systematic withdrawals from a non-guaranteed portfolio that also contains the possible risk of loss.

So let’s get started…

Commons Options And Problems

Option #1 - Taking Income From Interest Only

As people enter retirement, one of their greatest concerns is that they could run out of money in their old age.

The method that some people attempt to use as a means of protection from this fear is to look for the highest rate of return they can find in something “safe”, like a CD or other fixed-interest rate investment, and try to live purely off the yearly interest they earn.

They reason that this could potentially solve their need for income without ever having to dig into their principal balance.

For a simple example, let’s say that Robert, age 62, has $300,000 in savings, and he has be en able to invest in a bond or CD that is paying a 3% rate of return. This means that Robert’s CD would generate $9,000 per year or $750 per month of interest income ($3 00,000 x .09 = $9,000), without causing Robert to dip into his $300,000 principal.

Now, this strategy can certainly work, and has done so for many people. However, especially in light of the current low interest rate environment, many retirees have been experiencing more and more challenges and frustrations when it comes to meeting their ongoing needs with this type of an approach.

Let’s look now at the main problems that can occur with this option:


Problem #1 – Finding A Competitive Interest Rate

If someone is living on an income stream that is derived purely from the rate of return that they are earning, doesn’t that mean that they are basically a slave to whatever the current interest rate environment is at that time? Absolutely!

At the time this article is being written, we have seen a dramatic decline in interest rates on bonds and CD’s in recent years, and many retirees who were used to getting 4% or better in their fixed interest rate accounts are now having to renew at less than 2%.

If Robert, our retiree from the example above, was used to getting a 4% return on his $300,000 of principal, but now is only able to find a 2% return as a renewal rate, he has just experienced a 50% LOSS of his monthly income ($300,000 @ 4% produces $1,000 per month of income, but $300,000 @ 2% only produces $500 per month of income).

This is why so many retirees who are dependent on the interest income from their fixed-rate investments are having such a hard time.

How does one combat this problem? They either have to go out and find a higher rate of return, which as we have already discussed may not even be available, at least not at an acceptable level of risk – or they have to start withdrawing principal and interest at the same time, which now adds to the original fear they were first trying to avoid - the fear of running out of money.

Problem #2 – Living Off Interest Only = No Compound Interest

Compound interest is the simple, but powerful mathematical process of interest earning interest on itself over the years, giving the owner a snowballing-type of effect on the growth of their money.

Albert Einstein once said that compound interest was the eighth wonder of the world. Why would he say that?

Well, suppose that Christopher Columbus had deposited $100 into two separate bank accounts immediately upon his arrival (don’t ask us why there was a bank conveniently on the shores of the New World already waiting for him, but we’re pretty sure it would have been named “First National Bank”).

The first account paid 10% simple interest (that means interest only on the principal each year) and the other account paid 5% compounding interest (interest on the principal and previous interest earned). How much money do you think each account would be worth today?

Give up? 518 years later, the 10% simple interest account would have a balance of $5,250. Th e account with 5% compound interest would be worth over $8.61 trillion! Granted, we know that most folks are probably not going to have a 500-year retirement, but nonetheless, it is a very interesting example that illustrates the power of compound interest.

So what does all this have to do with living off bond or CD interest? Well, if you are living off your interest, then by definition doesn’t that mean you are withdrawing all of your growth as so on as it’s being earned?

And if you are withdrawing your growth as soon as it’s being earned, is your principal balance enjoying any compound interest? No, it’s not, which means that you could be missing out of on e of the most powerful of all mathematical laws, by not making sure that it is working in your favor!

Now, if you’re asking yourself yet, “Okay, so how do I fix this and what do you propose is better”? Just know that we are going to be offering some very simple and helpful solutions to all these challenges in the next several lessons that you will be receiving.

But for now, let’s move on and explore the next common way that people generate income during retirement and the challenges it creates.

Option #2 - Purchasing An Annuity With A Guaranteed Income Payout

An immediate fixed annuity is a contract between you and an insurance company stating that you will give them a certain sum of money (principal) and in return they will guarantee to pay you monthly amounts (income) for a certain number of years (10,15, or 20, etc.) or for your lifetime, depending on which payout option that you choose.


Since the time of the Romans, when annuities were first invented to pay the retirement salaries of retiring senators, to the present, people have been relying on annuities to provide systematic, safe, and predictable income to help meet their needs during retirement.

These types of financial vehicles can be a tremendous benefit when applied correctly and have helped meet the income needs of countless retirees over the centuries. However, they too come with some specific disadvantages that are being magnified even more now, due to the current negative economy.


Problem #1 – Irreversible Decision

When you purchase an immediate income annuity from an insurance company, what you are effectively doing is signing over ownership of your principal in an irreversible or irrevocable manner.

Let’s check back in with Robert, our fictitious retiree we met earlier in this article. You may recall that Robert had $300,000 in savings, and after learning about the limitations that come with living off his interest from CD’s, he wonders now if an immediate income annuity might be a better option.

If Robert were to use his $300,000 to purchase a fixed annuity, he would receive guaranteed monthly income payments of $1,800 per month for the rest of his life, which is certainly a higher guaranteed income stream than his CD’s were paying.

However, upon signing the annuity contract, he no longer is able to maintain ownership of his $300,000 principal. This means that 5 years from now, if he has an emergency and needs to access $40,000 quickly, he is not able to do so, even for a large surrender charge. The money literally does not belong to him anymore. He would still continue receiving his scheduled $1,800 per month of income, but he can never again access his principal for any reason or for any amount of penalty. It is simply no longer his.


Problem #2 – No Preservation or Recovery of Principal

We just discussed how Robert’s ownership of his principal has been forfeited, but it is important to understand that this also means there is no preservation or recovery of principal “at the other end” for his spouse or his children.

Had Robert selected a 20 year income stream instead of a lifetime income, the insurance company would have simply paid out his entire original principal of $300,000 with some minimal interest over a 20 year period; but at the other end, the contract would have expired, the income payments would shut off, and there would be nothing else left over.

Problem #3 – No Inflation Protection


While there are some exceptions out there, the vast majority of immediate annuities purchased in the United States offer no inflation adjustments to your income stream. This means that Robert will be receiving the same $1,800 at age 80 that he was receiving at age 62, even though the prices of the everyday goods that he purchases could have potentially doubled in the same time frame.


Therefore, in conclusion of this option, we see that while annuities can offer certain desirable benefits such as safety and guarantees, they are also a prime example of the “tradeoffs” that you are forced into making with this type of conventional approach. Most retirees want income, growth, and preservation of principal all at the same time, not one at the sacrifice of others.

Let’s now look at the third common way that people attempt to create income…

Option #3 – Systematic Withdrawals From A Non-Guaranteed Portfolio

OK, so at this point Robert is not feeling very confident about his needs being met adequately through bond/CD interest, or from an immediate annuity.

He wonders if maybe a “professionally managed diversified portfolio” would be a better option.

Perhaps he could earn enough interest each year to preserve his principal while still making consistent withdrawals each year for income purposes.


Well…perhaps!

Let’s first take a quick look at some basic rules of financial planning; then, we will look at the main problems and frustrations that can come about from this type of option.

Financially speaking, there are 3 primary phases in someone’s life:


Phase #1 – The Accumulation Phase

Phase #2 – The Transition Phase

Phase #3 – The Income and Preservation Phase

These phases are represented by the 3 graphics below.

Financial Phases of Life

Growth/Accumulation

Ages 20-50

Transition

Ages 50-60

Income / Preservation

Ages 60+

Moderate to Aggressive Risk

Less Risk - Increase Safety

Little to No Risk - High Safety

Most financial planners will agree that this is a correct philosophy to follow when it comes to selecting the types of investments that make up your portfolio.

The problem is that because we are all creatures of habit, chances are if you are used to using risk-based investments for the duration of your working career, you will likely be tempted to continue using a high percentage of risk-based investments throughout your Transition Phase, and possibly well into your Income/Preservation Phase.


However, our experience in working with thousands of retirees across the country is that one of the most dominant causes of financial problems during retirement is usually a result of when someone has continued using too high of a percentage of risk-based investments during retirement while trying to withdraw income at the same time.

Th is problem was especially evident during the significant market downturn of the 2008 financial crisis when retirees saw major losses of their principal and were forced out of retirement and back int o unwanted employment.

Sadly, the investors whose retirements were negatively impacted through the 2008 downturn, ended up in a very difficult situation primarily because they never had their portfolio re-designed correctly for this new phase of life that they were in.

Their Life Phase Cycle looks more like this:

Incorrect Phases

Growth/Accumulation

Ages 20-50

Transition

Ages 50-60

Income / Preservation

Ages 60+

Moderate to Aggressive Risk

Moderate to Aggressive Risk

Moderate to Aggressive Risk

Unfortunately, what can sometimes compound this problem further, is that many people are unknowingly working with a current advisor or broker whose specialty is focused more towards growth and accumulation, than towards income and preservation.

How do we know this? Well, if you are a 60-year old person who has been working with the same ad visor for the past 10 or 20 years (during your working career), chances are you are working with an Accumulation Phase advisor, since the majority of your relationship with them took place during that specific phase of your life.


The second test is that if you are currently experiencing any concerns about: losing money, running out of money, or getting your portfolio to generate enough sufficient income safely, that is compelling evidence that you likely have not been exposed to effective income-producing portfolio concepts that are capable of solving these types of concerns.

Just like some doctors are heart specialists and others are brain specialists, the financial services industry typically has many different kinds of advisors who specialize in different areas of expertise.

If someone is concerned about moving on from the services of a trusted advisor they have worked with for many years, they can certainly continue to respect and appreciate the relationship and good work that the advisor has done for them.

However, one of the most important decisions they can make for themselves is to transition their portfolio into the service and care of an advisor who is better trained and equipped to help them navigate the unique challenges of the Income and Preservation Phase of their life.

So now that we have discussed some general financial planning rules, let’s look at exactly what can go wrong when someone is depending on a non-guaranteed portfolio to provide growth and income during retirement.

Problem #1 – Drawing Consistent Income During A Declining Economy

A favorite selling point of stockbrokers is to talk about “average” rates of return. “Some years you’re up 20 percent, some years you’re down 20 percent, but on average, Mrs. Client, your portfolio should get about an 8% rate of return over the years,” they like to say.


Well, that can work to a certain extent during the Accumulation Phase of life. You can almost afford to “play the averages” because you’re NOT taking any income out. But you can imagine what happens mathematically when you start pulling consistent income out of your portfolio every single year whether the portfolio is up or down.


Withdrawing income out every year during retirement makes the “bad” years much worse, and can make the “good” years not nearly as good. Why? Think about what happens to your $500,000 portfolio balance if you’re losing 30% of your account value in a down economy at the same time you are withdrawing $30,000 as income.

Your portfolio balance would go from $500,000 to $320,000 in ONE YEAR!

Now again, this is typically when the stockbrokers start jumping up and down trying to convince you to “hang on”, telling you that the market will come back and “average” out with the next big rebound year.

Will it really? Let’s see. Usually even in the best rebound years we rarely see the market rise more than 25-35%. So in our scenario, let’s say your new portfolio balance of $320,000 has a 30% re bound return the very next year. Are you really back up to where you started at $500,000? Did the “averages” really work out like the brokers insisted?


Hardly! Why? Because remember, you’re retired now! You don’t have a paycheck from your employer anymore. You are dependent on your portfolio to provide your means for buying health insurance, food, and paying your mortgage and electric bills each year - so you still have to withdraw income out of your portfolio this year, and the next year, and the next year. How many retirees do you know that have the luxury of shutting off their monthly income for a couple of years to allow things to rebound all the way first? Not many.

So again, assuming our $320,000 participates in a 30% rebound the following year, let’s see if the stock brokers are correct in saying that everything will “average out.” $320,000 receiving a 30% ga in would temporarily bring our balance back up to $416,000, but once we subtract our income of $30,000 to pay our bills and living expenses for the year, we are back down to $386,000.

That is still a 22% reduction of someone’s life savings in only the first 24 months of their retirement! Does that really create peace of mind for a 62 year old with a 25-year life expectancy?

There are two extremely important points to understand about this type of strategy:

FIRST: Losses can be twice as powerful as the gains. If you have $100,000 and you lose 50% the first year, but then have a 50% gain the second year, you’re at least back to where you started right? Wrong! $100,000 minus 50% equals $50,000, but $50,000 plus a 50% gain only brings you back up to $75,000! Notice how it takes a 100% gain in order to offset a 50% loss? And that is assuming you are not taking any withdrawals for income.

SECOND: Withdrawing income from your portfolio each year can skew your averages. There are few things that can destroy a portfolio faster than drawing income in the same year that your underlying investments are losing value.

Summary

At Thrive Financial Services, we believe that most people over 55 are looking for three primary things:

1. How to create stable, predictable retirement income.

2. How to keep their money growing safely and consistently every year.

3. And how to preserve their principal balance throughout retirement so they do not run out of money too soon or have nothing to leave as an inheritance.


However, the reality is that many conventional financial products, investment vehicles, financial plans, and even financial advisors are simply not capable of giving someone all three of those re quests at the same time; at least not with any mathematical certainty.

The evidence? Just look at how much concern there is out there over retirement these days!

How many “options” have you been presented with where you have to choose between income OR preserving principal, growth OR safety, predictability OR liquidity?


Our experience is that many retirees are tired of the frustrating “trade-offs” that come with most conventional planning techniques.

Perhaps some of these sound familiar?

  1. Fear of losing money

  2. Fear of running out of money

  3. Concerned about not having enough income to meet their needs

  4. Worried about not having enough adequate growth of their nest egg

  5. Frustrated with growth and income being eaten up by taxes and fees


It is natural for people to blame the stock market, the economy as a whole, or even other factors as the causes of these problems.

However, in our experience working with thousands of retirees across the country during the past decade, we believe the REAL causes of these problems are even more specific:

They are:

1. A lack of REAL solutions to these problems

These issues are ONLY solved by proper PLANNING not PRODUCTS

2. A lack of truly skilled advisor

Investment vs. Planning, finding an advisor who is trained at giving correct advice

during the Income and Preservation Phase of life

3. Confusion over best options

Too much bad advice and/or information, analysis paralysis, feeling overwhelmed, fear of making the wrong decision or unfamiliarity in planning for new phase of life

4. Not following basic rules of financial planning

Proper Age/Risk Ratio or working with an advisor whose specialty is different from the phase of life in which you are currently living

Thomas Edison once said, “There’s a better way for everything. Find it!”