Retirement Income Planning Disasters (Part 1)

Since starting my blog I’ve gotten hundreds, maybe close to a thousand, email inquiries from people all over the US looking for some guidance/affirmation.  The affirmation requests come from folks who have implemented some type of retirement investing program.  They usually share some details, and then finish with, “Do you think this is a sound plan?  Will it work?  Could I do better?”

It’s always a little tough to get back with everyone, especially when I don’t know all the nitty-gritty details.

So I’m putting together a little two-part series about Retirement Income Planning.

This first part is called “Retirement Income Planning Disasters,” and in it, I will walk through the poor planning and product choices many people make without really understanding how to do it right.  In a follow up post I’ll cover “Retirement Income Planning Done Right,” where I’ll walk through the proper steps in building a safe, highly successful retirement income plan.

Let’s dig in…

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To help illustrate this I’ll use a completely fictional couple.  This should help readers identify with similarities, and hopefully allow then to avoid the missteps.  Keep in mind though that this is not a recommendation, everything shared is entirely hypothetical, and before doing any retirement/investment planning you should always seek out qualified, properly licensed counsel.

Enter Bill and Susan Doe…

Bill and Susan are recently retired.  Bill was an engineer for 40 years and Susan worked as an office manager before, and after, raising their 2 children.  They are both 62 years old, active, and in good health.  They’ve done a good job of saving, lived responsibly and paid off all of their debts, helped their children through college, and own their home.  Most of their working lives they saved modestly, but in the last 10 years (after the kids grew up), they were able to really put away savings significantly.

Before retiring Bill handled most of the “planning” with a little help from their broker and insurance agent.  Most of their money though was invested in Bill and Susan’s retirement plans through work.

Knowing some professional help would be wise as they were moving into retirement, Bill and Susan met with a few financial planners to see what they could offer.  After multiple meetings with multiple planners, they mutually agreed to work with Jim, a local “retirement investing expert.”  They like that Jim worked exclusively with retirees and focused on safe, guaranteed investments.

The primary goal for Bill and Susan was to create a stable retirement income with minimal risk.  They had some secure income from a small pension and Social Security, but also would need to supplement this income with investment income.

Here are Bill and Susan’s current assets:

And their current retirement income sources:

And lastly, their retirement living budget:

For those curious, the reason for the higher medical budget from age 62 to 65 is for insurance.  At 65 Bill and Susan will move to Medicare and only plan to need $4,000 per year for a supplemental policy, versus the full policy they have today.

At first glance, it looks like they should have more than enough assets and income for a very high quality, low stress retirement.  After all, just their Pension and Social Security Income’s tally up fairly close to their initial budget, and they have a sizable nest egg just over $800,000.

So let’s see what happens if they make some silly, under-educated decisions with their finances.

“You don’t have to worry, your retirement income is guaranteed for life.”

Since avoiding risk was paramount to Bill and Susan they really liked it when their financial planner presented a balanced investment plan using guaranteed annuities.  At first they were a bit apprehensive (about using annuities, that is), but the planner assured them of the safety of their chosen annuity companies and even helped them “diversify” by using multiple annuities so they could keep up with inflation.  Plus the planner advised they keep $50,000 in the bank for emergencies, and another $50,000 in stocks that Bill really liked.

The gist of the planners recommendations, and what sounded great to Bill and Susan, was “…you don’t have to worry, your retirement income is guaranteed for life, no matter what happens in the market.”

Here’s ultimately what was implemented and the rationale behind the planners suggestions:

Since Bill and Susan will have a gap between their fixed income and their budget of $23,500 from age 62 until 65, the first order of business was putting a product in place to fill it.  For this Bill and Susan simply kept an extra $70,000 in the bank and used the funds as needed for 3 years.  While the interest wasn’t much, they liked the security and flexibility this provided.

Now that they had to age 65 covered, they needed to fill their longer term income gap that started at 65.  For this they purchased an annuity with Bill and Susan’s IRAs that was specifically designed to guarantee $30,000 per year of income, for both Bill and Susan’s lives, no matter how long they lived.  After searching for the absolute highest income guarantee their planner found them an index annuity with lifetime income rider that fit the bill.  They would need to put all of Bill’s IRA there, as well as $60,000 from Susan’s IRA.

At this point Bill and Susan were feeling pretty good.  Especially since all of their retirement income needs were fully guaranteed and they still had a couple hundred thousand left over.  They did realize, with the help of their planner, that there would be inflation though.  So they would need to invest the remaining funds in something safe that could be used to make up for the future income needs when inflation kicked in, and that’s exactly what they did.

Since Bill and Susan wanted to keep $50,000 in the bank and $50,000 in some stocks, after setting up the first annuity, and the income reserve for ages 62-65, they had $190,000 left.  With this money they purchased another index annuity with income guarantee rider (just in case) that would grow at a guaranteed rate up to the point they wanted income – and they could turn the income on whenever they needed and have it guaranteed for life.

All was good for Bill and Susan.  They felt safe, secure, and confident.

Here’s how their money was ultimately invested:

So what’s wrong with this plan?

I see plans like this almost everyday.  It appears to be sound, the products used have the highest guarantees available, and clearly at least some thought went into it.  So what could be wrong with it?  Everything seems to be covered?

In oder to find out, we have to take a really close look.

The first thing we need to do in analyzing this plan is to validate the budget and run it out 30 years (or more).  To do this is pretty simple, and requires nothing more sophisticated than Microsoft Excel.  Since each component of Bill and Susan’s budget and fixed income sources have a separate inflation rate, that’s where we begin.

Let’s take a look at what Bill and Susan’s real budge would look like given the modest inflation rates from the budget table.  This assumes they both continue to live actively and with good health.  Obviously that might not happen, but it’s always wise to prepare for what could happen.  If plans work out under these scenarios then any variation that would cause a lower budget will clearly work also.

Perhaps now you can see the potential problems for Bill and Susan?  Especially when we do the same thing for their income sources.

Now that we know what the real (potential) income gaps are for the next 30+ years it’s very easy to tell if the safe and secure retirement income plan will work.  For this I use a financial planning program that cranks out some very simple charts showing the likelihood Bill and Susan will run out of money.  But before I show this – I should clear a couple things up:

1. We are assuming a 2% annual increase to Social Security.  This may or may not be accurate as it changes every year.
2. We are assuming Billa and Susan pay 18% of their Adjusted Gross Income (only counts part of their SSI) in taxes (State + Federal combined).
3. We are assuming the 50 year historical average return of the S&P 500 for their stock portfolio.
4. We are assuming an average return on their cash of 2%.
5. We are assuming an average return on their index annuities of 3% (which is accurate based on 50 year tests I’ve published here).

Without further ado, here is how Bill and Susan’s plan is likely to work out:

The image might be a little fuzzy, so here’s what it’s telling us:

1. Optimistically, they run completely out of money
2. Pessimistically, they run completely out of money
3. On average, they run completely out of money

However, they would still have a pretty solid fixed income up to when Bill and Susan pass away.  It’s just that guaranteed income only covers about 60% of their living expenses adjusted for inflation.  The way these calculations are done is via Monte Carlo simulation.  What that means, is we stress tested Bill and Susan’s plan 1,000 times and the image above shows the 90%, 50%, and 10% of those tests.  It’s a simple, yet incredibly smart way, to test if a retirement income plan holds water.

For some people Bill and Susan’s plan might be okay.  After all, despite running out of liquid funds – the income did in fact live as long as they did.  But there are better, smarter, safer ways to build a retirement income plan.  In the next week I’ll do a follow up post (Part 2) that explores such a plan.

So why do people end up with bad Retirement Income Plans?

Usually it’s because the advisors don’t actual do proper planning.  They shortcut the process so it sort of looks like a plan, but really is just a product sale.  They understand the emotional hot buttons that cause retirees fear, and use those to back into expensive products designed to address those very fears.  Often times (like how I’ve pointed out in my growing list of annuity reviews) the advisor exaggerates the potential performance of their products.  Instead of showing how something realistically works – they opt to share how it could work.  There’s a pretty big difference.

In the end, proper planning needs to be precise.  Budgets should be broken down into detailed categories, with individual inflation rates.  Investment plans should be stress tested so you have the highest probability of success, not just a plan that loosely works.  Since most planners/advisors don’t do these things – many individuals end up with very bad retirement income plans.

I should note (since I know I’ll get a few nasty emails because of this post) – the problem with this plan IS NOT the use of annuities.  In fact, when done properly annuities with income guarantees can be very useful as part of a well balanced retirement income plan.  They only really cause problems when the salespeople try to use them either too much or improperly.

I should also note that I’m not trying to scare anyone with inflation concerns or suggest that risky stock investments are the solution.  Quite the opposite really.  In my follow up post about planning done the right way you’ll see that most people can accomplish their goals without ever using stocks/stock funds/etc.  Just smarter allocations to conservative investments.  More to come on this in the next week

Part 2 is done and available here.

Have questions?  Have helpful feedback?

Feel welcome to use the “comment” feature at the very bottom of this page to reach out.  I always respond quickly and it’s nice to have a little dialogue regarding posts like this.  If you have specific questions about the validity of your own Retirement Income Plan – just reach out with the contact form and perhaps I can help point you in the right direction.

Thanks and have a great week,

Jason Wenk

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