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Many Americans who are contemplating retirement look back to the days when their parents or grandparents received lifetime incomes from their employers. For them, employer pensions continued for the lives of both husband and wife, and the monthly check was often adjusted upward to reflect the cost of living. These were the halcyon days of the qualified defined-benefit pension plan (QDBPP).
Unfortunately, the QBDPP has gone the way of big hair and telephone land lines. Such plans are available for some, but for most they are a relic from a bygone era.
And yet many near-retirees assume they’ll have an income for life. Some think Social Security will take care of the bulk of their financial needs during retirement. Others think they will be able to keep working until they die, thereby acting as their own source for an ongoing income. And yet others assume their 401(k), SIMPLE or IRA accounts will continue payments indefinitely. Regrettably, there are the many who simply put the issue out of their mind – until it’s too late.
These common misconceptions are not entirely the fault of the near-retiree. The decline in QDBPPs has only been a recent trend. There remains a lot of talk in the financial press about solutions that may eventually be available. It’s easy to understand how consumers can be confused about what is talk and what is real.
One culprit has been the government. Consider the myRA offered during the Obama administration. This simple solution was going to provide base-line retirement savings for a large cohort of the underserved population. It got a lot of media attention when introduced, but almost none when in 2017 it was announced that the program would be phased out. Similarly, several states claimed they were going to solve the retirement crises by mandating their own retirement plan requirements for employers. This has been more talk than action. And the federal government recently made similar claims with its highly touted bipartisan year-end retirement reform legislation. But a bill is not a law, and the reforms intended to reinvigorate defined benefits never came to fruition. Indeed the government was shut down instead.
The financial services industry has made its own attempts at filling the void left by the departure of QDBPPs. Some creative concepts seemed promising. An example is the so-called managed payout fund. Managed payout mutual funds are designed to provide investors with equal monthly payments. So, a particular payout fund might be structured with the objective of providing a 4% income to investors indefinitely. Many of these attempts at creating portfolios with lifetime income were victims of bad timing. The failure of a number of managed payout plans was hastened by the Great Recession.
Where do we stand now? Ignoring the clutter of what seems like a good idea or what is still in the proposal stage, are there any tangible ways an individual can build a defined benefit element into his or her retirement income portfolio? Is there a way to structure a floor income during retirement that can’t be outlived?
The answer is yes, but you must look to new places to identify the source of the defined benefit. Below are strategies that are available to help create a defined, lifetime income.
Annuities
Professor Wade Pfau at the American College of Financial Services has argued that annuities effectively serve as “actuarial bonds”. They mimic many of the features of bonds but have the added ability to continue their income streams for life – no matter how long that lasts. Driving this longevity feature are the “mortality credits” associated with annuity pricing. Essentially, if you outlive the average, you get a credit in the product. The expense associated with this feature may well be acceptable to a retiree because the annuity assures a lifetime income.
Originally, the annuity as a defined benefit meant buying a single-premium immediate annuity (SPIA), but with the turn of the century came a revolution in annuity-contract design. Some individuals wanted to delay deciding when to take payments while others didn’t necessarily want the payments to exhaust the value of their contract. An early answer to this market demand was the guaranteed withdrawal minimum withdrawal benefit (GWMB). The basic idea is to take a deferred annuity and add a rider which guarantees the policyholder a steady stream of retirement income regardless of market volatility. This way the policyholder locks in the right to withdraw a fixed income stream and not worry about how the stock market is helping or hurting the contract principal. While these riders were particularly popular prior to the Great Recession, they are still available to policyholders, but at more conservative payout levels.
Another annuity design revolution, and one particularly good for retirement-income planning, is the deferred-income annuity (DIA). Rather than be all things to all financial needs, this design focuses solely on providing a defined benefit. In its simplest form it says, “give me a pot of money, tell me when you want to begin your income, and we will guarantee you a pre-determined income for life.” These annuities cannot be surrendered for cash and are void of riders. But because of the stripped-down nature of the contract, they allow the insurance company to price defined-benefit payouts attractively. The internal rate of return on a DIA will typically be higher than on a traditional nonqualified deferred annuity.
Not to be overlooked is that DIAs can be funded with qualified-plan money. This option, called a qualified legacy annuity contract (QLAC), allows the employee to create a defined benefit out of his or her 401(k) or IRA. The retiree can name the age when the benefit should begin. Once the payout begins, it continues unencumbered by both the market and the required minimum-distribution rules.
Reverse mortgages
Notwithstanding the campy late-night TV commercials about this concept, for many individuals reverse mortgages represent an attractive means of locking in a defined-benefit payment from a bank. The basic idea is that individuals age 62 or older can use roughly 50% of the equity in their houses to generate an ongoing income paid by a mortgage lender. Instead of borrowing a lump sum of money from the mortgagor by posting the equity in the home as collateral, the process is reversed. The equity in the house is used to create a monthly income, causing the loan balance to increase. However, no matter how long the payout continues, the loan balance cannot otherwise be foreclosed. This is specifically for the tenure-payment option, and it provides a defined benefit for as long as the person remains eligible.
Similar to an annuity, this form of reverse mortgage effectively has mortality credits. The reverse mortgage requires that the mortgagees remain in their homes and maintain their property (i.e. remain eligible), in which case they have a government backed source of income for life. Much like the QLAC benefit discussed above, there are restrictions that apply, but a reverse mortgage is a means of obtaining a defined-benefit payout for consumers fortunate enough to have equity in their homes.
Bonds
It used to be common for retirees to place a significant portion of their retirement capital in bonds. Often mixing government bonds and highly rated corporate bonds, the semi-annual coupon interest created a source of retirement income. The bonds represented a defined-benefit income source in the sense that the bonds typically had long maturities and the retiree wasn’t planning to ever sell them.
This approach still works. Many bonds have long maturity dates, plus any proceeds can be reinvested in other bonds. Further, with some advanced planning bonds can prove even more productive as a defined-benefit income source. A bond ladder strategy helps match cash flows with the demand for cash. By investing in a basket of bonds with different maturities, the retiree can lower the interest-rate risk associated with reinvesting bonds as they mature. For example, five bonds could be purchased, one with a three-year maturity, one with a five-year maturity, one with a 10-year maturity, and so on. As a particular bond matures, it can be reinvested in a bond that best reflects current market conditions. This way, the investor is not saddled with owning only one long-term bond that, in an inflationary market, may lose both purchasing power and underlying value. Further, this strategy offers more chances for liquidity if the retiree runs into a situation where she needs to invade principal.
Funds
Financial planners often talk about having the retiree keep part of the retirement portfolio in equities and part in fixed income investments. The fixed income investments, for example bonds, represent the source of the defined benefit, while equities, i.e. stocks, are the source of growth. This distinction tends to blur the defined-benefit opportunities available from mutual funds and ETFs that have both equities and fixed income securities. In particular, the target-date fund strategy is useful as a funding vehicle for a defined-benefit strategy. It doesn’t provide a defined benefit, but as its name implies it targets a date at which a defined benefit will begin.
Similar to bond ladders, the idea is to buy mutual funds specifically designed to for a target date. Thus, a 2030 target date fund would begin with a heavy weighting of stocks, but as time transpires, the fund slowly moves towards a weighting of fixed income securities and, ultimately, cash. In contrast, a 2025 target date fund would start with more of a fixed income weighting because its target is coming sooner. These funds don’t pay out a defined benefit when they reach the target date, but they provide a funding mechanism for when a defined benefit income is sought. For example, a person planning on retiring in 2030 invests in a 2030 target date fund. When the time comes, the new retiree can use the mutual fund as a lump sum to purchase an annuity or to begin a bond ladder.
Mutual funds generally aren’t seen as a defined-benefit source because they are dealing with targets, not guarantees. Similar to the managed payout funds discussed in the introduction, targets don’t always translate into results. But, mutual fund and ETF product designers have been mindful of offering products that focus on decumulation, not just growth. In the right situation, some of these funds may supplement a defined benefit strategy.
Life Insurance
Life insurance primarily addresses the risk of dying too soon. In many ways, it is the antonym of an annuity. Still, it can be an important way to assure a defined income during the retirement years. First, consider the retirement income risk associated with the death of a spouse. The death benefit from life insurance provides a hedge for the surviving spouse when there is lost income associated with a spouse’s death. Consider, for example, the financial burden of end-of-life medical funeral expenses. Life insurance can provide lump-sum cash benefits that cover these costs, thereby avoiding the depletion of retirement capital for the surviving spouse. Similarly, where a lifetime income is being measured on only one of the spouse’s lives, life insurance proceeds at that spouse’s death can provide the funds needed to create a new annuity income for the survivor. With the mortality risk of a dying spouse covered by life insurance, the defined benefit income can continue.
A second use of life insurance as a defined benefit is to provide a more tax efficient income stream at retirement. For example, consider how a cash-value life insurance policy owned during working years can be re-tasked when the worker retires. Premiums were originally paid into the policy to assure that a death benefit was available in the event of a premature death. But at retirement, assuming enough premiums were paid in, the premiums can cease, and an ongoing income can be drawn from the policy’s cash values.
The tactics for generating this income stream depend on the nature of the policy and the tax needs of the retiree. One approach is to annuitize the policy’s cash value either internally or by making a tax-free exchange of the cash values to a separate annuity. The policy has switched from protecting income in case of death to paying out a defined income during life. Another approach is to take an income from the policy by making tax-free withdrawals from the policy cash value up to the policy’s tax basis and then switching to net loans. Some insurance companies can structure this transaction so that the payouts are automated, and even so the exhaustion of the cash values does not generate a taxable event.
Another use of life insurance is to provide a defined benefit upon a triggering event during retirement. This involves life insurance policies that have accelerated benefit features. With the right policy, if the retiree has a chronic illness or a long-term care event, the policy can begin paying out monthly benefits from the policy’s cash values. Some life insurance policies provide long-term care as an accelerated benefit feature, while some have standalone long-term care benefits. With age comes the increased risk of an illness or a need for long-term care. These additional features in life insurance contracts are, essentially, another way to define an income benefit during retirement.
Business owners
For many small business owners, the primary source of retirement income is the equity in their businesses. This represents a retirement planning challenge because it is difficult to convert an illiquid, undiversified asset into a defined stream of income for life. Still, there are ways.
If the business is intended to be the owner’s retirement fund, the obvious choice is to sell the business to create an income. An installment sale is a common means of both spreading out the seller’s tax liability and generating an ongoing source of income. There are two closely-held business sales techniques that are specifically designed to generate a lifetime defined benefit payout: the private annuity and the self-cancelling installment note (“SCIN”).
The private annuity concept has regained popularity as a means of structuring the sale of a business, particularly with family-owned businesses. The owner sells his shares, typically to an adult child involved in the business, for a lifetime income. The payments are calculated to be the actuarial equivalent of the present value of the business. This way the seller is assured he will receive a lifetime income from his ownership. The buyer receives a windfall if the seller dies prematurely but risks an extended obligation if the seller exceeds life expectancy.
A second way of structuring a sale is the self-cancelling installment sale (“SCIN”). A SCIN entails the sale of the business for a typically long installment period, but with a provision that if the seller dies before the end of the installments, the buyer’s obligation ceases. For the seller, the SCIN’s long installment period represents a defined-benefit income; for the buyer, there is an incentive to agree to a higher payout since the seller may predecease the installment period.
Social Security bridging
Most people know that Social Security retirement benefits represent an on-going defined benefit. What they may not know is that through the proper use of other investments and assets in the retirement portfolio, the Social Security defined benefit can be enhanced. So-called bridging strategies can cause the total benefit received during retirement to be larger.
There is financial leverage in a bridging strategy because of two core aspects of Social Security. First, the retirement benefit increases approximately 8% with each year the retiree waits to claim benefits (up to age 70); and second, once the benefits begin, they are inflation adjusted. Accordingly, if a retiree has other assets available to withdraw as an income, it is generally better to exhaust these assets first, giving the eventual Social Security benefit time to increase. Two examples demonstrate this concept:
An executive is eligible to receive a deferred compensation benefit at retirement. Since these employer benefits are rarely inflation adjusted, if the executive retires at 62, she should take her deferred compensation over three years, and elect to begin taking her Social Security benefit at age 66 (her fully insured retirement age). By making this delay, her monthly Social Security benefit would be approximately 25% higher. She has effectively used the employer plan as a income bridge, giving time for her Social Security benefit to increase significantly.
Say, instead, a person is the owner of a small business, and is planning to retire at age 65. He wants to use the sale of his business as a supplement to his government benefit. This owner could sell his business using a 5-year installment note. The installment payments would provide a defined payout to the seller from age 65 to 70. At age 70, he would then elect Social Security and receive the maximum available benefit. This bridging strategy helps lock in a higher overall defined benefit.
DIY defined benefits
According to a recent study sponsored by The American College of Financial Services , on average consumers expect to live to age 86. Thus, the average expectation is for an approximately 20-year retirement period. Nearly three in five of those in the study say having monthly guaranteed lifetime income in addition to Social Security is very important.
Yet the percentage of non-governmental companies that actually offer a QDBPP is in the teens. Most Americans must initiate their own strategies for creating an income they can’t outlive. Many techniques exist for generating a defined benefit income, but all require planning.
Steve Parrish, JD, RICP®, CLU®, ChFC®, AEP®, is an adjunct professor and Director of the New York Life Center for Retirement Income at The American College of Financial Services, and interim director of the Compliance and Risk Management program at Drake University Law School. He can be reached at [email protected]
Read more articles by Steve Parrish
