Since the introduction of individual retirement accounts (IRAs), then 401(k) plans and more recently, Roth IRAs, as ways for people without traditional defined benefit pensions to meet expenses in old age, advisors and their clients have focused most of their attention on accumulating the largest pool of assets possible. Very little thought was given to what happened when it came time to live off of those assets.
Then the financial world destabilized and long-range plans based on a perpetual bull market and lofty double-digit returns no longer seemed like such a good idea, as investors nearing retirement suddenly found their portfolios had in value dropped by 25% or more and years of savings disappeared overnight.
One lesson many advisors learned was that protecting a client’s assets can be just as important as helping to accumulate them, particularly in the five or ten years immediately preceding and following retirement. This period forms a “fragile decade” where a poor sequence of returns can have a debilitating impact on a client’s long range plans. If a portfolio suffers a significant drop in assets during this period, the abbreviated time horizon makes it almost impossible to recoup the loss. For example, a client who suffers a 33 percent decline in portfolio value at age 30 will have decades to make up the loss, but by age 60 the individual has a much smaller window of opportunity and would need to achieve a 50 percent gain to recover that loss.
Historically, advisors have sought to protect their clients during this crucial period by shifting assets toward bonds. Once clients entered retirement, RIAs would help them establish a withdrawal plan that would maintain the assets for the entire retirement period—best exemplified by the “4 percent rule” originally suggested by William Bengen in the Journal of Financial Planning in 1994.
Like much pre-2007 investment thinking however, that rule needs to be re-evaluated. In the last few years, advisors have dealt with an unprecedented array of historical and economic factors that have undermined their clients’ ability to have enough money to last their entire retirement. Simulations have predicted that, after adjusting for inflation, 6 percent of portfolios using a 4 percent withdrawal will fail in less than 30 years. Projected failure rates can jump as high as 57 percent when calibrating for current bond returns. These models do not factor an advisor’s fee, which effectively turns the strategy into a 5% withdrawal, compounding predicted failure rates.
Unfortunately for RIAs and their clients, the challenges of unsure markets and increased potential to outlive assets appear to be growing. A growing number of clients desire the benefits of a guaranteed retirement income stream but are turned off by the restrictions imposed by traditional annuities. And many fiduciary advisors are uncomfortable recommending guaranteed retirement income solutions if they cannot control how the underlying assets are invested. To meet these market needs, insurers developed the Contingent Deferred Annuity (CDA), an evolution in retirement insurance strategies.
For those unfamiliar with this new annuity innovation, the National Association of Insurance Commissioners describes CDAs as “similar to living benefit riders to variable annuities but, instead of protecting funds or assets chosen by an insurer, the policyholder chooses the underlying investment vehicle, such as a 401(k), mutual fund or managed money account.” The underwriter of the CDA agrees to make periodic payments for the holder’s lifetime after the holdings in a designated investment portfolio, which are not held or owned by the insurer, are depleted due to contractually permitted withdrawals, market performance, fees or other charges.
How CDAs Work
A CDA has three distinct phases. During the accumulation phase, while the portfolio is growing, the amount of the guaranteed annual payment is determined as a percentage of the total assets in the separately managed account. As those assets increase in value (for example through investment gains or additional deposits), the CDA benefit amount increases. Once a benefit amount has been set, the CDA guarantees that the benefit amount can never decrease due to investment losses. In other words, should the underlying assets decrease in value due to poor market performance; the CDA’s benefit amount does not decline. In this way, a CDA provides a guaranteed lifetime income stream should covered assets run out.
The second phase of a CDA is the withdrawal phase in which the participant, usually a retiree, begins to draw funds from the separately managed account. During withdrawal no benefit payments are made under the CDA, which sets a maximum periodic withdrawal amount that a participant may take. If the participant withdraws funds in excess of the contractually permitted amount, the amount of benefits available under the CDA decreases, potentially all the way to zero.
The final phase is the payout or settlement phase. Upon exhaustion of the separately managed account, the CDA begins making periodic benefit payments until the participant’s death. Once they age out of that fragile decade, policy holders may decide they no longer need the portfolio protection and can cancel the contract with no penalty.
In rethinking their approach to retirement many advisors have come to realize that proper risk management does not start at age 55 or on the day of retirement. The more traditional model focused on accumulating assets until the day the client retired, at which time a switch was flipped and the relationship became about de-accumulation, or distribution, of those assets.
Successful retirement planning for the 21st Century means maximizing principal growth by integrating risk management solutions into portfolio construction and investment strategies long before the client gets to retirement. Today’s environment demands that fee-based RIAs find solutions that protect clients of retirement age against adversity and insolvency. For many clients CDAs can be an important part of the response to that challenge.
David Stone is Chief Executive Officer of Aria Retirement Solutions
