While most use pre-retirement spending, the 4% ‘rule’ or a bucket strategy, some advisors apply more math and science to avoid commonplace mistakes, according to a Russell survey.
Advisors say their top challenges in serving clients near or in retirement are "setting reasonable spending expectations" (52 percent), "maintaining sustainable plans" (44 percent), and "determining sustainable spending policy" (33 percent), according to the Financial Professional Outlook (FPO), a quarterly survey of U.S. financial advisors from global asset manager Russell Investments.
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Although more than 60 percent of survey participants said that more than half of their clients are in or near retirement, there is still no clear consensus about how to create a sustainable retirement spending plan that accounts for market volatility and other unpredictable financial shocks.
"While generating sustainable retirement income for their clients is already a challenge for advisors, the eventual rise in interest rates could certainly further impact the financial security of those in or near retirement," said Rod Greenshields, consulting director for Russell’s advisor-sold business.
"With the Fed’s quantitative easing measures drawing to a close and the American economy back on line, there could be momentous implications for retirees once interest rates rise."
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By GlobalDataIn the face of challenging marketing conditions, advisors continue to struggle to find strategies which are simple for their clients to understand and yet sophisticated enough to meet an investor’s individual needs. In designing a retirement spending plan, 16 percent of advisors consider a client’s funded ratio, or the actuarial net present value of assets divided by expected lifetime liabilities.
Most take a less scientific approach. Among survey respondents, 25 percent said that they based the retirement spending plan on pre-retirement spending patterns, followed by 22 percent who chose a rule of thumb like the ‘4% rule,’ and 19 percent who used some type of time-segmented bucket strategy.
"Common approaches like the ‘4% rule’ are easy to understand, but do not account for a client’s individual circumstances and can lead to unintended mistakes," said Greenshields.
"At Russell, we think advisors would do well to follow the lead taken by defined benefit plans and calculate a funded ratio. By determining the cost of a client’s liabilities compared to the value of their assets, the funded ratio offers a superior method of evaluating retirement readiness. The math behind the ratio is sophisticated, but the outcome is a simple yet powerful percentage that most clients understand immediately. This individualized approach gives advisors the opportunity to engage with clients in a meaningful conversation about their progress toward retirement goals and the amount of risk they may need to take in order to meet them."
Understanding risk capacity
In determining their approach to asset allocation for clients near or in retirement, 38 percent of advisors said that they rely on a risk profile questionnaire to determine the asset allocation of portfolios. These questionnaires tend to define how much risk clients think they can tolerate.
This is very useful during the accumulation phase but as clients approach retirement it becomes critically important to understand how much risk their assets can handle while also funding retirement expenses. This is their risk capacity.
The investor’s funded ratio incorporates risk capacity. The ratio represents the surplus or deficit of assets necessary to fund their lifetime retirement liabilities. This yardstick helps measure the feasibility of a spending plan and it can be used to monitor and adapt a portfolio’s allocation through time.
Most importantly, the funded ratio, and any asset allocation based on it, relies on the capacity for risk as determined by the client’s assets rather than the client’s self-reported tolerance for investment risk.
More advisors like yield-focused strategies
Despite the current low yields, a majority of advisors (66 percent) believe yield-focused strategies are a good option because they protect the client’s initial investment, are sustainable, and are simple for investors to understand. But not all advisors see it this way. Thirty percent don’t like yield focused strategies for the following reasons: current yields are not attractive enough to meet clients’ retirement income needs; because yields change over time, a yield-focused strategy presents too many challenges to support consistent income; and the risk/return trade-off is too great.
"We understand why clients ask for yield-seeking strategies – they are simple and clients like the idea of preserving principal while living off dividends and interest. It seems like a safe plan to eat the eggs but spare the chicken," said Greenshields. "However, in this low yield environment, what seems simple may end up increasing risk. If income isn’t sufficient, clients have to cut back expense or chase yield."
In search of the right tool
"Reading between the lines of the research, we believe that advisors and their clients need tools that help them think and talk about how the math and science required translate into real life decisions about spending and investing," says Greenshields.
The Russell Retirement Lifestyle Solution (RRLS) is an example of a product designed to help financial advisors who are looking to scale their offering of personalized income planning for clients in or near retirement. Russell has recently streamlined the program’s planning process, improved its web-based tools and created three investment options designed for different financial and personal circumstances.
"Many baby boomers are reaching the age of 65 every day and looking for help with a difficult question: ‘Will I outlive my money?’ We believe that a retired investor’s asset allocation should adapt through time as their situation changes and as their assets grow or shrink relative to their future spending," said Greenshields.
"Our retirement program is designed to help financial advisors scale their businesses to meet the growing demand for customized retirement income planning."
RRLS offers three different model strategies – Conservative, Moderate and Balanced – designed for different funded ratios and risk capacities. Each is a globally diversified portfolio with mix of bonds, alternative investments and an equity allocation ranging from 20 percent to 70 percent of the portfolio.
The strategies are comprised of mutual funds in order to increase the flexibility that is so important for retirees. As the client’s assets and spending needs change, the client and advisor can adapt the investment strategy.
