Are Mortality Credits Missing from Your Client’s Retirement Income Plan?
As people age and approach retirement, they tend to become more cautious in their spending and investing and generally more averse to financial risk. With that said, how would you create a retirement income plan for a client who has a relatively conservative risk tolerance? The first thought that comes to mind might be a simple laddering of bonds, a time-tested solution that has worked for many. But is there a more efficient solution that does not introduce excess risk?
Our AgencyONE 100 advisor’s hypothetical client is 70 years old and has $1MM in savings from which to draw retirement income. The client is not willing to accept market risks and thus plans to use a laddered bond strategy from which to draw down funds at a rate that will last 25 years – believing that to be the longest reasonable time period they might expect to live. Assuming a 5% average annual rate, they can begin to draw $52,397 annually (increasing each year with a 3% cost of living adjustment). As shown in the table below, the account balance will zero out at the end of 25 years at that withdrawal rate.
In a world of perfect information and no uncertainty, this would be an optimal situation with no risk. However, we do not live in a world without uncertainty and while this can be challenging in many ways, it can also present an opportunity for your clients to increase their retirement income.
What are Mortality Credits and Risk Pooling?
The risks associated with an unknown time horizon are twofold:
- If the individual does not live as long as expected they will have taken smaller distributions than they could have, potentially making lifestyle sacrifices along the way.
- Conversely, if the individual lives longer than planned, they will outlive their money.
Because the latter is (arguably) a more severe outcome, it makes sense for the conservative investor to plan based on a longer time horizon. Pooling risk can help address both potential pitfalls.
Let’s say that your client has 25 peers who decide to come together to pool their retirement funds, all invested in the same manner and with the same time horizon. We can assume that participants in this group will die at regular intervals – one per year leaving the last remaining participant alive at the end of the 25-year planning horizon. At the end of each year that a participant dies, they will leave their pool of funds available to be amortized over the remaining time by the remaining participants. The “extra” payments can be thought of as morality credits and provide a distinct advantage that is not possible with individual bond laddering.
Obviously, it is not feasible for an individual to devise and execute such a plan on their own; however, annuity carriers ARE able to do exactly that when pricing their income annuity products. So, while they are using fundamentally similar underlying investments, the carrier can take advantage of millions of data points to assess risks across a large base of clients. The calculated mortality credits from the annuitants who will die early increase the income for everyone else remaining in the pool.
How does an Annuity Solution Compare to Individual Bond Laddering?
In the same example from earlier, your client uses their $1MM of funds to purchase a life-only income annuity (from a highly rated mutual carrier) with a 3% cost of living adjustment. The annualized income provided by the annuity solution is $70,159. Compare that to the $52,397 annual distributions from the laddered bond plan. Risk pooling and mortality credits can increase the client’s annual income by more than 25% while insuring your client against the risk of living longer than they had planned for. Truly a win-win scenario!
Bottom Line
If interest rates are all that you’re considering, you may not be seeing the whole picture. An income annuity can provide both extra income from mortality credits and insurance against longevity that can help your clients thrive in retirement.
Please contact the AgencyONE Annuity Department at 301.803.7532 or craig@agencyone.net for more information or to discuss a case.