Approaches to the Retirement Income Challenge

Failing safety nets and longer life-spans are spurring financial advisers to generate sufficient retirement income. More than two-thirds of advisers surveyed (71%) by Jefferson National say current conditions make this difficult, but tax deferral can be an effective strategy.

A simple and effective strategy, according to Laurence Greenberg, president of Jefferson National, is asset location, which leverages the power of tax deferral and can be used for almost any client. “By locating assets based on their tax efficiency between taxable accounts and tax-deferred vehicles, research has shown that tax deferral can increase potential returns by 100 to 200 basis points—without increasing risk,” Greenberg tells PLANADVISER.

The first step is to consider the tax-efficiency of asset classes, Greenberg says. “Tax-efficient assets generate long-term capital gains, which are currently taxed at a maximum of 20%,” he explains. “Tax-inefficient assets generate ordinary income or short-term capital gains, currently taxed as high as 39.6%.”

Next, tax-efficient assets, such as index funds, funds with low turnover and passively managed investments, should be located in a taxable account. Tax-inefficient assets, such as bond funds, real estate investment trusts (REITs), commodities, actively managed funds and many hedge-like liquid alternative funds, should be located in a tax-deferred vehicle to minimize the tax bill and to increase after-tax returns—without increasing risk, Greenberg says.

Asset location can absolutely be used to increase returns for defined contribution (DC) plan participants, according to Greenberg. “If the client has a good mix of tax-efficient and tax inefficient assets, and they have a taxable account as well as a DC plan, they can benefit from an asset location strategy,” he says.

Tax-efficient assets (such as those named above) can be located in their taxable account. Tax-inefficient assets (bond funds, REITS and so on), can be located in their tax-deferred DC plan to increase returns by as much as 100 basis points—without increasing risk, according to Greenberg. “Once clients max out contributions to qualified plans such as 401(k)s and IRAs (individual retirement accounts), low-cost no-load variable annuities are next in line to help maximize tax-deferred compounding. And keep in mind, low-cost is key,” he says.

Watch Out for Charges

Tax deferral can add between 100 and 200 basis points to earnings, but traditional variable annuities, which charge an average of 135 basis points for basic Mortality and Expense, 125 basis points for an income guarantee, and additional fees for other features and benefits, can cost up to 300 basis points or more—effectively wiping out the value of tax deferral.

“To cut costs, help clients accumulate more and generate more retirement income, we are seeing more companies introduce low-cost and flat-fee variable annuities designed to maximize the power of tax deferral,” Greenberg says.

Another tactic is the total return strategy, which uses the overall annual return of an investment portfolio, Greenberg explains. “This includes using capital appreciation, as well as dividends and interest, to generate retirement income,” he says.

Compared with other approaches, such as the bucket approach, or income investing, or a bond ladder, the total return strategy is increasingly popular for a number of reasons, Greenberg says. “There are several factors that are changing the landscape of retirement planning,” he says. More than two-thirds of advisers say their biggest challenge in generating retirement income is caused by a low-yield environment, maintaining adequate equity exposure and managing volatility.

“In today’s low-yield environment, advisers cannot rely on fixed income alone to meet their client’s income needs, and so they are moving away from the traditional income-generating approaches such as bond ladders, or the traditional income investing strategy that uses just dividends and interest alone to generate retirement income,” Greenberg explains.

The issues of longevity from increasing life spans and a retirement that could last 30 years or more means that the No. 1 concern for most Americans is outliving and outspending their savings, Greenberg says. “Today’s advisers recognize the need to maintain a much higher allocation to equities in their client’s retirement income portfolios. They are managing these portfolios for total return to improve the chances of generating more income for more years,” he says.

Higher equities of course come with higher risks, Greenberg points out. Proactive risk management is imperative, given the challenge of ongoing volatility. He says a growing number of funds are designed to manage volatility, provide downside protection and generate predictable income. “These funds use sophisticated strategies like those favored by hedge funds, elite institutional investors and insurers managing risk on their own balance sheets—but with lower fees and much greater flexibility,” he says.

Retirement Income Concerns

Jefferson National recently surveyed more than 400 advisers about issues of current concern to them. It found that advisers and their clients are very focused on being able to generate sufficient income in retirement. A majority of those surveyed (85%) say tax deferral is a critical component of achieving retirement income. When using this strategy, 88% report they rely on asset location to help increase returns without increasing risk, while 76% rely on withdrawal sequencing, first spending down taxable accounts and then spending down tax-deferred vehicles.

Other findings based on advisers surveyed are:

• When implementing a withdrawal strategy, 48% of advisers use a dynamic withdrawal strategy, adjusting clients’ withdrawals based on market conditions and portfolio valuation. Other withdrawal strategies include constant dollar amount (23%), constant percentage (14%), and changing percentage based on life expectancy (8%).
• The most popular products to generate retirement income are a diversified portfolio of mutual funds (67%); variable annuities with income guarantees (51%); and dividend-paying equities funds (51%).
• Delaying Social Security to increase benefits is one of the most popular strategies to help enhance retirement income (78%).

It is more challenging than ever in today’s economy, Greenberg says. And really part of the key to providing retirement income is to focus more on financial planning. “It’s not just investing, but also understanding client needs in retirement and tax optimization strategies. You’ll have to use a variety of tactics to get the client to to be where they need to be. How and when you take money out, delaying Social Security. Advisers have to take a really strong financial planning approach.”