Perhaps the most shocking development to spring from the economic malaise of recent years is the precarious state in which many Baby Boomers find themselves as they approach the cusp of retirement. Reports are pouring out on the ever dimming prospects for a secure retirement for millions of Boomers who have suffered through one of the worst recessions in history. Chalk it up to a decade of poor stock market returns, the elimination of defined benefit plans, and a pitifully low savings rate over the last ten years. Going forward, for the Boomers and future generations, it has become critically important that only the best sources of retirement income be considered for a secure future,
The experience of this retiring generation has clearly shown that we can no longer rely on any one source of income and that sound retirement planning needs to incorporate a mix of sources that, when combined, can provide income longevity as well as stability. Over the years, more products have come out designed to give retirees more control over their investment income. Among the many retirement income vehicles available, two are being touted as the best sources for providing a sustainable and stable income.
Target Retirement Funds
Among the more recent innovations in mutual funds is the target retirement fund which is based on the premise that a portfolio can be managed to parallel a pre-retiree’s evolving risk tolerance as the retirement date approaches, and then continue to manage it to generate an income for the life of the retiree or until it runs out, whichever comes first.
The target date is the retirement date (or any date selected) and the portfolio is allocated among stocks, bonds and other securities. As the time horizon shortens, the allocation is gradually adjusted to a more conservative allocation. At retirement, a calculation is made to determine an amount of income that can be paid out over the retiree’s life based on an assumed rate of return.
Among the concerns that some retirees have is that these funds tend to remain invested in stocks or risk oriented securities more so than they think is safe. However, as recent experience has shown us, retirees are in greater need of growth-like returns on their retirement assets in order to stretch them through their retirement years.
Target retirement funds are subject to market risk which could impact the amount of income available over time, and they should only be considered by pre-retirees who have at least a 10 to 15 year time horizon.
The only individual retirement vehicle that can guarantee a lifetime of income is an immediate annuity. In exchange for a lump sum deposit, a life insurer will promise to pay a stream of income that is calculated to last until a person’s life expectancy or death, whichever is later. The payout is based on the age of the person in relation to his or life expectancy and the interest rate credited to the annuity balance. Because a portion of the payout is a return of principal, the older a person is at the time of annuitization, the higher the payout.
In a fixed immediate annuity, the income payments are fixed for the duration of the annuity, so, over a long period of time, they are not likely to keep pace with the increasing cost of living. Some annuity contracts offer an inflation rider that, for an additional cost (which is deducted from annuity payments), will adjust payments based on an inflation index.
Alternatively, a variable immediate annuity, in which the annuity payments are tied to the performance of the stock and bond markets, could potentially generate an income that, over time, will outpace inflation. There is a risk that income could decline in down markets, however, most contracts include a minimum income guarantee, or one can be added for an additional charge.
Choosing the Right Source
As with any investment, the right income source for you is going to be based on your own financial situation, needs, risk tolerances and investment preferences. Forward looking retirees are coming to the realization that they are going to need some combination of growth and income predictability if they are going to enjoy a comfortable retirement. The best option for most people is to create some combination of vehicles which, when working together, can provide the ideal level of security, growth and income stability.
A strategy that combines a vehicle such as a target retirement fund (if you are younger than age 60) and an immediate annuity can be structured to optimize asset growth while ensuring that your income will last a lifetime. Depending on your age and risk tolerance, a larger portion of your assets can be invested in a target fund that can potentially keep your assets and income growing.
Another portion can be invested in a deferred annuity which can be converted to an immediate annuity at a later point in your retirement. The immediate annuity can provide the additional income you might need to cover cost of living increases, and it also creates the assurance that you won’t outlive its income. By waiting until you are older to annuitize, your income payout will be higher due to the return of principal.
While this particular strategy may or may not work in your situation, the bottom line is that it will take some creativity and some combination of tools and resources to ensure that you won’t join the millions of Boomers who are now lying awake at night.