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Solutions to the Retirement Income Dilemma

Jason Stipp

Jason Stipp: I am Jason Stipp for Morningstar. Building a sufficient and sustainable retirement income stream is a critical issue in any environment, but it's especially difficult in today's tough environment for retirees. Here with me to talk about some agreed-upon solutions and also some open questions in the retirement income arena is Morningstar's Christine Benz. She is director of personal finance. Thanks for joining me Christine.

Christine Benz: Jason, nice to be here.

Stipp: So at the Morningstar Conference recently you hosted a panel about retirement income, some of the issues around it and some of the possible solutions. A good place that I'd like to start is just why is today's environment so difficult for folks who want to retire and get that income stream going?

Benz: Well, the raw materials are really challenging, Jason, so you've got a very low interest rate environment. You've got still-depressed portfolio values following the bear market. You've also got a lot of retirees who have not saved enough. In fact, there are some data showing that the typical retiree blows through his or her 401(k) plan in less than five years. And you've also got retirees who want to spend more than they have. So all of this adds up to a very challenging environment for retirees and pre-retirees.

And one other thing is that the economic downturn has hit the pre-retirees, the post-55 set, harder than the younger populations, and that has made it more difficult for them to put in place that right footing for retirement.

Stipp: So some of these issues have been around for a little while. Some of them are very newer depending on the economic environment. But a lot of folks have been thinking about what are some things that we can do, what are some solutions that retirees can take, and there are some agreed-upon solutions. So what are the things that a lot of folks are sort of coming to the same conclusion about?

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Benz: Well, one thing, and it's an outgrowth of the currently low interest rate environment, is that the idea of being able to live off of the income that your portfolio generates and maybe not touch principal--This is something that our grandparents were able to do perhaps in their retirement years when yields were much higher--that's just not a realistic possibility for most retirees, except for those who have an awful lot of wealth. So the only alternative is to take a total return approach, focus on building that nest egg, and then periodically invading principal to meet living expenses. It seems that for most retirees that's the way it's got to be.

Stipp: And a potential downside of only wanting to focus on that income, you might actually end up stretching for more income by going into higher-yielding investments that could actually be much more risky than you expected them to be?

Benz: Exactly. And that's a concern I have right now, that you could have investors really reaching into these securities for a big share of their portfolio. It's not the end of the world if you might use MLPs or perhaps preferreds, although I don't love the asset class, for a small portion of a portfolio, but I hear from a lot of retirees where they are looking to these vehicles for the lion's share of their investment assets and that does entail a certain amount of risk.

Stipp: So even if you do take a prudent total return approach, for some retirees, that still might not be enough, their portfolios have really been hit, as you said, in the downturn. So it seems like I might have some difficult decisions to make?

Benz: Well, that was one thing that came out of the panel, too, Jason. It seems that there was a consensus view that most retirees are going to have to make some hard choices. So if they cannot keep the withdrawal rate to that safe level, usually agreed-upon as 4% or so, and that's hard to generate a livable income unless you have a lot of money, if you can't keep your withdrawal rate below that level, working longer is going to be part of the solution for a lot of pre-retirees.

Stipp: So maybe taking an eraser to some of your expense and trying to get that down to a more manageable size and extending your time in the work force. So I have to say that neither of those really seem like great solutions. Is there any way to kind of make that a little bit brighter? Is there a silver lining there?

Benz: Well, I agree. It's not an appealing prospect, but Christine Fahlund from T. Rowe Price was on the panel and she presented some research that T. Rowe has done about this concept of working longer. So what T. Rowe found was that additional retirement plan contributions once you're passed the age of, say, 55 or 60, do not add a lot to your overall portfolio. So you don't benefit a whole lot from compounding if you're going to be taking the money out in 10 years or so.

So what they found was that one compromise for people in this predicament is to keep working, but forego those additional retirement plan contributions and instead spend them. So kind of start enjoying some of the benefits of retirement, start enjoying those vacations with the kids and grandkids, spend some of that money but continue working and continue building wealth, and also defer taking Social Security, which is another important lever that people can take advantage of.

Stipp: So maybe it's a way to pre-tire…

Benz: Right.

Stipp: …while you are waiting to actually retire in full.

Benz: I like that word.

Stipp: So there – given there that the retirement income, it's still – there is still a lot of folks who are thinking about solutions to this and there is some open questions out there, and some differences of opinion about some of the solutions. And some of those came out in your panel. Can you talk about some of the big ones?

Benz: The annuities were one of the key flash point areas, where on one end of the spectrum, Frank Armstrong, who is a financial planner, said that he never touches annuities for client portfolios, mainly because he is concerned about the insurance company's solvency. And I think the whole spectacle of the financial sector's downward spiral in 2008 probably exacerbated his worries, but he does not use them at all.

Tom Idzorek from Ibbotson was also on the panel. And Tom and the folks at Ibbotson have actually done some research that points to variable annuities with guaranteed minimum withdrawal benefits actually being very positive in terms of prolonging the life of portfolios and making portfolios sustainable. So differing opinions there.

Stipp: And there is also, obviously, the interest rate environment that has a lot of folks concerned, and the interest rates can't go much lower than they are, if at all. So they really only have one direction to head and that could be bad news for bond holdings. What's the thinking about adjusting portfolios to just kind of prepare for this rising rate environment that should eventually hit us?

Benz: Yeah, well, there again, we heard a variety of opinions. Frank Armstrong, actually as a matter of course, keeps client portfolios quite short, client fixed-income portfolio. So his view is that this sleeve of the portfolio is there not to be lost, so he keeps it high quality and he keeps it short term. It's not necessarily a response to the current interest environment. It's something he does always.

Tom Idzorek said, at Ibbotson, they do stake a big share of fixed income portfolios in intermediate term bonds, and it's not something they monkey with based on whatever is happening with the interest rate environment. In fact, that was one thing that came out from this panel. It did seem like there was some consensus around the idea of not actively jockeying interest rate exposure depending on what you think rates are going to do.

Stipp: Well, certainly some interesting perspectives on a very tough problem. Thanks for your insights, Christine.

Benz: Thank you, Jason.

Stipp: For Morningstar, I am Jason Stipp. Thanks for watching.