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Financial tradeoffs common in retirement

By: Humberto and Georgina Cruz

Retire Smart

Here's our problem: We want our money to be safe in retirement and to earn a good return. We want it to provide an income that lasts as long as we live and keeps up with inflation.

And we want our money to be readily available in case of emergencies or to pay for special needs or wants, and still have some left to pass on to heirs or a favorite charity.

The problem is that our goals - typical of retirees - conflict with one another. Aside from the mega-rich, the rest of us will have to make tradeoffs among these competing goals to satisfy both our financial and emotional needs.

We have come to this realization as we grapple with the challenges and potential pitfalls of managing our money in retirement. So, it was with great personal interest that we came across a new research report that validates our thinking and suggests we are on the right track.

The report by the Fidelity Research Institute, "Structuring Income for Retirement," discusses the "complex interplay" among a variety of risks retirees face, such as increasing longevity (the risk is living "too long" and running out of money), inflation and market volatility.

And it makes the case that, just as we are wise to diversify our investments, it makes sense for retirees to utilize - or at least consider - a variety of approaches to generate lifetime income.

Specifically, the report discusses how retirees can create a "personally optimal" retirement income stream by assessing combinations of three basic options for generating income in retirement. These include:

- Lifetime income annuities that provide income for life in exchange for a lump-sum premium and therefore offer "longevity insurance."

- Variable annuities with so-called living benefits that guarantee a minimum annual withdrawal for life. The withdrawal amount can go up if the underlying annuity investments do well. Unlike what happens with lifetime income annuities, account holders retain access to their account value and the potential to leave a bequest.

- Traditional systematic withdrawal plans with diversified investments in stocks, bonds and cash. The retiree draws from a diversified portfolio "systematically," typically at a conservative rate to minimize the risk of running out of money. A common strategy is to withdraw from 4 percent to 5 percent of the portfolio value the first year in retirement, increasing the amount each year to keep up with inflation.

Each option plays a different role, and each can partially or fully hedge various retirement risks but with different costs and tradeoffs, said Van Harlow, managing director of the Fidelity Research Institute, part of Fidelity Investments.

For example, if you're particularly concerned about inflation, systematic withdrawals should be a significant source of retirement income because, over time, a diversified portfolio has provided returns that outpace inflation.

But if the certainty of receiving a known payment every month is important regardless of the ups and downs of the market, the lifetime income annuity may be most suitable.

Meanwhile, variable annuities with minimum lifetime withdrawal guarantees can hedge against longevity, inflation and market risk. The tradeoff is that they come with higher costs that lower their return compared to that of similar investments without guarantees. We found their inclusion in the Fidelity report significant because the company does not currently offer this type of annuity.

"It is important to note that no one option absolutely dominates the others," Harlow said. "For every person the answer is different" as to which option, or mix of options, is more appropriate.

With our money, we rely mostly on systematic withdrawals from a diversified portfolio. But we also own a variable annuity with a minimum lifetime withdrawal guarantee, and are looking to add a lifetime income annuity with inflation protection. The annuity options address as much our emotional as our financial needs, a topic we'll discuss next week.