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July 25, 2014

Five Factors For Solving The Retirement Income Challenge

Laurence Greenberg, President, Jefferson National

 

Today’s uncertain market, combined with rising tax rates, longer lifespans, and a shrinking safety net, makes retirement planning more important than ever. Research shows that most Americans still need to accumulate more to generate sufficient income in retirement. And outliving their assets in retirement has become their number-one concern. Studies also indicate that even high-net-worth investors face serious risks to their retirement incomes—including rising healthcare costs, the threat of inflation, and the impact of prolonged periods of increased tax rates on their investments.

According to a March 2014 Jefferson National survey of more than 400 RIAs and fee-based advisors, more than two-thirds (71 percent) identified three key hurdles that limit their ability to generate retirement income for their clients: a low-yield environment, maintaining adequate equity exposure, and managing volatility. What can advisors do, in light of these critical obstacles, to solve the retirement income challenge?

Step 1: Leverage the power of tax deferral

The vast majority (85 percent) of advisors identified tax deferral as a critical component to generate more retirement income. It is widely accepted that tax deferral is key to maximizing long-term accumulation, allowing investments to continue compounding for years without paying taxes until income is distributed in retirement, when clients are often in a lower tax bracket.

And to truly optimize the power of tax deferral, 88 percent of advisors use an asset location strategy to further minimize the impact of taxes and enhance after-tax returns. Research has shown that asset location can help to increase returns by an average of 100 basis points or more—without increasing risk.1 Start by evaluating investments based on their tax characteristics. Locate tax-efficient assets, typically taxed at the lower long-term capital gains rate, in taxable accounts. And locate tax-inefficient assets, which are taxed at the higher rate for ordinary income or short-term capital gains, in tax-deferred vehicles.

A recent study from Morningstar has shown that asset location, when combined with a tax-optimized withdrawal sequencing strategy, can add as much as 320 basis points of additional retirement income per year.2 The power of tax deferral, leveraged at every step of the process from accumulation to withdrawal, can help you control how much clients will pay in taxes, and when they pay, to capture more tax-alpha for the long haul.

 
   

Step 2: Invest for Total Return

Jefferson National’s recent survey found that in today’s low-yield and volatile market environment, more than half of RIAs and fee-based advisors (58 percent) prefer a total return strategy to generate retirement income. This strategy increases the potential for growing the overall portfolio through a diversified mix of assets—some will produce income, such as interest paid by fixed-income, distributions, and dividends; some will contribute to the bottom line by appreciating in price; and some will do both.

Likewise, it’s clear that in this low-yield environment, many are moving away from traditional income-generating approaches. Compared to previous years, today’s advisors are far less likely to implement a bucket strategy (25 percent), an income investing strategy using only dividends and interest (8 percent), or a bond ladder strategy (1 percent).

Step 3: Pick the Right Products

To implement a total return strategy, advisors need a broad choice of assets and the flexibility to adjust investments as needed. As shown though our survey, the product of choice to generate retirement income is a diversified portfolio of mutual funds, used today by 67 percent of advisors. Other popular products include dividend-paying equity funds (51 percent) and bond funds (45 percent).

While variable annuities with income guarantees have been a traditional solution for many advisors, they are waning in popularity. As the industry has changed in recent years, 51 percent of the advisors who use variable annuities with income guarantees are no longer satisfied. Those with concerns cite rising costs (69 percent), decreasing benefits (69 percent), limited liquidity (44 percent), and limited fund choices (43 percent).

But recently, next-generation variable annuities have come to market. In a stark departure from traditional VAs, these new entrants feature no commissions, low or flat fees, and a broad choice of funds, which together can provide the low-cost tax deferral and greater flexibility needed to manage for total return.

Step 4: Use Dynamic Withdrawals

In light of the current low yield environment, Morningstar recently suggested a “safe” withdrawal rate of 2.8 percent.3 However, the vast majority of advisors (83 percent) do not believe that their clients have accumulated enough assets to live off of a 2.8 percent withdrawal rate. Instead, more than half of advisors (53 percent) would recommend a “safe” withdrawal rate of 4 percent.

More advisors agree that the job of determining a sustainable and “safe” withdrawal rate is one that requires a more flexible approach. Therefore, 48 percent of RIAs and fee-based advisors recommend a dynamic withdrawal strategy, adjusting withdrawal rates annually based on factors such as market conditions and portfolio valuation. This approach can help to preserve the portfolio, prolong savings, and increase the probability of generating more income for more years.

In comparison, a much smaller percentage recommend a constant dollar amount (23 percent), a constant percentage (14 percent), or changing percentage based on life expectancy (8 percent).

Step 5: Delay Social Security

A holistic approach to planning means looking at all available tactics to help enhance retirement income. One of the most popular tactics, used by more than 78 percent of advisors, is to delay Social Security to increase long-term benefits. A client can choose to collect Social Security as early as age 62, but doing so may result in a reduction of as much as 30 percent. But if clients are willing to wait until age 70, Social Security actually pays as much as 8 percent more per year. There are very few investments that can guarantee an additional 8 percent, plus cost of living adjustments. The benefits of maximizing this asset are clear.

Five Factors for Solving the Retirement Income Challenge

With life expectancy increasing at a time of low yields, ongoing volatility, and rising taxes, the job of planning for a retirement that could last 30 years or more has changed radically. While RIAs and fee-based advisors are clear on the biggest hurdles they face, they are just as clear on the solutions that they can use. By relying on these five factors—the power of tax deferral, total return, the right mix of products, dynamic withdrawal, and delaying Social Security—advisors can provide significant value to their clients and help them solve the retirement income challenge.

Laurence P. Greenberg is President of Jefferson National, innovator of the industry’s first flat-fee variable annuity with the largest selection of underlying funds. For more information, please visit jeffnat.com or call 1.866.WHY.FLAT (949.3528).

1“The Tax-Efficient Frontier: Improving the Efficient Frontier with the Power of Tax Deferral,” by David Lau, Jefferson National, June 2010. 2“Alpha, Beta, and Now…Gamma,” by David Blanchett and Paul Kaplan, Morningstar, August 2013. 3Low Bond Yields and Safe Portfolio Withdrawal Rates, by David Blanchett, Michael Finke and Wade Pfau, 2013.