Baby boomers will turn age 65 at a rate of nearly 8,000 per day for the next 17 years.i In the past, retirement planning was centered on maximizing contributions and investment allocations. Now more Americans than ever before will be transitioning from the accumulation phase of retirement planning to the distribution phase. Since most retired couples can no longer solely rely on retirement plans such as Defined Benefit Plans or Social Security to provide guaranteed monthly income, they will have develop a retirement income model that will transform their retirement accounts, such as IRAs and 401(k) plans, into a steady stream of income that will last two lives.
When approaching retirement age, couples will need to determine the investments, withdrawal rate and order of withdrawals that will create the most sustainable income stream. Retirees who incorrectly structure their retirement assets could face a reduction in retirement income, possibly later in life when only one of the spouses is still alive.
Longevity Risks
Once a healthy married couple reaches age 65, there is a nearly 50 percent chance that one of the two spouses will live to age 92.ii Accordingly, most baby boomers need to plan for 30 years in retirement. To plan for that longevity, financial experts suggest withdrawing no more than 4 percent of retirement assets annually. However, the Required Minimum Distribution (RMD) rules for IRAs and 401(k) plans will eventually require annual withdrawals in excess of 4 percent. Per the IRS distribution tables, the initial RMD withdrawal rate is 3.65 percent. As the account owner ages, the RMD withdrawal rate quickly climbs, exceeding 4 percent by age 73, 5 percent by age 79, 6 percent by age 83, 7 percent by age 86 and 8 percent by age 89.iii
Market Risks and the Variability of Returns
Additionally, IRA owners over age 70–and-a-half may find that they are required to begin taking distributions at a time when the IRA has had poor performance. According to Monte Carlo simulations, the sequence of returns is more important than the average rate of return for sustainability purposes. For instance, assume we have an IRA that had annual returns of –20 percent, –10 percent, +15 percent, +20 percent and +10 percent. The rate of return for the five-year period would be 9.29 percent. However, if the IRA owner were forced to take RMDs in the years when the IRA experiences negative performance, by the time the IRA experiences positive investment returns, the value of the IRA would have been greatly affected. IRAs are particularly vulnerable to this type of risk since the IRS rules regarding Required Minimum Distribution often dictate the timing of withdrawals and not the IRA owner.
Risks of Spousal Impoverishment
In an effort to protect retirement plans, Congress has passed a variety of legislation designed to provide retirement income for both the retiree and the surviving spouse. The Retirement Equity Act was passed due to the "inequitable" possibility that the surviving spouse would receive "no survivor benefits under the plan even though the participant had accrued significant vested benefits before death."iv The concern of Congress was even more acute when the spouse was a homemaker without assets of his or her own.v To remedy this, Congress required all defined benefit plans, and most defined contribution plans, to provide a default payout option of a Qualified Joint and Survivor Annuity (QJSA). However, many plan participants choose to waive their QJSA rights and roll the retirement assets to an IRA because they want the increased liquidity, growth and control of the retirement assets. Unfortunately, these IRAs generally provide few guarantees and protection against the negative effects of poor markets.
To help address this concern, some insurance companies have created an annuity product that provides the spousal protection the government has been trying to provide, albeit unsuccessfully, for the past 30 years. Some annuities will offer certain protective riders, for an additional fee, that can address the market, inflation, longevity and timing risks inherent in all IRAs, as well as provide guaranteed income over the lives of both spouses. For instance, a Guaranteed Minimum Withdrawal Benefit (GMWB) with a "spousal" rider could guarantee a withdrawal rate beginning at age 65 over the lives of both spouses. The withdrawal rate is guaranteed regardless of market performance and regardless of how long the IRA owner and his or her spouse live.
Furthermore, some GMWBs "spousal" riders will not be adversely affected by RMDs, meaning that at any time the RMD exceeds the rider's allowable withdrawal rate, the annuity will permit such withdrawal without reducing the guarantee. In other words, the IRA owner and his or her spouse will be assured to receive the greater of the guaranteed withdrawal amount or the RMD each and every year for the rest of their lives.
When considering an annuity for use in an IRA or other tax-qualified retirement plan (i.e., 401(k), Keogh or profit sharing plan), it is important to note that there is no additional tax-deferral benefit, since these plans are already afforded tax-deferred status. Thus, an annuity should only be purchased in an IRA or qualified plan if some of the other features of the annuity are of value, such as access to specific portfolio choices, the ability to have guaranteed payments for life and other guaranteed benefits, and the policyholder is willing to incur any additional costs associated with the annuity to receive such benefits. The guarantees are backed by the claims paying ability of the issuing insurance company.
Another popular feature of some GMWBs is an automatic "step-up" feature that locks in potential market gains periodically, sometimes daily, for retirement income purposes. These step-up features help IRA owners keep up with the inevitable increase in the cost of living.
Finally, some GMWBs also offer a deferral credit feature that increases the guaranteed withdrawal balance each year a withdrawal is not taken during the initial years. Should the IRA perform well, future step-ups could increase the IRA owner's guaranteed withdrawal balance and since the deferral credits and step-ups work together, any available credits could be based off of the higher stepped-up amount. Where the RMD rules for IRAs typically fail many Monte Carlo simulations, this annuity strategy may allow IRA investors to maintain a structured withdrawal program while addressing the longevity, timing, market and inflation risks faced by many retirees. Most importantly, this income protection continues even after the first spouse dies.
Before making any election regarding retirement distributions, make sure consideration is given as to how the election could affect the surviving spouse's standard of retirement living.
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