Retirement income solutions in a DC world

Retirement income 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:

  1. Longevity Risk
  2. Investment Risk
  3. Inflation Risk
  4. Liquidity Risk
  5. Standard of Living Risk
  6. 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With the investment earnings method, interest and dividends are withdrawn and form the basis of retirement income.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.

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Inquiries or comments concerning this article may be addressed to:
Tom Dodd, CFA, CAIA, FSA
Executive Director
Pavilion Advisory Group Inc.

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