Don’t Run Out of Money, Have a Retirement Income Plan

In a guest article written for PLANADVISER, Thomas Dodd, executive director of Pavilion Advisory Group Inc., compares and contrasts common retirement income strategies—including the pros and cons of each method, as viewed from the perspective of participants.

In an environment where the primary source of retirement income is shifting from defined benefit plans to defined contribution plans, retirees are now faced with a new decision: How much do I withdraw from my defined contribution accounts? 

The first step is to encourage retirees to develop a withdrawal plan, in contrast to withdrawing money in an impulsive manner based solely on immediate spending needs. Retirees may have a feeling of wealth when they see their account balance, but not realize how little it provides when converted to an annual income. To help ensure a retiree does not run out of money, a systematic withdrawal plan is preferable to no plan at all.

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A withdrawal plan should be developed with attention to the following risks that increase the likelihood of running out of money:

  • Longevity Risk
  • Investment Risk
  • Inflation Risk
  • Liquidity Risk
  • Standard of Living Risk
  • Behavioral Risks

There are a limitless number of withdrawal plans available to retirees, but we will focus on those that have gained at least some acceptance and usage and, most importantly, are rules based. These withdrawal plans fall into three categories, including investment earnings, systematic withdrawals and annuities.

Investment earnings

Under this method, interest and dividends are withdrawn and form the basis of retirement income. The principal of the assets is left intact. A variation of this is to also withdraw the realized capital gains. This strategy can be managed by the retiree or an adviser.

Systematic withdrawals

This is a rules-based approach that is managed either by the retiree or an adviser. These strategies generally fall into three categories. 

  • Constant dollar amount – A dollar amount is determined at retirement usually based on a percentage of the retiree’s assets that he or she commits to the strategy. This fixed dollar amount can be adjusted annually for inflation or other rules-based adjustments.
  • Endowment method – Each year a percentage of assets is withdrawn. This percentage does not change over time.
  • Life expectancy method – Annual withdrawals are based on the remaining life expectancy of the retiree (or joint life expectancies of the retiree and partner). 

Annuities

Annuities are a series of payments at fixed intervals guaranteed for a fixed number of years or the lifetime of one or more individuals—and the options available to retirees are plentiful. There are immediate and deferred annuities. There are annuities that pay a constant amount and annuities that have a variable payment. Some annuities have an inflation adjustment component. There are annuities with a guaranteed minimum withdrawal benefit (GMWB), a hybrid product that has characteristics of both an annuity and a systematic withdrawal plan. There are annuities with a death benefit. Finally, there are Qualified Longevity Annuity Contracts. These allow retirees to move 25% of plan assets (up to $125,000) into an annuity that commences payments no later than age 85 and the amount is not subject to the minimum distribution rules.  

Which of the three withdrawal strategies should a retiree choose? There are advantages and disadvantages to each and the tradeoffs can be analyzed across four dimensions:

  • Is the level of income provided adequate?
  • How predictable is the income amount?
  • How liquid are the retiree’s assets?
  • What level of advice or guidance does the retiree want?

Given the above, we can quickly dismiss the investment earnings strategy as it does not address any of the risks.

The systematic withdrawal approaches offer liquidity, flexibility, upside potential in favorable markets and inflation protection. Also, systematic approaches have lower fees than annuities, usually just investment management fees. The two significant downsides are limited protections against both longevity risk and investment risk. Also, behavioral risks are not curbed under systematic withdrawal approaches, although if the systematic program is managed by an adviser, behavioral risks can be minimized.

Annuities offer exceptional protection against longevity risk and investment risk. Variable annuities do provide some upside potential during periods of favorable investment performance. Annuities also eliminate most of the behavioral risks. On the downside, annuities provide no liquidity and are subject to high fees. Most annuities provide no inflation protection, except if the retiree purchases an inflation rider, but these can be expensive. Finally, there is solvency risk, the risk of the insurance company going bankrupt.

As both annuities and systematic withdrawal approaches offer their own unique advantages, one solution is to combine the two. The retiree divides his or her retirement savings between an annuity and a systematic withdrawal approach. The split depends on the tradeoff between the desired level of protection against longevity risk and investment risk and the desired liquidity and flexibility. Also, Social Security should be factored into this decision as that may be a significant source of annuity income.


Note from the editor:

Thomas H. Dodd, Executive Director, Pavilion Advisory Group Inc., in Chicago, oversees relationship management, guides investment strategy and leads business development at Pavilion Advisory Group. He has 43 years of investment and actuarial experience and is a CFA charter holder and a member of the CFA Institute, the CFA Society of Chicago and a Fellow of the Society of Actuaries. 

This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Asset International or its affiliates.

Disclosures from Pavilion:

This material contains proprietary and confidential information of Pavilion Advisory Group Inc. (“Pavilion”) and is intended for the exclusive use of the parties to whom it is provided. The opinions contained within this document are those of Pavilion and is subject to change based on changes in the firm’s opinions and other factors such as changes in market or economic conditions. Pavilion has relied on the use of third-parties in the preparation of this material. While we believe our sources to be reliable, we cannot be liable for third-party errors or omissions.

This information should not be construed as an offer to sell or the solicitation of an offer to buy any security and does not constitute investment advice.  Investing involves risk, including the loss of principal invested. Past performance is no guarantee of future results. You should carefully review and consider the applicable prospectus or other offering documents prior to making any investment.

Pavilion Advisory Group is a registered trademark of Pavilion Financial Corporation used under license by Pavilion Advisory Group Ltd.in Canada and Pavilion Advisory Group Inc. in the United States. Pavilion Advisory Group Inc. is a U.S. based investment adviser registered with the U.S. Securities and

Exchange Commission. Pavilion Advisory Group Ltd., our Canadian affiliate, is an investment advisor registered with the securities commissions of various Canadian provinces.

OCIO Model Can Improve Outcomes for DB and DC Plans

The benefits of an outsourced chief investment officer (OCIO) can lead to cost savings and improved returns.

The outsourced chief investment officer (OCIO) model is a shifting of responsibility in investment decision making—a discretionary investment manager shares fiduciary responsibility with a retirement plan sponsor related to the investment portfolio, explains T.J. Kistner, director for Segal Marco Advisors in Chicago.

Most of the time, the OCIO discussion is related to defined benefit (DB) plans. Together, DB plans and nonprofits continue to represent the majority of the assets under management (AUM) of OCIOs polled by Cerulli Associates (81.1%), and while the OCIO model was once limited to small or mid-sized institutions that felt they lacked the size and resources needed to effectively manage their investment portfolios, a recent report from Greenwich Associates, “Winning in the New World of Outsourced CIO,” finds that larger institutional investors are now embracing the model.

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However, the OCIO model is akin to the 3(38) investment manager model for defined contribution (DC) plans, as Kistner says, “Any time responsibility for investment decisions is outsourced—whether for DB plans or DC plans—it can add value.”

Rich Joseph, leader of the OCIO business in the U.S. at Mercer based in Boston, says his firm has about $40 billion in DC OCIO assets today in the U.S., about the same as it has in DB OCIO assets. He says using an OCIO model allows both DC and DB plan sponsors to be more strategic.

“For DC plans, they can discuss with OCIOs why they offer the plan, their objective and the outcome they want for participants—how to ensure participants are retirement ready,” he notes. In addition, he points to the tremendous amount of legal action being taken against DC plans over investment menus, and suggests that focusing on participants is easier in the OCIO framework.

“On the DB side, many plans are headed to exit,” Joseph says. “The complexity in managing DB assets is extraordinary today. How should plans align with Trump tax reform? Is it the right time to accelerate contributions? With the whipsaw in the markets in the last two months, DB plan sponsors should consider whether they are managing the plan as effectively as they can. Historically DB plan sponsors were focused solely on performance, but now they are focusing on funded status and getting liability and assets in tandem to get the plan off their balance sheet.” For those not planning a DB plan exit, he says the focus is how to reduce the volatility of performance to reduce balance sheet risk.

The Greenwich Associates research confirms that funds change their asset allocation considerably when turning to OCIOs. This presents an opportunity for managers who are able to bring greater sophistication to the table.

In comparing the allocation decisions of current OCIO users to more independent, like-sized peers with under $500 million in assets, there are several notable differences. For one, OCIO users show a shift away from the most liquid asset classes—average active U.S. equity allocations for OCIO funds are 27%, compared to 32% for peers of similar size. Likewise, OCIO funds are reallocating these assets up the risk-return spectrum, as evidenced by their more globalized portfolios. The research shows that mean active international equity and fixed-income allocations within OCIO portfolios sit near 25%, while like-sized institutions average only 17%.

Kistner agrees that managing complexities of the investment program is one of the benefits of the OCIO model. “The sheer number of investment managers and strategies available to asset owners presents the challenge of identifying best-in-class investment ideas. An OCIO can relieve asset owners of some of these complexities by providing the decision-making framework and operational discipline necessary for managing a successful investment portfolio,” he says.

But, Kistner points to many other benefits of the OCIO model for plan sponsors. First, it allows them to focus on their core responsibilities to their plans. There is also great potential for fee and cost savings due to the scale of an OCIO’s platform. “OCIOs can combine a plan’s assets with a larger pool of assets under its platform to drive down fees, and plans that on their own couldn’t participate in certain investments due to required minimum amounts can do so with an OCIO’s platform,” he says.

“Some of these benefits taken together with others can lead to better risk-adjusted performance,” Kistner says. “A discretionary investment manager has the ability to react quickly and efficiently in today’s market.” In addition, Kistner points to an enhanced governance structure. “Utilizing the OCIO model can provide the governance and committee structure needed to ensure the portfolio is being managed and monitored frequently, as opposed to the typical meeting cycles of a board of trustees, investment committee or other governing body,” he says.

All these benefits trickle down to retirement plan participants. Joseph says DB plans will be better funded, and Kistner notes that cost savings impact DC plan participants’ fees and produce better returns.

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