"Predictable income" is not good enough for me, by Scott Stolz, CFP, RICP (week 63)

 

I recently received an email from Bank of America that encouraged me to “start my next chapter” by enrolling in their Merrill Lynch “plan for predictable income in retirement.”  As a recent retiree and retirement income geek, I was obviously intrigued.  I was curious to see the methodology BofA/ML suggested to provide me with “predictable income for my retirement.  And just how “predictable” would it be?  A few clicks later and I found myself inputting the necessary personal information that was necessary to get an illustration of their Guided Investing advisory program.  I told the online tool that I was 66, had $100,000 to invest and wanted to start receiving income in January of next year.  I was offered three risk profiles – low, moderate and high.  The low risk profile portfolio would be more heavily weighted in fixed income and provide more what they refer to as “baseline income”.  The high-risk profile portfolio would be more heavily weighted in stocks and provide less “baseline income” initially but potentially more income down the road should stocks perform well.  I chose the moderate risk profile.

Below is the illustration generated by the online tool.

 

At the end of the day, this is a portfolio designed to follow the infamous 4% withdrawal rule.  My $100,000 investment would initially generate $3,964 in “baseline income” in year one and increase that income by 2.8% per year to cover the assumed rate of inflation.  Their methodology assumes I will live to 91.  It therefore begins to pay me additional income in year five in order to fully spend down my initial $100,000 by my presumed date of death.  I suspect however, that most clients would elect to pass on this “variable income” in order to attempt to keep their initial investment intact.  After all, no one likes to see their retirement assets decline as they age.  And dying by age 91 is hardly a sure thing.

Now, there is nothing wrong with the Merrill Lynch approach.  The 4% withdrawal rate rule has proven to be a successful retirement income strategy for three decades now.  And since Merrill’s design uses a 90% probability of success that the baseline income will be achievable until age 91, the odds are that clients that pass up the variable income will actually see their account value grow.  But there is one other thing my illustration came with – a lot of disclaimers.  As I’ve mentioned in numerous blogs, there’s just too many things no one can know – starting with how long I will actually live and what returns each year the portfolio will actually achieve (and it what order I will experience those annual returns).

That is why I’ve elected to offload most of these risks to an insurance company.  As I mentioned in a previous blog post (I Just Earned 3.3% on my Annuity. So why am I so Happy About it? by Scott Stolz, CFP, RICP (week 54), if I elect to start taking income from my Eagle Life fixed indexed annuity (FIA) next year when I turn 67, I can take 6.4% per year for as long as I live.  That’s 60% more income for each invested dollar than the BofA/ML solution.  And it will continue even if I live past 91.

Let’s think of this another way.  To generate the same $3,964 income that the BofA/ML program will pay out, I only need $61,937 in my FIA.  Since the volatility that comes with the stock market won’t impact my income, I can take the other $38,063 and invest it all in stocks to maximize growth.  I only have to earn an average of 4% per year on that $38,063 to have it grow back to $100,000 by age 91.  If I can earn 8% on average – a return that should be achievable if I’m 100% in stocks, I will have $260,000 at age 91.

A retiree would likely achieve similar results if they followed the 4% rule and likewise invested their retirement assets in all stocks.  But there are two problems with this.  The first problem is emotional.  Since the income is “predictable” rather than guaranteed, most retirees would likely get very nervous if the stock market started to fall, thereby causing their retirement balance to drop.  Many would immediately cut back on spending.  The second problem is a regulatory concern that every financial services firm faces.  A 60/40 portfolio of stocks and bonds has become the regulatory standard for the industry – particularly for retirees.  If they invest a retirement income portfolio much beyond a 60% allocation to stocks, they will expose themselves to considerable regulatory and legal risk.  It’s difficult, if not impossible, to defend a lawsuit brought by a retiree that had his or her retirement plan blow up because of an over exposure to stocks. 

Now don’t misunderstand.  I’m not advocating anyone put 100% of their retirement assets in stocks.  In reality, I’m not doing that either.  My FIA that provides my guaranteed lifetime income is essentially my replacement for the 40% of a portfolio that is typically recommended to be in bonds.  The bond portion of a portfolio both reduces volatility and provides the “predictable” income.  My FIA does the same thing.  It simply does it more efficiently and with more certainty.