Statements from investment companies and 401(k) plan sponsors don’t provide the information needed for retirement planning. Whether made available quarterly, monthly or on-demand, those reports are incomplete and sometimes misleading. Advisors can help overcome the shortcomings; clients need more frequent reporting that goes beyond asset-value statements and shows what their income in retirement will be.
I’ll propose the improvements that are needed.
In this June 7 Advisor Perspectives webinar, David Blanchett addressed the issue of incomplete information. In addition to portfolio balances, a more complete retirement planning picture requires projections of:
- Social Security benefits
- Future contributions to retirement savings
- Income from pensions or annuities
- Potential retirement income from housing wealth
For many clients, retirement income from those sources will far exceed amounts generated from existing savings, so the investment statements during their working years don’t provide nearly enough information.
Expanded investment statement
I’ll use an example to illustrate an expanded investment statement that includes the present values of those additional sources of retirement income. This will be based on a 45-year-old individual earning $100,000, planning to work until age 67, and contributing 15% of pay to a 401(k). This individual will receive estimated Social Security income of $38,000 per year (stated in current dollars) beginning at age 70 and has an assumed life expectancy of age 90. Existing savings are $500,000 in the 401(k) and $200,000 in taxable investments. This individual owns a home worth $400,000 with a $250,000 mortgage but will have the mortgage paid off before retirement.
Here is an investment statement that includes values for those additional items stated in current dollars.
Expanded investment statement
|
Category
|
Amount
|
|
Taxable retirement savings
|
$200,000
|
|
401(k) balance
|
$500,000
|
|
PV of future retirement contributions
|
$330,000
|
|
PV of Social Security benefits
|
$760,000
|
|
Home equity
|
$150,000
|
|
Total
|
$1,940,000
|
Source: author's calculations
But the expanded investment statement doesn’t do the whole job of providing information to clients about the status of their retirement planning and helping with important decisions. The key planning issue for clients is retirement income – its amount, variability and sustainability. In this Harvard Business Review article, economist Robert Merton criticized “communication with savers that is framed entirely in terms of assets and returns,” and argued for focusing instead on retirement income.This chart is based on the simplifying assumptions that wages grow at the inflation rate and the real risk-free rate used for discounting is zero, approximately in line with current TIPS yields. With the additional items, we see quite a different picture than one based only on investment statements for taxable savings and the 401(k). Total assets are close to $2 million and a substantial share is represented by present values of Social Security benefits and future retirement contributions – more akin to bonds than stocks. With this expanded view, a client might become more comfortable investing a substantial share of savings in stocks.
He argued that focusing on assets sends the absolute wrong signals about retirement risk. Using the above example, investing the $700,000 of retirement savings in money market funds would appear “safe” as an asset class, with minimal month-to-month fluctuations in asset values. However, a projection of future retirement income recognizing interest rate variability would show a wide variation in potential outcomes. By contrast, investing the funds in a long-term TIPS ladder in order to lock in the future level of inflation-adjusted retirement income would produce considerable month-to-month volatility in reported investment values. So the investment statements would be sending the wrong signals about retirement income risk.
A related issue is that clients and advisors who focus on investment statements view bond funds as risky given the likelihood of future interest rate increases that will lead to capital losses. But as I argued in this 2013 Advisor Perspectives article, the vast majority of clients will benefit from such increases because the present value of future retirement expenses will decrease by more than the decrease in bond fund values, reflecting the longer duration of such expenses.
There are also tax issues that distort the relationship between investment-statement values and potential retirement income. Professor William Reichenstein has made the case in numerous articles, such as this one, that tax-deferred savings should be thought of as a partnership between the investor and the taxing authority with the taxing authority’s share equal to the estimated marginal tax rate at the time funds are withdrawn.
In the above example, if the applicable tax rate were 25%, the $500,000 401(k) balance would be split $375,000 for the investor and $125,000 for the government, and the $375,000 would effectively be a tax-free investment. By those calculations the investor’s asset value would be $375,000 rather than the $500,000 shown on the 401(k) statements, or 1.875 times the $200,000 value of taxable investments. But because the $375,000 is tax free and the $200,000 is taxable, the ratio of retirement income generated will be greater than 1.875. If we assume a 25% marginal tax rate, investments held in bonds earning a nominal 2% yield, 22 years until retirement at age 67 and 23 years in retirement, the $375,000 would generate $31,072 of retirement income, the $200,000 would generate $14,144 and the ratio would be 2.20.
It turns out that neither the 401(k) statement value of $500,000 nor the recalculated $375,000 investor’s share provides an accurate picture of retirement income potential relative to a taxable account, and income potential is what matters to the investor. This is another reason why projected after-tax retirement income is a more useful measure than asset values, even with adjustments.
Another problem with providing asset values to clients is that most individuals have a poor understanding of the relationship between them and the amount of income they generate. In the 2016 NBER paper “Cognitive Constraints on Valuing Annuities,” a group of economists headed by Jeffrey Brown reported on a large survey where respondents were asked about tradeoffs between future Social Security income and lump sums. One finding was that when respondents were asked how much they would pay for an additional $100 per month of Social Security income, the midpoint response was $3,000. This compares with a median actuarial value computed by the authors of $16,855. This difference in the subjective response versus actuarial value indicates that reporting asset values to clients, even with appropriate adjustments, is more likely to confuse than inform.
Providing a clear picture to clients will require shifting the focus to income.
Retirement income statement
The following chart provides a simplified example that takes the asset-based investment statement and turns it into an income statement.
Prospective retirement income statement for an age 45 worker
|
Source of income
|
Annual amount after-tax
|
Income starting age
|
Inflation increases
|
|
Taxable retirement savings
|
$7,143
|
67
|
YES
|
|
401(k) at age 45
|
$15,563
|
67
|
YES
|
|
Future 401(k) contributions
|
$10,271
|
67
|
YES
|
|
Social Security benefits
|
$29,925
|
70
|
YES
|
|
Reverse mortgage tenure payment
|
$13,409
|
67
|
NO
|
|
Total
|
$76,311
|
|
|
Amounts of retirement income stated in 2016 dollars
Source: author's calculations
Developing this chart involved a two-step process. I brought all age-45 taxable and 401(k) savings forward to age 67, conservatively assuming a 2% nominal return and 2% inflation (zero real return). Next I converted the age-67 savings to annual income amounts by making the artificial assumption that such savings will be converted into inflation-adjusted single-premium immediate annuities (SPIAs). I used current SPIA pricing for a 67-year-old female from the pricing information service CANNEX, which produced a payout rate of 4.15%.
My rationale for using an inflation-adjusted SPIA was based on the argument made by Professor Moshe Milevsky (in this article) that the price of an inflation-adjusted SPIA is the appropriate benchmark for retirement-income calculations. Although all asset values are converted to annuities for the income projections, I’m not recommending that they be annuitized; the objective is to convert all values to a common measure of income potential.
Income amounts are reduced for taxes, as applicable, based on the assumed 25% marginal rate, and dollar amounts are stated in current dollars as of age 45. All income except the reverse mortgage payments assume annual inflation-adjusted increases. The reverse mortgage annual payments are based on a tenure option, which guarantees level annual payments for as long as the recipient remains in their home. Such payments are guaranteed to continue even if the home equity has been depleted. For this example, the tenure payment was determined using the online calculator provided by the National Reverse Mortgage Lenders’ Association (NRMLA).
Pros and cons
This income statement is deliberately oversimplified and utilizes a conservative return assumption. Arguments could be made that a best estimate of future returns should replace my zero real return assumption and that projections should show the potential variability of retirement income, perhaps based on Monte Carlo simulations. However, there is a tradeoff between providing comprehensive information versus creating confusion.
Another possible shortcoming of the approach I have outlined is that it does not address asset allocation – how to determine optimal mixes of asset classes for taxable investments and 401(k)s. It’s worth reemphasizing the point I made earlier that an expanded view, considering all potential income sources, points toward optimal investment portfolios heavily invested (or even 100% invested) in equities, in part because it illustrates the fixed-income nature of a client’s other assets (e.g., Social Security and home equity). The asset allocation decision may depend more on client risk tolerance than on financial optimality. Having an income focus that recognizes all potential income sources may help build more tolerance for investment portfolio fluctuations than when investment portfolios are the sole focus.
Even though this income statement is simplified, it focuses on the right direction for retirement planning. Projected retirement income will be increased by earning more, saving more, working longer or earning higher returns. An increase in interest rates, which will raise SPIA payout rates, will also raise projected retirement income. Having such an income statement provides much more meaningful information than asset amounts.
For such a retirement income statement to be an effective tool, it needs to be updated frequently enough and made easily available to clients so that it can supplant the investment and 401(k) statements that used to be sent out either monthly or quarterly but now are readily available online. Providing comprehensive retirement income projections should be a natural fit for robo-advisors if they are able to shift their focus beyond asset accumulation.
Final word
The David Blanchett webinar I referred to earlier made the case that “No Portfolio is an Island” and that a broader view is needed of all the resources clients can utilize to generate retirement income. This broader view will be further enhanced by a translation from asset values to projections of future income.
Joe Tomlinson, an actuary and financial planner, is managing director of Tomlinson Financial Planning, LLC in Greenville, Maine. His practice focuses on retirement planning. He also does research and writing on financial planning and investment topics.
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