Retirement income solutions in a DC world
In an environment where the primary source of retirement income is shifting from defined benefit plans to defined contribution plans, retirees are now faced with a new decision, how much do I withdraw from my defined contribution accounts? The first step is to encourage retirees to develop a withdrawal plan. A withdrawal plan should be developed with attention to the following risks that increase the likelihood of running out of money:
- Longevity Risk
- Investment Risk
- Inflation Risk
- Liquidity Risk
- Standard of Living Risk
- Behavioral Risk
There are a limitless number of withdrawal plans available to retirees; although, three types have gained widespread acceptance: investment earnings, systematic withdrawals and annuities.
With the investment earnings method, interest and dividends are withdrawn and form the basis of retirement income. The corpus of the assets is left intact. There are three commonly used systematic withdrawal methods: constant dollar, endowment, and life expectancy. Annuities are a series of periodic payments guaranteed for a fixed number of years or the lifetime of one or more individuals. Which of these three should a retiree choose?
We can quickly dismiss the investment earnings method as it does not address any of the risks.
The systematic withdrawal approaches offer liquidity, flexibility, upside potential in favorable markets and inflation protection. Also, systematic approaches offer lower fees than annuities. The two significant downsides are limited protection against longevity risk and investment risk.
Annuities offer exceptional protection against longevity risk and investment risk. On the downside, annuities provide no liquidity and are subject to high fees.
Since both annuities and systematic withdrawal offer their own unique advantages, one solution is to combine the two. A guaranteed minimum withdrawal benefit annuity offers a prepackaged combination of an annuity and systematic withdrawal.
The need for a withdrawal plan is compelling. Unfortunately, most retirees are ill-equipped to make a decision on how to proceed. Plan sponsors and financial intermediaries need to examine their educational focus and expand it to include resources for this important aspect of retirement planning.
Inquiries or comments concerning this article may be addressed to:
Tom Dodd, CFA, CAIA, FSA
Pavilion Advisory Group Inc.
Disclaimer: This material contains proprietary and confidential information of Pavilion Advisory Group Inc. (“Pavilion”) and is intended for the exclusive use of the parties to whom it is provided. The opinions contained within this document are those of Pavilion and is subject to change based on changes in the firm’s opinions and other factors such as changes in market or economic conditions. Pavilion has relied on the use of third-parties in the preparation of this material. While we believe our sources to be reliable, we cannot be liable for third-party errors or omissions. The information should not be construed as an offer to sell or the solicitation of an offer to buy any security and does not constitute investment advice. The content herein is intended solely for the recipient and not for broader distribution. Investing involves risk, including the loss of principal invested. Past performance is no guarantee of future results. You should carefully review and consider the applicable prospectus or other offering documents prior to making any investment. Pavilion Advisory Group is a registered trademark of Pavilion Financial Corporation used under license by Pavilion Advisory Group Ltd.in Canada and Pavilion Advisory Group Inc. in the United States. Pavilion Advisory Group Inc. is a U.S. based investment adviser registered with the U.S. Securities and Exchange Commission. Pavilion Advisory Group Ltd., our Canadian affiliate, is an investment advisor registered with the securities commissions of various Canadian provinces.